The Yale Endowment 2010

Endowment HighlightsFiscal Year

2010 2009 2008 2007 2006

Market Value (in millions) $16,652.1 $16,326.6 $22,869.7 $22,530.2 $18,030.6Return 8.9% -24.6% 4.5% 28.0% 22.9%

Spending (in millions) $ 1,108.4 $ 1,175.2 $ 849.9 $ 684.0 $ 616.0Operating Budget Revenues 2,681.3 2,559.8 2,280.2 2,075.0 1,932.0(in millions)Endowment Percentage 41.3% 45.9% 37.3% 33.0% 31.9%

Asset Allocation (as of June 30)

Absolute Return 21.0% 24.3% 25.1% 23.3% 23.3%Domestic Equity 7.0 7.5 10.1 11.0 11.6Fixed Income 4.0 4.0 4.0 4.0 3.8Foreign Equity 9.9 9.8 15.2 14.1 14.6Private Equity 30.3 24.3 20.2 18.7 16.4Real Assets 27.5 32.0 29.3 27.1 27.8Cash 0.4 -1.9 -3.9 1.9 2.5

Endowment Market Value 1950–2010

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Contents

A Message from theYale University President 2A Message from theChief Investment O!cer 3

1. Introduction 42. The Yale Endowment 53. Investment Policy 84. Spending Policy 285. Investment Performance 326. Management and Oversight 34

Front Cover:Window of Sterling Memorial Library, east façade.

Right:Branford Courtyard in the spring.

2

A Message fromthe Yale UniversityPresident

Yale’s Endowment provides a critical foun-dation for the University’s mission, sup-porting today’s scholars with annualspending distributions while promising tomaintain support for generations to come.The central importance of the University’spermanent resources became acutely clearduring the recent financial crisis.

During this period of economic di!-culty, we are as fortunate as ever to havethe management of Yale’s financialresources in capable hands. Chief Invest-ment O!cer David F. Swensen and his tal-ented sta" continue their tireless e"orts insupport of Yale’s mission. The InvestmentsO!ce’s stellar long-term record of wealthcreation provides a critical underpinning ofthe University’s current operations andfuture aspirations.

Just as I am thankful for the strength ofthe University’s investment sta", so am Igrateful for the extraordinary work of theYale Corporation Investment Committee.Chaired by Douglas A. Warner, the Invest-ment Committee is composed of Fellowsof the Yale Corporation and other distin-guished Yale alumni who bring formidablejudgment and expertise to the oversight ofYale’s investment program.

As a member of the Investment Com-mittee, I witness firsthand the contributionof these industrious and dedicated Yale

men and women. Our discussions arethoughtful, rigorous, and vibrant. Amidturbulent markets and an uncertain econ-omy, the Investment Committee has pro-vided a steady hand at the tiller, o"eringindispensable guidance with a perspectivethat befits Yale’s long-term goals.

Sensible management and oversight ofYale’s investment portfolio cannot aloneensure that Yale will have the financialresources it needs. An institution withYale’s scope and ambition needs active andsupportive alumni and friends to helpbuild the Endowment. Gifts to Yale havefueled the University’s growth throughoutthe centuries. Today, more than ever, Yaleneeds your support.

Under the care of highly skilled invest-ment professionals and a strong Invest-ment Committee, I am confident that theUniversity’s financial resources will con-tinue to support its dynamic and ever-expanding mission. I hope that you enjoy,as I have, this report on the 2010 YaleEndowment, which provides a distillationof the thinking that guides the manage-ment of Yale’s financial resources.

Richard C. Levin

University President Richard C. Levin ’74 ph.d.(right), with Investment Committee ChairDouglas A. Warner iii ’68 (left) and ChiefInvestment O!cer David F. Swensen ’80 ph.d.

