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It is not a secret that Yale University's Endowment Fund, headed by Chief Investment Officer David F. Swensen, has shown remarkable success under his administration: the fund has grown more than twenty-fold since the 90s. Mr. Swensen is notable for inventing The Yale Model, which is based upon the principles of Modern Portfolio Theory. According to him, Yale's portfolio was overly conservative and under-diversified upon the beginning of his supervision. The fund was highly exposed to domestic equities and fixed-income securities. Although these measures helped reduce market risk, assets as a whole seemed to not have been performed adequately and efficiently over the long-term. Mr. Swensen decided to change asset allocation towards riskier classes. Even though this decision added risk to the portfolio, the additional returns well compensated the increase in overall market risk. Partially, this can be explained by the addition of uncorrelated assets to the portfolio: its variance of returns was actually reduced by the expansion of classes. The asset mix that delivered compounded annual returns in excess of 11% for the last 20 years is presented below:

Individual investors, unlike Yale University, do not generally have the same access to "smart money" which disables them from owning the same assets as Yale in order to maximize returns in like manner. However, there are options they may look into that can simulate Yale's holdings.

I have created a list of 18 ETFs and individual stocks that represent the six asset classes owned by the endowment fund. StockRover helped me screen funds to get filter out the ETFs based on absolute returns and adequate trailing record. The chosen-ones had to show a history of at least 5 years (where applicable: some asset classes were too young and are represented by too few funds) and had to be in the top quartile in return records. In addition, I tried to choose those that can be purchased through major brokerages.

Asset Classes and Corresponding Options for Individual Investors

Most asset classes in the portfolio are represented by 2-3 broad ETFs. I specifically chose ETFs as the core of the holdings because they can be purchased and disposed in timely manner and offer superior diversification. This way, there is one more level of diversification as opposed to a portfolio consisting of individual securities.

Alternative Strategies

This asset class focuses on non-traditional investment philosophies and can take on various strategies to enhance returns and drive away exposure from common asset classes. The definition is so broad that it is sometimes easier to describe what Alternative Strategies is not rather than is. The two ETFs that I chose have only been in existence for a little over 3 years and have not yet provided positive returns. On the other hand, they have shown the least variability in returns among all other asset classes within the portfolio.

Wisdom Tree Global Real Return (RRF)

The fund seeks investments that provide return in excess of inflation in the long-run environment. Assets held include inflation-linked fixed-income securities from U.S. and foreign issuers (at least 40% of assets dedicated to non-US securities). The fund also allocated some funds to investing in other ETFs, primarily in those managed by the same entity. The fund offers a dividend yield of 1.1% and has a beta of 1.67. Its market capitalization is $4.23M.

Wisdom Tree Managed Futures Strategy (WDTI)

This ETF actively invests in futures contracts and, in ideal, expects positive returns uncorrelated with the results of traditional asset classes in a given timeframe. At least 80% of capital plus any borrowings are invested in "managed futures," which include financial, commodities, and other futures contracts. The fund is $147M in size, has a beta of 0.21, and pays no dividends.

Real Estate

Retail investors generally have access to real estate investments through REITs, both private and public. However, choosing two or three REITs, in my opinion, does not provide adequate diversification. Hence, I chose three ETFs that invest in REITs and are traded in the U.S.

Vanguard REIT ETF (VNQ)

This investment vehicle invests in equities of REITs and tracks the return of MSCI US RIET Index. It offers a dividend yield of 4.17% on a beta of 1.3. The ETF has a market cap of 18.13B and has delivered a CAGR of 5.4% since 2004. The fund is advised by The Vanguard Group, Inc.

Wisdom Tree International Real Estate Fund (DRW)

I decided to include this fund for diversification purposes as it tracks the Wisdom Tree International Real Estate Index, which measures performance of real estate companies around the developed world excluding USA and Canada. The ETF has a market cap of $128.5M and offers a 4.68% current yield. The beta is 1.22.

iShares FTSE EPRA/NAREIT Global Real Estate ex-U.S. Index Fund (IFGL)

This high-yield ETF tracks performance of the FTSE EPRA/NAREIT Global Real Estate ex-US Index. It has a market cap of $755.66M, a dividend yield of 11.22% (several payments over the last few quarters were skipped), and a beta of 1.16. The fund trades below its 2008 IPO price.

Domestic Equity

One cannot simply do without good old stocks: the portfolio includes two funds aimed at US broad and small cap stock markets. In fact, these two funds had the most optimum risk/reward ratios: while the standard deviation of returns was below 20% over the last decade for both funds, weighted-average returns were in the low teens. Both ETFs pay comparable dividend yields and have similar betas. Covariance between the two vehicles is at the matrix average.

