Yale University has had one of the best-performing endowment portfolios over the past decade and more. Yale’s Chief Investment Officer, David Swensen, farms out all of the money to outside managers, watches costs, and diversifies broadly. He believes that an equity-oriented portfolio is necessary for growth, but one of his hallmarks has been significant exposure to alternative assets that might provide equity-like growth. Yale’s endowment typically maintains a 15-25% exposure to private equity and includes investments in hedge funds as well, so it’s not something that can be easily replicated by Mr. Jones.
In an article, “A New Yale Tale,” in the most recent issue of Financial Planning, Craig Israelson, Ph.D, a professor at BYU, asks the following question:
The Yale Endowment Fund has excelled through all kinds of markets. Is it possible to build a similar portfolio that is accessible to everyone?
He goes on to build a multi-asset replication portfolio that owns 12 equally weighted ETFs.
Beneath the seven core asset classes in the multi-asset portfolio are 12 ETFs in the following sub-asset classes: large-cap U.S. equity, mid-cap U.S. equity, small-cap U.S. equity, developed non-U.S. equity, emerging non-U.S. equity, global real estate, resources, commodities, U.S. aggregate bonds, U.S. Treasury inflation-protected securities, non-U.S. bonds and U.S. money markets. The 12 ETFs have equal weights and are rebalanced annually.
This is an elegant solution and Dr. Israelson provides a nice table of returns that shows how the multi-asset portfolio, while not quite on par with Yale’s endowment, performs much better than the Vanguard 500 Index and the Vanguard Balanced (60/40) Index over the last decade. In addition, the volatility is much lower than Yale’s portfolio. How does it accomplish such a feat?
Both the Yale Endowment and multi-asset portfolio view alternative assets as critically important components of a well-diversified portfolio. Why? Because including nontraditional assets enhances performance and reduces risk.
There is some truth to this in terms of including alternative assets in the mix, but it is also the case that almost every asset class performed better than domestic equities over the last decade. Owning mid-caps, small-caps, commodities, and resources ensures that you did much better than the Vanguard 500 over the last ten years-but what about the next ten years? What happens if domestic equities are one of the top asset classes going forward? A passive portfolio with a fixed (and limited) exposure to stocks might lag substantially.
One possible solution to this problem is the Arrow DWA Balanced Fund (DWAFX). It has many of the attributes of the Yale Fund: it is equity-oriented, with holdings in domestic and international equities, but also includes fixed income and alternative assets like precious metals, real estate, and inflation-protected securities. Unlike the passive 12-ETF portfolio, however, the allocations are made tactically and the size of the allocation can vary (within a range) depending on the current relative strength of an asset class. This gives the portfolio wide latitude to adjust its exposure as market conditions change. In other words, good performance is not so dependent on the next ten years looking like the last ten years!
click to enlarge
Click here for a historical performance disclosure.
Above we have replicated Dr. Israelson’s table of returns, but we’ve added a new column for DWAFX. Using the tactical strategy over the last decade has resulted in both higher returns and lower volatility than the 12-ETF solution. The key gain from a tactical approach is flexibility-the asset weights are not fixed and thus can respond to new environments. Higher returns and lower volatility are a pretty nice combination for investors looking for both stability and flexibility in their long-term portfolio. DWAFX’s trailing three-year performance is in the top 15% of all moderate allocation funds according to Morningstar (as of 3/11/2010). If you have a client looking for a foundational product for a portfolio, DWAFX might fit the bill. You can find at more at Arrow Funds.
Posted by JP Lee 