3

During financial crises, investors frequentlyshorten their perspective to an unreason-ably short time horizon and often engagein counterproductive activities. In 1987,after the October market crash, portfoliomanagers sold stocks and bought bonds—selling low, buying high, and damagingportfolio prospects. In 1998, amid Long-Term Capital Management’s threat to thefinancial system, many investors rushedto exit hedge fund positions, liquidatingaccounts at the point of maximum pain(and maximum prospective opportunity).In 2008, during the most recent crisis,investors behaved as they did in 1987 and1998, disposing of assets that carried riskand illiquidity in favor of risk-free andultra-liquid U.S. government bonds.

After the onset of the 2008 crisis, Yale’sapproach to endowment management,with its focus on equities and emphasis onalternatives, received a great deal of criti-cism. A November 2008 Barron’s article,titled “Crash Course,” typified the negativepress, suggesting that the Yale model calledfor too much in alternatives and providedtoo little diversification. The antidote—more traditional stocks and bonds.

Barron’s was promoting the trade ofthe day. Investors with large allocationsto marketable bonds (particularly U.S.Treasury securities) and publicly tradedequities fare better in the heart of a crisis(as the bonds benefit from a flight tosafety) and in the immediate aftermath ofa crisis (as the stocks benefit from a reliefrally). Viewed in the narrow timeframe ofthe crisis, liquid assets performed betterthan illiquid assets and safe assets per-formed better than risky assets. Viewed ina timeframe more appropriate for a long-term investor, well-chosen positions inilliquid assets perform better than other-wise comparable liquid assets and well-selected portfolios of risky assets producebetter returns than risk-free U.S. Treasurysecurities.

Throughout the crisis, Yale resisted theflight to a safe haven and maintained itsequity-oriented, well-diversified portfolio.With an investment horizon measured indecades, if not centuries, a commitment toequities generates the long-term returnsnecessary to provide significant support forcurrent scholars, while maintaining pur-chasing power for future generations. Sub-stantial allocations to alternative assetso"er a level of diversification unavailable toinvestors in traditional assets, allowing thecreation of portfolios with superior riskand return characteristics.

Consider Yale’s ten-year return of 8.9percent per annum, which remains atop theinstitutional rankings. During that period,a portfolio with 70 percent in domesticmarketable equities and 30 percent indomestic bonds returned a disappointing1.5 percent per year. Yale’s alternative assetclasses produced far superior results, withprivate equity returning 6.2 percent peryear, real estate 6.9 percent per year, abso-lute return 11.1 percent per year, timber 12.1percent per year, and oil and gas 24.7 per-cent per year. When evaluated over a rea-sonably long time horizon, alternatives(many of which are illiquid) contributedmightily to the University’s results.

During the decade ending June 30,2010, Yale’s investment program added$7.9 billion relative to the results of theaverage endowment. The University’stwenty-year returns tell a similar story. Amarket-leading return of 13.1 percent perannum produced $12.1 billion in valueadded to support Yale’s mission of teachingand research. Sensible long-term policies,grounded by a commitment to equities anda belief in diversification, underpin theUniversity’s investment success.

David F. Swensen

A Message fromthe Chief InvestmentO!cer

Yale’s Endowment generated an 8.9 percent return in fiscal year 2010,producing an investment gain of $1.4 billion.

Over the past ten years, the Endowment grew from $10.1 billion to$16.7 billion. With annual net investment returns of 8.9 percent, theEndowment’s performance exceeded its benchmark and outpaced institu-tional fund indices. The Yale Endowment’s twenty-year record of 13.1 per-cent per annum produced a 2010 Endowment value of over six times thatof 1990. Yale’s long-term record results from disciplined and diversifiedasset allocation policies and superior active management results.

Spending from the Endowment grew during the last decade from$281 million to $1,108 million, an annual growth rate of approximately15 percent. On a relative basis, Endowment contributions expanded from22 percent of total revenues in fiscal 2000 to 41 percent in fiscal 2010. Infiscal 2011, spending will amount to $986 million, or 38 percent of pro-jected revenues. Yale’s spending and investment policies have providedsupport for current scholars while preserving Endowment purchasingpower for future generations.