Rydex S&P Equal Weight ETF (RSP)

The fund seeks to trail the returns of S&P 500 Equal Weight Index as closely as possible. It has a market cap of $6.66B, a beta of 1.16, and offers a dividend yield of 1.27%. In the past 5 years, the fund has actually surpassed S&P 500's returns by about 50%. It has delivered a CAGR of almost 12% with a standard deviation of 19.5%. Security Investors, LLC, which operates under the name Rydex Investments, serves as the investment adviser of the Fund.

Vanguard Small-Cap ETF (VB)

The investment vehicle employs a passive management approach in tracking the returns of the MSCI US Small Cap 1750 Index. It has a market cap of $8.38B, a beta of 1.26, and a dividend yield of 1.29%. The fund returned a CAGR of 12.4% since its inception in 2004 at a slightly smaller deviation of 18.8% than its broader-index partner. The fund's investment advisor is The Vanguard Group, Inc.

Foreign Equity

Exposure to international markets not only provides opportunities to capitalize on idiosyncratic country trends but also offers fantastic diversification. The only problem has been the fact that foreign stocks, at least those held in the chosen ETFs, have delivered a negative alpha in comparison with its domestic counterparties. They also have shown a significantly higher deviation of returns, having been compensated for only by considerably higher dividend yields (more than 2X higher than domestic stocks). Nevertheless, I believe it is too early to judge the results since the two funds have not been in existence for more than a decade, and there is room to grow.

Vanguard FTSE All-World ex-US ETF (VEU)

The fund employs its capital in such a manner as to track performance of Vanguard FTSE All-World ex-US Index Fund. The Index includes approximately 2200 stock from 46 countries around the world, a mix of emerging and developed nations. A small portion of assets can be held in various derivative contracts, convertibles, currency exchange contracts, and other. The fund has a market cap of $11.65B, a beta of 1.24, and a yield of 2.68%. Since its inception in 2007, the fund has delivered a weighted-average return of 3.6% on a standard deviation of 22.7%, mostly due to the crash in 2008 and a market dip in 2011.

PowerShares DWA Developed Market Tech ETF (PIZ)

PowerShares DWA Developed Markets Technical Leaders Portfolio is based on the Dorsey Wright Developed Markets Technical Leaders Index. The fund includes securities of the "developed economies" as defined by Dorsey Wright & Associates. The ETF has a market cap of $646M, a beta of 1.32, and a dividend yield of 2.8%. It has posted a weighted-average return of 8.3% since 2008 with a standard deviation of 28.5%. The Fund's investment advisor is Invesco PowerShares Capital Management LLC.

Fixed Income

The two funds in the portfolio that represent the fixed income portion of the portfolio are quite different from each other. The first one is an ETF that invests in high-yield securities and generally tracks the performance of equities, while providing above-average income yields. It has a significantly lower beta than the market, although still higher than the Alternative Strategies class. The main purpose of this holding is to boost overall dividend yield of the portfolio. On contrary, the second fund, which invests in US government medium-term debt, has an extremely low and negative beta. In other words, it is expected to perform poorly during market run-ups but deliver positive returns during market crashes. The data shows that this has been the case over the entire observation period. Moreover, what is remarkable is that it has a negative covariance with every single holding in the portfolio. This means that, on average, the fund moved in opposite directions than all other holdings in majority of times over the observation period. The ETF compensates investors with a modest for its class yield. The major purpose of the fund is to mitigate portfolio losses during market downturns.

SPDR Barclays Capital High Yield Bond ETF (JNK)

The fund seeks to provide investment results that correspond to the price and yield performance of the Barclays Capital High Yield Very Liquid Index. It invests in corporate bonds denominated in USD with maturities over one year that are non-investment grade and rated below average. The ETF offers a 5.99% yield, has a market capitalization of $10.04B, and a beta of 0.61. The investment manager of the Fund is SSgA Funds Management, Inc.

iShares Barclays 7-10 Year Treasury Bond Fund ETF (IEF)

The ETF seeks to track the investment results of an index composed of the United States Treasury bonds with remaining maturities between seven and ten years. The fund has a market cap of $3.86B, a beta of -0.11, and offers a yield of 1.75%. It has the third smallest deviation of returns in the portfolio and the best return at a minimum risk. BlackRock Fund Advisors acts as an investment adviser of the Fund.

