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In recent years, Yale University's Endowment has received much well-deserved attention for its exceptional performance. With a 20-year compound return of 15.6% annually through fiscal 2007, it arguably has generated the most impressive returns of any managed institutional portfolio over the past two decades. The university's Investments Office is highly regarded. Many institutional and private investors are trying to emulate the Endowment's investment approach. In order to understand whether or not the Endowment's success has investment implications for private and institutional investors, we decided to study in more detail the underlying factors that drove the Endowment's remarkable returns.
Financial economists and investment practitioners have spent years researching and debating the drivers of return in diversified portfolios. Among the questions we address in this article:
* Do the Yale Endowment's returns depend more on strategic asset allocation and exposure to common risk factors or on the use of skilled investment managers who can select securities and time markets?
* To what extent has the Endowment's success been driven by investment in public versus private markets?
We find that exposure to common equity risk factors and manager skill in private equity are largely responsible for the Endowment's returns. These key findings may have significant implications for private and institutional investors who are seeking manager skill across asset classes.
A UNIQUE CASE STUDY
In addition to 20 years of portfolio data and returns in the public domain, Yale's highly stable Investments Office has employed longterm strategic asset allocation. With the aid of public disclosures including the Yale Endowment's annual reports and the Harvard Business School case study on the Yale University Investments Office, we were able to study the Endowment's gradual transition from a conventional public-markets strategy to one capitalizing on alternative investments - notably private equity, real assets, and hedge funds. The 20-year time frame also helped minimize the smoothing of returns associated with the valuation of private assets.
For purposes of this analysis, we go on the initial premise that total return within diversified portfolios is driven by two primary sources:
* Expected return, which is driven by nondiversifiable risk exposures that determine cost of capital (to be later defined as beta, size, and value);
* Excess return, which is the component of total return...