Introduction

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Endowment Growth Outpaces Inflation 1950–2010

Totaling $16.7 billion on June 30, 2010, the Yale Endowment containsthousands of funds with a variety of designated purposes and restrictions.Approximately three-quarters of funds constitute true endowment, giftsrestricted by donors to provide long-term funding for designated pur-poses. The remaining one-quarter represent quasi-endowment, moniesthat the Yale Corporation chooses to invest and treat as endowment.

Donors frequently specify a particular purpose for gifts, creatingendowments to fund professorships, teaching, and lectureships (24 per-cent), scholarships, fellowships, and prizes (18 percent), maintenance(4 percent), books (3 percent), and miscellaneous specific purposes(26 percent). Twenty-five percent of funds are unrestricted. Thirty-fivepercent of the Endowment benefits the overall University, with remainingfunds focused on specific units, including the Faculty of Arts and Sciences(29 percent), the professional schools (23 percent), the library (7 per-cent), and other entities (6 percent).

Although distinct in purpose or restriction, Endowment funds par-ticipate in a commingled investment pool and are tracked with unitaccounting much like a large mutual fund. Endowment gifts of cash,securities, and property are valued and exchanged for units that representa claim on a portion of the whole investment portfolio.

In fiscal 2010 the Endowment provided $1,108 million, or 41 percent,of the University’s $2,681 million of operating income. Other majorsources of revenues were grants and contracts of $641 million (24 per-cent), medical services of $462 million (17 percent), net tuition, room,and board of $230 million (9 percent), gifts of $82 million (3 percent),and other income and transfers of $157 million (6 percent).

The Yale Endowment

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BooksMaintenance

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UnrestrictedEndowment

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Endowment Fund AllocationFiscal Year 2010

Operating Budget Revenue in MillionsFiscal Year 2010

Strong growth in the Endowment duringthe past two decades raises questions aboutcontributing to an already wealthy Yale.The answer is simple: had the Endowmentnot benefited from generous gifts in recentdecades, current support for Yale’s broadprogram of education and research wouldbe vastly diminished. Although the YaleEndowment is one of the largest in theworld, donor support remains critical tothe future of the University.

Gifts Support Yale’s GrowthOver the past century, the growth of theYale Endowment enabled dramatic expan-sion of the University’s programs. In 1910the Yale Endowment totaled $12.1 millionand funded 50 percent of the budget.One hundred years later, the Endowmentamounted to $16.7 billion and provided 41percent of the University’s budget. Thebeginning point of 50 percent and the endpoint of 41 percent both represent signifi-cant departures from the average Endow-ment support of 34 percent of Yale’s opera-tions over the last one hundred years.

In 1910, Yale had 3,317 students enrolledin the College and eight graduate and pro-fessional schools; as of June 30, 2010, Yalehad 11,520 students enrolled in the Collegeand thirteen postgraduate schools. Theexpansion was dramatic across the board.New schools founded in those one hun-dred years include the School of Architec-ture, the School of Drama, and the Schoolof Management. The School of Medicineexpanded its program dramatically in thepast century. The growth of the Yale fac-ulty was even more striking. As of June 30,2010, Yale employed 3,227 faculty mem-bers, approximately eight times the 1910figure.

With expansion in the number of stu-dents and faculty at Yale came explosivegrowth in the size of the campus. In 1910,Yale’s physical plant totaled approximately1.5 million square feet; one hundred yearslater, that figure was around 17.5 millionsquare feet, easily outpacing the growthin students and faculty. Most dramatic,though, was the exponential growth offinancial aid o"ered by Yale. In the 1910fiscal year, when much of the University’sstudent body came from a±uent back-grounds, financial aid totaled only $4.2million in 2010 dollars. In the year endingJune 30, 2010, Yale o"ered $296.7 millionof financial aid, an amazing 71-fold increasefrom one hundred years earlier.

