Making the Grade: Investing Like the Ivies

Jan. 24, 2008 — -- The major university endowments have recently received much attention for their stellar investment records, and deservingly so.

The fiscal year that ended in June proved to be another banner year for the colleges, with Yale scoring an amazing 28 percent return, by far trumping the 18 percent return for the S&P 500 during the same period.

What is more remarkable is that in the last decade, Yale delivered an 18 percent average annual return while the S&P 500 averaged only 5 percent.

What's the secret? Two simple ideas: diversification and long-term thinking.

Like most people, you have probably heard and read a lot about diversification, but most of this tends to focus on only two asset classes: stocks and bonds, and focuses on common questions. Is now a good time for large cap or small cap stocks? Growth or value? U.S. or foreign?

The key to building a well-diversified portfolio akin to that of Yale, however, is not just to diversify within public equity and fixed income but to diversify across asset classes into so called "alternative" asset classes, such as absolute return, private equity, real estate and natural resources such as oil, metals and timber.

The purpose of this is to assemble a portfolio of investments that will perform differently in different market environments. Many of the sectors within public equity and fixed income tend to be highly correlated, as buying frenzies and selling panics tend to move these investments within these asset classes in lock step. Diversifying only across stocks and bonds, therefore, may provide limited benefits.

High net worth investors, with the help of their investment advisers, can accomplish Yale-like diversification by accessing private funds in each of these alternative asset classes. For the average investor who may not be able to access private funds, either because of investment minimums or liquidity, another way to emulate Yale's diversification strategy may be through exchange-traded funds, known as ETFs.

Myriad new ETFs have come to market in the past few years. There seems to be a new one coming out almost every day. They have become popular as a way to get low-cost, passive exposure to particular segments of the stock market, such as large or small cap, or energy, technology or financials.

While most ETFs focus on specific areas within public equity or fixed income, there are a number that go outside that scope. Today one can find ETFs that cover real estate, natural resources and even private equity. In fact, absolute return (hedge funds) is the only major asset class that is not covered by ETFs.

The second key driver of Yale's success has been long-term thinking. While Yale tends to take a long-term view on its investments, individual investors have commonly proved to be their own worst enemies.

Take the study by fund consultant Dalbar, which indicated that over the 20-year period ending in 2005, the average mutual fund investor received an annualized return of only 3.9 percent compared with the S&P 500, which returned 11.9 percent annually over the same period. The reason for this was almost entirely due to investor behavior: "As markets rise, investors pour cash into mutual funds, and a selling frenzy begins after a decline."

We find that one of the most common investor mistakes is "buying what you wish you already owned." You saw real estate speculators doing that in spades over the past couple of years. Today investors are piling in with new bets on oil, Chinese equities and British Sterling, despite the fact that even these speculators themselves know that these instruments cannot continue to build value the way they have in the past year.

In other words, proper asset allocation is not enough to successfully emulate Yale's investment style. Individual investors need to discipline themselves to stay away from attempts at market timing or speculation, which has been proved repeatedly not to work, and to think about their portfolios in terms of years, not months or quarters.

That's how the typical investor can, over time, become a truly "smart money" investor.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

Liad Meidar is Managing Partner at Gatemore Capital Management LLC, a boutique investment management firm based in New York serving high net worth families and mid-size institutions.