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Is David Swensen Lucky or Good?

David Swensen has been the chief investment officer of the Yale Endowment Fund since 1985. He has authored two books I highly recommend, Pioneering Portfolio Management and Unconventional Success. Because of the success of Yale Endowment Fund -- a 20-year annualized return of 15.6 percent through fiscal 2007 -- Swensen is one of the most respected investment managers in the world.

The success of the Yale Endowment Fund raises an interesting question: Why haven't other similar endowment funds, run by other very smart people with large resources at their command, generated these kinds of returns? In other words, is Yale's success a result of manager skill, a result of exposure to risk or perhaps a lucky random outcome?

Peter Mladina and Jeffery Cole sought to answer that question in their study "Yale's Endowment Returns: Manager Skill or Risk Exposure?," which was published in the summer 2010 edition of the Journal of Wealth Management. The following is a summary of their findings:

  • For their public equity holdings, the returns are fully explained by exposure to risk factors and not manager skill. The endowment's exposure to small-cap and value stocks provided the excess returns over the Wilshire 5000 (the chosen benchmark). A similar result was found internationally. While the endowment beat its benchmark (MSCI EAFE Index), the outperformance was explained by exposure to emerging market stocks and the same Fama-French risk factors. In other words, the benchmarks were wrong.
  • The private equity managers they hired added value. It's important to note that private equity is the one asset class or investment category in which there is some evidence of persistence in performance. (Though this isn't true for hedge funds.)
The implication is that the endowment's private equity exposure -- venture capital in particular -- has been the unique source of its excess return.

The authors found the same results when they studied the last 10 years of the period. Thus, they concluded that Yale's returns can be explained by consistent exposure to diversified, risk-tilted, equity-oriented assets and extraordinary outperformance in private equity (and venture capital in particular). Outside of private equity, the endowment appeared to underperform risk-adjusted benchmarks.

The authors concluded that any disciplined investor with a high risk tolerance could replicate Yale's results using publicly available index funds and some degree of leverage. They added that they saw value in Yale's broad diversification across asset classes with relatively low correlation.

The implication is striking: If Yale, with all of its resources, can't identify the future alpha generators, what are the odds you can? This is why I believe that active management is the triumph of hype, hope and marketing over wisdom and experience.