Gifts Maintain the Endowment’sRelevanceExamining the experience of Harvard, Yale,and the Carnegie Institution over the pastone hundred years provides insight intothe importance of gifts. The CarnegieInstitution of Washington, one of AndrewCarnegie’s many philanthropies, pursuescutting-edge scientific research in astron-omy, plant biology, embryology, globalecology, terrestrial magnetism, and earthsciences. After establishing the institution

in 1902 with a $10 million gift, Carnegiemade subsequent gifts to bring the 1910endowment to $22 million, nearly equal toHarvard’s 1910 fund balance of $23 millionand vastly exceeding Yale’s $12 million.

Over the course of the past one hundredyears, the Carnegie Institution endowmentmore than kept pace with inflation, withJune 30, 2010 assets of $687 million com-fortably ahead of the approximately $500million needed to match the rise in pricelevels. But the formerly comparableHarvard endowment, now at $27.6 billion,

Gifts and Endowment

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Yale Expands Dramatically 1910–2010

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and the previously smaller Yale Endow-ment, currently at $16.7 billion, dwarf theCarnegie fund. Because the three institu-tions followed roughly comparable invest-ment and spending policies, the absence ofcontinuing gift inflows constitutes the sin-gle most important reason for Carnegie’sfailure to keep pace. The result is thatCarnegie’s endowment, once one of thelargest in the country, now ranks far lower.By way of comparison, had the YaleEndowment grown at the same rate asCarnegie’s, it would total approximately$375 million today; Endowment spendingwould have been an insignificant $25 mil-lion in fiscal 2010, compared to the actualfigure of $1.1 billion.

A more precise understanding of theimportance of gifts to the Endowmentcomes from a look at Yale’s post-1950 expe-rience, covering the period for which theUniversity has high-quality financial data.Without the benefit of Endowment giftsto Yale in the last sixty years, the 1950Endowment of $132 million would havegrown to about $3.8 billion by 2010 ratherthan $16.7 billion. The di"erence—a stag-gering $12.9 billion—comes from gifts andinvestment performance on those gifts.

Yale’s current academic distinction wouldbe unthinkable without these financial con-tributions. Looking forward, Yale will fail

to maintain its importance as a global cen-ter for teaching and research unless donorscontinue to provide Endowment support.

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Historic Impact of Gifts to the Yale Endowment 1950–2010

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Harkness Tower and the New Haven skyline.

Yale’s portfolio is structured using a combination of academic theory andinformed market judgment. The theoretical framework relies on mean-variance analysis, an approach developed by Nobel laureates James Tobinand Harry Markowitz, both of whom conducted work on this importantportfolio management tool at Yale’s Cowles Foundation. Using statisticaltechniques to combine expected returns, variances, and covariances ofinvestment assets, Yale employs mean-variance analysis to estimateexpected risk and return profiles of various asset allocation alternativesand to test sensitivity of results to changes in input assumptions.

Because investment management involves as much art as science,qualitative considerations play an extremely important role in portfoliodecisions. The definition of an asset class is quite subjective, requiringprecise distinctions where none exist. Returns and correlations are di!-cult to forecast. Historical data provide a guide, but must be modifiedto recognize structural changes and compensate for anomalous periods.Quantitative measures have di!culty incorporating factors such as mar-ket liquidity or the influence of significant, low-probability events. Inspite of the operational challenges, the rigor required in conductingmean-variance analysis brings an important perspective to the asset allo-cation process.

