Can you guess the answer?  They invest in alternative, or non-traditional, investments!  In fact, 87.5% of their investments are categorized as non-traditional according to Yale’s 2015 report.

Wouldn’t you think just the opposite?  I don’t know much about endowments, but I would think that the managers would only have the option to stick with equities and bonds, with very little “at risk” in non-traditional assets.

Yale and other top schools are investing in alternative investments.

Yale and other top schools are investing in alternative investments.

Yale, Stanford, and other large universities have figured out that while non-traditional investments can vary widely in their level of volatility, the risk with non-traditional investments is actually lower than it is with investments that are considered traditional.

Here is an excerpt from their report:

“Today’s actual and target portfolios have significantly higher expected returns than the 1985 portfolio with similar volatility.”

This is something I have believed in (and proved to be true) over the last 7 years by managing non-traditional investments in my own business.  But I did not realize that large institutions with a whole lot of money think the same way I do.  I must thank my friend, Morgan White, for opening my eyes to this.

Here’s another excerpt from Yale’s report:

“In 1985, 80% of the Endowment was committed to U.S. stocks and bonds.  Today, target allocations call for 12.5% in domestic marketable securities, while the diversifying assets of foreign equity, natural resources, leveraged buyouts, venture capital, absolute return, and real estate dominate the Endowment, representing 87.5% of the target portfolio.”

Over the last 30 years, the management of the Endowment has progressed by reducing its dependence on domestic marketable securities and reallocating assets to non-traditional classesA big challenge for college or university endowments is their greater vulnerability to inflation.  Even us normal investors can’t ignore the fact that inflation erodes our buying power over time as well.  Including non-traditional assets in your investment plan can help alleviate this problem, while also increasing diversification, which we all know is essential.

The report from Yale adds:

The heavy allocation to non-traditional asset classes stems from their return potential and diversifying power.”

Endowment managers at Yale know it is almost impossible to get enough diversification investing only in domestic marketable securities.  They must have realized 30 years ago that they needed to invest “outside that box,” which apparently has paid off for them.  Moving more dollars to non-traditional assets has not only provided the desired diversification, but has benefited their portfolio immensely.

This may be my favorite paragraph in the whole report:

“Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management.  The Endowment’s long time horizon is well suited to exploit illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.”

Exactly!  Hence, the title of my book – Excess Returns.  How do you find the right balance between risk and reward that keeps the profit in your pocket?  It is always in inefficient markets that can be actively managed, giving ultimately more control to the asset owners in the long run.

You could argue that this strategy is effective in small niche markets, but difficult to implement when deploying $25 billion.  At least that was my thought prior to this enlightenment.  However, both Yale and Stanford have figured out how to make it work, and both are beating their benchmarks when compared to others in similar situations.

If non-traditional investments are good enough for the big, conservative endowments, they are certainly good enough for you and me.  They are not scary, or “risky,” as people might think when hearing the word “alternative.”  In fact, they are just the opposite once you open your mind enough to learn about them.

If you are interested, here is the link to the full Yale 2015 report: