The Yale Endowment Model

Welcome to the 88th Pari Passu newsletter.

After our AutoZone Deep Dive last week, today we are diving deep into a less-known concept: the Yale Endowment Model.

The numbers tell us some of the world’s largest pools of private wealth lie in the endowments of America’s elite institutions. The six universities with the largest endowments own approximately $200bn in combined assets. Leading all schools is Harvard University, with an endowment of $50bn as of 2022. In today’s deep dive, we will explore the world of college endowments – why they exist, why they hold so much wealth, and their effect on society as a whole [3].

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Alright, let’s now get to the post!

History of College Endowments

College endowments have not always existed. It was not until the early 1800s that American universities began to actively fundraise. The earliest institutions to begin fundraising were Harvard and Yale University. Since these schools were cut off from state funding, they turned to other avenues for fundraising, namely via alumni grants and donations [2].

However, the endowment landscape would rapidly shift beginning in 1889 when American industrialist and multi-millionaire Andrew Carnegie published “The Gospel of Wealth”. In this highly influential piece, Carnegie argued that the wealthy should use their money and influence for the greater good of the common public. Having achieved an inflation-adjusted peak net worth of $310bn, Carnegie would go on to donate over 90% of his fortune to foundations and charitable organizations [2].

With Carnegie leading by example, he would begin an era of foundation culture and philanthropy, in which the wealthiest Americans began contributing significantly to various foundations. A major recipient of these donations would be colleges and universities. By 1977, American institutions held an inflation- adjusted $15bn in endowment assets. Naturally, as more advanced models were developed, university endowments grew larger and larger [2].

Current State of College Endowments

As of 2023, endowment assets of U.S. institutions total approximately $839bn, which is equivalent to the twentieth largest GDP in the world [2].

While these elite institutions have done so well in accumulating such large pools of wealth, it begs the question: why?

There are a few key motivations behind maintaining an endowment fund:

• Rainy day funds: Many institutions explain that the function of their endowment is to serve as a buffer against economic recessions. Essentially, the endowment is an emergency fund that can be accessed when the university’s operating revenue is insufficient to match its expenses [1] [2]. 

• Inflation protection: Another important function is that endowments serve as protection against monetary inflation. Many top institutions state that university costs increase at a faster rate than inflation – therefore, the endowment is necessary to match those costs [1].

• Prestige: Likely the strongest motivation for an endowment fund is the simple fact that money buys prestige and influence. The simple fact of having a large endowment is a symbol of power and prestige that boosts the public image of that university. Furthermore, it means that the university has more money to expand/renovate its campus, attract student applications, and hire renowned faculty [2].

• Financing university expenditures: A large majority of university endowments are sourced from alumni donations. However, most of these donations are restrictive, meaning the donated money must be utilized for a specific purpose, determined by the donator. One donator may want the money spent on a new laboratory; another may want it go towards a new research grant. Therefore, universities pull from their endowment to finance these projects [2].

Interestingly enough, the concept that endowments are used as rainy day funds is a misconception. Annually, only about 5% of total university endowments are spent. However, whenever the economy experiences a downturn, endowment spending typically decreases. Instead of taking a larger portion of the endowment to bolster university financials, universities actually spend a smaller portion of their endowment. This is contrary to the idea that endowments function as buffers against recessions [2]. 

Endowment funds are generally allocated into two main categories: investment and spending. In 2018, Harvard reinvested approximately 95% of its endowment while allocating the remaining 5%, about $1.8bn, as that year’s operating budget. Most elite institutions adhere to similar practices [2].

A question that naturally arises is why universities don’t eliminate, or greatly reduce, the cost of tuition by using their endowment. In fact, Harvard, for instance, could eliminate tuition for all of its students, both undergraduate and graduate, and maintain current spending patterns without spending more than 10% of its endowment. Unfortunately, this is impossible due to donor restrictions, which limit how endowment funds can be spent. For context, 90% of Stanford University’s $27bn endowment are considered restricted funds. However, one university that has eliminated tuition for all of its students is a small, top-ranked liberal arts college in Kentucky, Berea College. With a total endowment of approximately $1.5bn, the college does not charge tuition for its students by accepting a small student body, minimizing capital expenditures, and allocating 5% of its endowment to cover tuition costs [1] [2] [4].

The Yale Model

Total U.S. university endowments have grown from $15bn in 1977 to $839bn in 2023, computing to an astounding 5493% change. In this section, we will be exploring the transformative model that most elite institutions have adopted to achieve such substantial, consistent growth: the Yale Model.

Core Principles

The Yale Model was originally developed by David Swensen, who served as the President and Chief Investment Officer of the Yale endowment fund, and his colleague Dean Takahasi in the mid-1980s. At the time Swensen took over the Yale endowment, the endowment landscape was very new and underdeveloped. At the time, universities placed little emphasis on growing their endowments and endowments were magnitudes smaller than they are today. The model that Yale was using was a very basic 60% stock and 40% bond model that performed poorly. This model minimized risk by investing in low risk, liquid securities, such as bonds [7].

Before we dive into the specifics of the Yale Model, let’s examine Swensen’s framework and key investing principles that he outlined in his book, Pioneering Portfolio Management. These principles form the core of the Yale Model [4]:

1. Equity bias: Investors approach markets with a strong bias towards equity, since accepting the risk of equity investment rewards investors with higher long-term returns. In other words, investors will be more inclined towards investing in equity due to the prospect of superior returns.

2. Diversification: Concentrating investment in a single asset class generates a significant amount of risk to the overall portfolio. Diversification is a simple way to massively reduce risk without sacrificing expected returns.

3. Alignment of interest: As is human nature, fund management suffers from decisions that are made against the best interests of asset principals and instead for personal interests. In other words, fund managers are susceptible to conflicts of interests, such as favoring investment in certain assets that they hold stake in. However, evaluating all involved parties in investment activities with skepticism can help reduce the negative impact of major conflicts of interest.

4. Search for inefficiency: Capitalizing on market inefficiencies in various asset classes is key to generating significant returns. Due to the wide range of assets available, diversification can be achieved through specialization of external managers of individual asset classes.

Capital Allocation

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