The combination of quantitative analysis and market judgmentemployed by Yale produces the following portfolio:

June 2010 June 2010Asset Class Actual Target

Absolute Return 21.0% 19.0%Domestic Equity 7.0 7.0Fixed Income 4.0 4.0Foreign Equity 9.9 9.0Private Equity 30.3 33.0Real Assets 27.5 28.0Cash 0.4 0.0

Investment Policy

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Dean J. Takahashi ’80, ’83 mppmSenior Director

David F. Swensen ’80 ph.d.Chief Investment O!cer

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The target mix of assets produces an expected real (after-inflation)long-term growth rate of 6.2 percent with a risk (standard deviation ofreturns) of 14.7 percent. Because actual holdings di"er from target levels,the actual allocation produces a portfolio expected to grow at 6.1 percentwith a risk of 14.3 percent. The University’s measure of inflation is basedon a basket of goods and services specific to higher education that tendsto exceed the Consumer Price Index by approximately one percentagepoint.

At its June 2010 meeting, Yale’s Investment Committee adopted anumber of changes in the University’s policy portfolio allocations. TheCommittee approved an increase in the private equity target from 26.0percent to 33.0 percent to accommodate anticipated growth in privateequity exposure and decreased the real assets target allocation from 37.0percent to 28.0 percent. These changes in the illiquid asset classes werebalanced by a 4.0 percentage point increase in the absolute return targetallocation to 19.0 percent, a 0.5 percentage point decrease in the domesticequity target allocation to 7.0 percent, a 1.0 percentage point decrease inthe foreign equity target allocation to 9.0 percent, and a 0.5 percentagepoint decrease in the cash target allocation to zero percent.

The need to provide resources for current operations as well aspreserve purchasing power of assets dictates investing for high returns,causing the Endowment to be biased toward equity. In addition, theUniversity’s vulnerability to inflation further directs the Endowmentaway from fixed income and toward equity instruments. Hence, morethan 95 percent of the Endowment is targeted toward investment inassets expected to produce equity-like returns, through holdings ofdomestic and international securities, real assets, and private equity.

Over the past two decades, Yale dramatically reduced the Endow-ment’s dependence on domestic marketable securities by reallocatingassets to nontraditional asset classes. In 1990, almost three-fourths of theEndowment was committed to U.S. stocks, bonds, and cash. Today, tar-get allocations call for 11.0 percent in domestic marketable securities,while the diversifying assets of foreign equity, private equity, absolutereturn strategies, and real assets dominate the Endowment, representing89.0 percent of the target portfolio.

The heavy allocation to nontraditional asset classes stems from theirreturn potential and diversifying power. Today’s actual and target portfo-lios have significantly higher expected returns and lower volatility thanthe 1990 portfolio. Alternative assets, by their very nature, tend to be lesse!ciently priced than traditional marketable securities, providing anopportunity to exploit market ine!ciencies through active management.The Endowment’s long time horizon is well suited to exploiting illiquid,less e!cient markets such as venture capital, leveraged buyouts, oil andgas, timber, and real estate.

Alexander C. BankerDirector

Peter H. Ammon ’05 m.b.a., ’05 m.a.Director

Policy asset allocation targets provide thefoundation for the investment process, asno other aspect of portfolio managementplays as great a role in determining a fund’sultimate performance. Yale derives its tar-get allocation using a combination of quan-titative and qualitative analysis. By employ-ing the quantitative tool of mean-varianceoptimization, the Investments O!ce iden-tifies e!cient portfolios with expectedreturns that surpass those of all other port-folios for the same level of risk. Inputs tothe process include estimated return, risk,and correlation measures for di"erent assetclasses. Important qualitative considera-tions include the nature of active manage-ment opportunities, the degree of assetclass illiquidity, and Yale’s comparativeadvantages as an investor and activemanager.

In producing portfolio recommenda-tions, the Investments O!ce complementstop-down mean-variance optimizationwith bottom-up assessment of market con-ditions. By evaluating the absolute and rel-ative attractiveness of investment opportu-nities uncovered by Yale’s far-ranging ros-ter of external investment managers, theInvestments O!ce directs funds towardmore attractive opportunities and awayfrom less compelling situations. That said,given the long-term nature of policy tar-gets, bottom-up considerations play a sec-ondary part in the asset allocation processrelative to the lead role of mean-varianceoptimization.