Natural Resources

This asset class, represented by the Real Assets section on the diagram, is a unique solution to the diversification problem. This class involves assets such as timberland, farmland, mines, plays, and other. There are three ETFs in the portfolio that hold stocks of companies involved in oil & gas production, timber & forestry, and other commodities. All three did remarkably well over the last business cycle and are ranked best by U.S. News Money magazine. Their notable features include low covariance with other asset classes and rather large standard deviation of returns. Dividend yields are on average higher than those of domestic stocks but lower than foreign equities.'

iShares S&P North American Natural Resources Sector Index Fund ETF (IGE)

The ETF invests in sectors, such as oil gas & consumable fuels, energy equipment & services, metals & mining, containers & packaging, paper & forest products, construction materials, and other. The fund has been in existence for over a decade and has returned on average 8.8% at a standard deviation of 21.1% over the past ten years. It offers a dividend yield of 1.5%. Its market capitalization is $2.19B and its beta is 1.18. BlackRock Fund Advisors serves as the investment adviser to the Fund.

SPDR S&P Oil & Gas Exploration & Production ETF (XOP)

The ETF seeks to duplicate as closely as possible the total return performance of the S&P Oil & Gas Exploration & Production Select Industry Index. The S&P Oil & Gas Exploration & Production Select Industry Index represents the oil and gas exploration and production sub-industry portion of the S&P Total Markets Index. Since its inception in 2006, the fund has delivered an average rate of return of 11.4%, the highest among its class peers at a second-lowest standard deviation of 23.4%. However, the fund provides the lowest dividend yield of 0.85%. it has a market capitalization of $723M and a beta of 1.3. SSgA Funds Management, Inc. is the Fund's investment advisor.

iShares Global Timber & Forestry ETF (WOOD)

The investment vehicle seeks investment results that correspond generally to the price and yield performance of the S&P Global Timber & Forestry Index, which consists of approximately 25 publicly-traded companies engaged in the ownership, management or upstream supply chain of forests and timberlands. The youngest in the group, the ETF has so far returned the least among its peers (7.5% weighted-average) at the highest risk (29% standard deviation) since its inception in 2008. These numbers can be partially explained by the fact that the fund was launched at the dawn of the 2008 - 2009 financial crisis. Nevertheless, it now trades above its IPO price and offers the highest yield among its peers (1.55%). The ETF has a beta of 1.4 and a market capitalization of $340M. The Fund's investment adviser is BlackRock Fund Advisors.

Private Equity

Perhaps the most prestigious asset class, well-known for its superior returns over an established observation period, private equity makes up a large chunk of Yale's Portfolio. Private equity firms invest its partners' money in leveraged buyouts, growth equity, venture capital, merchant banking, and many other combinations of illiquid securities. This market is considerably less efficient than the good old U.S. stock market which allows able managers to deliver returns in excess of the broader public markets' indexes. Needless to say, risk are correlated with returns and are higher than average. Retail investors generally do not have access to PE funds as limited partners but they can definitely invest in PE firms' equities and ETFs that contain them. I have gathered one ETF that invests in private equity and three stocks of the most prominent PE firms in the world.

PowerShares Global Listed Private Equity Portfolio (PSP)

The fund seeks to replicate returns of the Global Listed Private Equity Index by investing at least 90% in securities of 40 to 60 publicly listed private equity companies around the world. Over the course of its life (since 2006), the ETF produced mixed returns, averaging 1% annually. The standard deviation of returns was also quite high: at 25.5%. However, it offers a compelling dividend yield exceeding 13% with income paid quarterly (note: dividends are volatile). The fund has a market capitalization of $512M and a beta of 1.63. The Fund's investment advisor is Invesco PowerShares Capital Management LLC.

The Blackstone Group L.P. (BX)

The most famously known PE firm, founded and run by Stephen Schwarzman, takes the first place on the stock list. I have previously written on BX and will not get into details here. It is a diversified investment company operating in 4 business segments. The stock achieved superior returns on the market during 2013: up 95%. Although this may sound as quite a run-up, it still trades almost 6% below the IPO price of 2007. Blackstone offers the best yield (3.6%) among the three PE firms chosen for the portfolio. It has a beta of 2.21 and a market capitalization of $18.74B. The company strives to continuously transform its product line and has recently engaged in sales of "rent-backed securities" on properties it owns in its Real Estate segment.

