When is a decline of 16 percent in portfolio value deemed a “success?” When you're the endowment manager of the University of Pennsylvania, that's when.

Penn's investment honcho had long suffered from an inferiority complex when her results were compared to those of her Ivy League counterparts at Yale and Harvard. The Yale endowment, especially, has been lauded for its consistent market-beating returns under the stewardship of David Swensen (even in these august pages: see “Illiquidity is Beautiful for Some” in Registered Rep.'s July 2007 issue, in print and online).

In the wake of last year's credit market collapse, however, the Yale portfolio, chock-a-block with illiquid private equity deals, hedge funds and natural resources partnerships, took a 24.6 percent drubbing in its fiscal year, ending June 30, the worst decline in its history. The Elis, at least, could take some comfort in the knowledge that they still outdid Harvard. The Crimson portfolio got shellacked by a 27.3 percent loss in fiscal year 2009.

The relatively modest 15.7 percent hit sustained by the Penn endowment earned it the top-of-table slot for investment performance among the Ivies. Princeton's portfolio lost 23.7 percent while Cornell, Dartmouth and Brown were visited with losses greater than 20 percent. Columbia's performance — a 16 percent loss — was the league's second best.

That the Pennyslvania portfolio held a much lighter load of illiquid assets and a heavier dollop of fixed income compared to Yale's or Harvard's has got some financial advisors wondering if the so-called Yale Model of endowment investing pioneered by Swensen — striving for equity-like returns through a diverse mix of uncorrelated and unconventional assets — should be tossed.

Yale's appetite for alternative investments — private equity in particular — has been steadily growing over the past few years. Penn hasn't been as hungry, allocating only 12 percent of its assets to private equity compared to Yale's 21 percent exposure. In the aggregate, Yale's most recently published target portfolio allocates more than 70 percent to illiquid assets.

Yale makes room in its portfolio for these investments partly at the expense of fixed income. Bonds, however, remain a significant component of the Penn endowment. At 15 percent of the portfolio, Penn's allocation is more than three times the size of Yale's in percentage terms.

What Went Wrong?

Yale's portfolio has been battered by a storm of rising correlation. Previously dissimilar asset classes started moving in the same direction — down — when investors started dumping their risky holdings to fund purchases of risk-free U.S. Treasuries.

It's happened before. In both the 1987 crash and the Long-Term Capital Management crisis of 1998, flights to quality caused a correlation convergence. When calm was eventually restored after each incident, correlations migrated back to their former state of disparity.

Reflecting the wholesale exodus to safe-haven Treasuries, the single asset class that produced positive results for the Yale portfolio last year was fixed income. That, however, is the endowment's lightest exposure and wasn't large enough to provide much shelter. (See table below.)

Yale's returns were further impacted by the endowment's inherent illiquidity. Illiquidity wasn't problematic when asset prices were rising, but, when values reached unsustainable levels in mid-2008, the strategy backfired. Private equity participations, the hedge fund investments making up the absolute return allocation and real assets all are credit dependent. When lending contracted in the financial meltdown, the notional value of these investments rapidly plummeted.

Further compromising liquidity were covenants restricting the sale of these assets. Private equity deals, for example, often require endowments to commit to multi-year holding periods — a decade is not uncommon — before withdrawing their investments.

There's yet another problem with the private equity deals — capital calls. A capital call represents an unfunded commitment undertaken by an endowment to supply additional cash to the partnership. These commitments can amount to 25 percent or more of an endowment's original investment.

Even when an endowment is free to unload these investments, ready buyers can't always be found. The Harvard endowment discovered this when it offered its private equity participations to so-called secondary funds at a 35 percent discount in an effort to raise cash. The offer didn't attract any buyers. Ultimately, bids at 50 percent of book value emerged, but the university balked at such a deep haircut and ended up issuing debt to fund its commitments.

Hedge funds offer marginally better liquidity, but typically restrict redemptions on a calendar basis. The general partners, too, can suspend capital withdrawals altogether when the partnership's own liquidity is compromised. There was plenty of that in last year's credit freeze, to be sure.

The Yale real assets allocation holds timberland and oil deals, among other things. Turning such assets into cash can be difficult in the best of times. In the midst of a credit crunch, it's often impossible. In the aftermath of last year's crude oil crash, the value of Yale's oil deals was nearly halved.

Defending the Model

So, is the Yale Model no longer relevant? Has the notion of diversification failed? And what should financial advisors who've built copies of the Yale Model take away from this?

Forecasting the model's demise on the basis of one market cycle — bad as it was — may be premature. Yale's investment strategy bore sweet fruit for a couple of decades before last year's souring “six sigma” event.

In fact, one bad year, ought not to be a surprise. At least according to Yale president Richard Levin, who recently told stakeholders, “If a portfolio produces gains of 41 percent (as the Yale endowment did in the year ended June 30, 2000) and 28 percent (as it did in the year ended June 30, 2007), the possibility of suffering the symmetry of double-digit losses should be anticipated.”

Levin is quick to point out that the last time the Yale portfolio suffered an investment loss was two decades ago: it declined 0.2 percent in the year ended June 30, 1988.

Yale's endowment manager, David Swensen, has a grittier assessment. As he told ProPublica earlier this year, “If you want to have a fair assessment of any investment strategy, get through the crisis and then look back and see how things performed.”

Swensen, like Levin, harkens back to Yale's long-term track record. “If you look back ten years from June 30, 2008, Yale's performance was 16.3 percent per annum. Bonds were five percent plus or minus, and stocks were three percent plus or minus. So what are you going to do? You're going to give up that kind of performance to hold a lot of bonds to protect against the financial crisis?”

For Swensen, the Yale Model's track record speaks for itself. “Where's the alternative that performs so much better?” he challenges critics. “One hundred percent government bonds? Is that the alternative? Well, then what would have happened if you had held that the decade before? I don't get it.”

With perfect hindsight, perhaps the actively managed Yale endowment would have started the year in a more liquid position, with less exposure to some of the hardest-hit alternative asset classes, and with greater weight given over to bonds. Hindsight is always 20/20. Asset managers, however, get paid for foresight.

Despite the recent hit absorbed by the Yale endowment, its past performance speaks well for its managers' foresight. Time will tell if it remains intact.?