In June 2010 the University adopted anumber of changes in its policy targets.Real assets moved from a target of 37.0percent to 28.0 percent, private equitymoved from 26.0 percent to 33.0 percent,absolute return moved from 15.0 percent to19.0 percent, foreign equity moved from10.0 percent to 9.0 percent, and domesticequity moved from 7.5 percent to 7.0percent.

Yale’s newly adopted target asset alloca-tion produces an expected real (after-infla-tion) long-term growth rate of 6.2 percentper annum with a risk (standard deviationof returns) of 14.7 percent. This risk-returncombination compares favorably to theaverage endowment portfolio, which o"ersa lower expected real return with higherrisk. Yale’s spending disruption risk—defined as the likelihood of a real reductionof 10 percent in spending from the Endow-ment over any five-year period—is 28percent for the current target portfolio.Impairment risk—defined as the likelihood

of losing half of purchasing power over afifty-year horizon—is 17 percent. In con-trast, the average endowment runs a 35percent chance of spending disruption anda 28 percent chance of impairment.

Even though Yale’s portfolio haschanged dramatically from its position inthe mid 1980s, moving from a typical insti-tutional portfolio dominated by marketablesecurities to a well-diversified, equity-oriented collection of assets, the year-to-year changes tended to be small. Mostyears saw changes in targets of 5.0 percentor less; in fact, in seven of twenty-fiveyears no changes occurred at all.

Yale reviews asset allocation targets onlyonce per year, limiting the possibility ofdamage from ill-considered moves made inresponse to the transient gloom or eupho-ria surrounding market movements.During the 1987 stock market crash, a 25-standard-deviation event in which thedomestic equity market fell more than 20percent in one day, Yale maintained policytargets in the face of pressure to moveassets out of stocks into fixed income. Infact, shortly following the crash, Yale pur-chased tens of millions of dollars of S&PIndex futures to rebalance the portfolio tolong-term targets. While other institutionssold depressed equities, purchased inflatedbonds, and missed the ensuing recovery,

Yale held positions it had adopted as partof the June 1987 annual policy targetreview. Accordingly, the Universitybenefited from a sensible long-termportfolio allocation.

Serious investors recognize that theprinciples of diversification and equity-orientation underlie successful long-terminvestment strategies. Yet many institu-tions fail to honor these basic tenets. In themid 1980s typical endowment portfoliosexhibited neither diversification nor equityorientation, with roughly 50 percent indomestic equities, 45 percent in domesticbonds and cash, and 5 percent in alterna-tive strategies. Two and a half decadeslater, average allocations have made sub-stantial progress, with approximately 17percent in domestic equities, 18 percent inbonds and cash, and 65 percent in alterna-tive strategies. But Yale remains ahead ofthe curve: with the Endowment’s six assetclasses exhibiting allocations between 4percent and 33 percent, the portfolio meetsthe test of diversification; with five highexpected return asset classes accounting for96 percent of assets, the portfolio embod-ies a substantial equity-orientation. Byimplementing a diversified, equity-orientedasset allocation, Yale’s Endowment is wellpositioned to serve the needs of both cur-rent and future generations of scholars.

Policy Asset Allocation Targets

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Yale’s Portfolio Achieved Diversification by the Mid 1990sYale Target Asset Allocation 1985–2010

U.S. Equity U.S. Bonds Foreign Equity Absolute Return Private Equity Real Assets Cash

Prior to 1999, real assets was made up solely of real estate. Oil and gas and timber were classifiedas private equity.

pantone 5455c

Yale’s six asset classes are defined by di"erences in their expected responseto economic conditions, such as price inflation or changes in interestrates, and are weighted in the Endowment portfolio by considering risk-adjusted returns and correlations. The University combines the assetclasses in such a way as to provide the highest expected return for a givenlevel of risk.