BlackRock, Inc. (BLK)

Previously owned by Blackstone, BlackRock has grown to become the largest asset management firm in the world with assets under management in excess of $3.86 trillion in comparison with Blackstone's $230B. The company has a market capitalization of $54.2B and has delivered extraordinary returns since its IPO in 1999: almost 22X on every dollar invested. Current yield offered on its stock is slightly below Blackstone's at 2.41%. On the other hand, during the past decade the stock delivered a weighted-average annual return of ~21% (vs. Blackstone's 18.5%) at a lower standard deviation (30.4% vs. 46.3%). This can be partially explained by a larger observation period for BlackRock. The stock has a lower beta at 1.57. During 2013 BlackRock's equity delivered an alpha of approximately 11% in comparison with S&P 500 for the same time period.

Evercore Partners Inc. (EVR)

Evercore is an independent investment banking advisory firm. It operates in two segments: Investment Banking and Investment Management. Its Investment Management segment includes Wealth Management and Private Equity. The firm has improved its profitability in the last 5 year, growing EPS almost two-fold, while more than doubling revenues since the beginning of 2010. The firm's stock has a beta of 1.32 and offers a dividend yield of 1.58%. The stock has delivered a 100%+ return in 2013 which caused the yield to decrease. On the other hand, dividends increased three-fold since its IPO in late 2006. Partially due to the short history of trading on the exchange in combination with a recent run-up in prices, Evercore has delivered the highest weighted-average return in the entire portfolio (30.3%) on a staggering standard deviation of 64.2%. Even so, the company's market capitalization is slightly above $2B, which is dwarfed by the sizes of its two aforementioned competitors.

Portfolio Allocation Strategies

The following few strategies are sample choices investors can make based on their needs and investing styles. They may download the Excel model and, using the Solver function, optimize the weights according to their preferences.

Plain Vanilla: Equal Weights

This allocation model is simple and well-known to most investors: take your money and buy equal quantities of each asset on the list. As time progresses, become overweight on winners and cut short losses. As the data shows, it is not a bad strategy at all: it delivers a reasonable expected return (excluding dividends, which contribute an extra return of 3.5%).

Minimum Variance Portfolio

This scenario involves short-selling and may not be appropriate for a lot of investors. The minimum market risk is achieved by a meager return on investment. The negative dividend yield, arisen from shorting the highest-yielding securities (PSP and IFGL), makes proponents of this strategy pay cash to the counterparties in form of dividends. Short-term gains may be realized through shorting recent run-ups, such as Evercore and Blackstone. Overall, to achieve similar returns at similar risk, it is advisable to simply hold a diversified portfolio of sovereign debt with mixed maturities (I may create such a portfolio in the following articles). Besides the absence of shorting, it will also be cheaper in establishing.

Long-Only Portfolio at a Reduced Variance

Those who seek modest returns with minimum risk should look into the Long Only Portfolio scenario. This portfolio holds 6 assets from five asset classes and demonstrates the second-lowest risk/return ratio across all scenarios. Note the comfortable average dividend yield. The exact allocation is shown below:

(click to enlarge)

Components of Long-Only Portfolio:

  1. Alternative Strategies: 31% (RRF and WDTI)
  2. Small Cap Domestic Equity: 25%
  3. Fixed Income Sovereign Debt (medium-term US Treasuries): 30%
  4. Natural Resources (O&G exploration and production): 3%
  5. Private Equity (blend with Investment Management): 11%

Long 5% to 15% Weights Return Maximized Portfolio

More aggressive investors who seek double-digit returns and decent dividend yields should look into the Return Maximized matrix. An interesting solution presented there is to invest in all securities listed in the selection, while being overweight on Evercore partners. Hence, the expected return based on past data is almost 10% with a dividend yield in excess of 3% in addition to that. On the other hand, with increased expected return investors should be prepared to accept higher risk in low-20%. Nevertheless, this is a more preferable option in terms of risk/return in this section of the table.

Yale Model Portfolio

I tried to reproduce Yale's Portfolio as close as possible using ETFs and stocks. In terms of returns, it offers the lowest ROI in the Maximized matrix but a higher inclusion rate (number of stocks in long position chose from the list) than its closest competitor, Long Only Return Maximized portfolio. Dividend yield offered is one of the highest on across all the options. Investors may shuffle weights within each asset class in this portfolio as I have made allocations equal for simplicity purposes.

Portfolio Optimization Matrix:

(click to enlarge)

Epilogue

As one can see, there are many ways to optimize one's investment portfolio according to needs and goals using the same amount of securities. After all, mutual funds and ETFs also employ similar techniques when allocating money towards selected investments. In my opinion, not only should average investors be able to select securities and value them appropriately but they ought to be able to shuffle their portfolios in search of the optimum solution.

Please remember that expected returns and volatility (standard deviation) are based on historical results, which may not persist in the future.

Source: Replicating Yale's Endowment Portfolio With Accessible Instruments