In July 1990, Yale became the first institutional investor to pursue abso-lute return strategies as a distinct asset class, beginning with a targetallocation of 15.0 percent. Unlike traditional domestic and foreign equityinvestments, absolute return investments provide returns largely indepen-dent of broad market moves. In contrast with diversifying investmentssuch as cash and bonds, absolute return strategies have excellent pros-pects of generating high long-term real returns.

Absolute return investments seek to generate high long-term realreturns by exploiting market ine!ciencies. The absolute return portfoliois managed by investment firms pursuing a wide variety of strategies,which can be broadly categorized as event-driven or value-driven. Event-driven strategies generally involve hedged investments in mispriced secu-rities and depend on specific corporate events, such as mergers or bank-ruptcy settlements, to achieve targeted returns. Value-driven strategiesalso entail hedged investments in mispriced securities, but rely on chang-ing company fundamentals or increasing market awareness to drive pricestoward fair value.

Today, the absolute return portfolio is targeted to be 19.0 percent ofthe Endowment. In contrast, the average educational institution allocates24.6 percent of assets to such strategies. Event-driven strategies areexpected to generate real returns of 5.5 percent and value-driven strategiesare expected to generate real returns of 5.0 percent, both with risk levelsof 15.0 percent.

An important attribute of Yale’s absolute return investment strategyconcerns the alignment of interests between investors and investmentmanagers. To that end, absolute return accounts are generally structuredwith performance-related incentive fees, hurdle rates, and clawback pro-visions. In addition, managers invest a significant portion of their networth side by side with Yale. In any investment arrangement, when gainsare strong, managers benefit and Yale profits. But if losses are incurred,only providers of capital su"er. Significant general partner co-investmentensures that losses will be felt by both the manager and Yale. By aligningthe interests of Yale and its managers, the University avoids many of thepotential pitfalls of the principal-agent relationship.

Given the opportunistic nature of the absolute return asset class, Yaleseeks to vary allocations in response to changes in the investment envi-ronment. Fluctuations in bankruptcy rates and merger activity, as well aschanges in the regulatory environment and in valuation levels, all a"ectthe relative attractiveness of absolute return strategies. Yale structuresaccounts to allow timely cash flows (in and out) in order to match assetsize with investment opportunities. The University is wary of dedicatedspecialist funds that lock up investor assets and encourage managers toput money to work regardless of the investment climate. Yale prefers tohire managers that possess the depth and scope of experience to evaluateand invest in more than one strategy.

Asset ClassCharacteristics

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Absolute Return

Timothy R. Sullivan ’86Director

Alan S. FormanDirector

Deborah S. ChungAssociate General Counsel

Stephanie S. Chan ’97Associate General Counsel

Domestic Equity

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Since June 30, 1990, the absolute return portfolio has achieved itsgoal of generating high returns with modest volatility and low correlationto domestic equity markets. The portfolio has returned an annualized 11.5percent in the twenty years since its inception, outperforming its bench-mark by 0.8 percent. In addition, the portfolio has outperformed theWilshire 5000 Index return of 7.9 percent over the relevant time period.The monthly standard deviation of the portfolio was a remarkably low5.3 percent annualized, relative to 15.4 percent volatility exhibited by theWilshire 5000. The correlation of monthly returns with the Wilshire5000 has been 0.16, highlighting the significant diversifying e"ect of theasset class.

Finance theory predicts that equity holdings will generate returns supe-rior to those of less risky assets such as bonds and cash. Traditionally apredominant asset class in U.S. institutional portfolios, domestic equityrepresents a large, liquid, and heavily researched market. While the aver-age educational institution invests 17.1 percent of assets in domestic equi-ties, Yale’s target allocation to this asset class is only 7.0 percent. Thedomestic equity portfolio has an expected real return of 6.0 percent witha standard deviation of 20.0 percent. The Wilshire 5000 Index serves asthe portfolio benchmark.

Despite recognizing that the U.S. equity market is highly e!cient,Yale elects to pursue active management strategies, aspiring to outper-form the market index by a few percentage points annually. Becausesuperior stock selection provides the most consistent and reliable oppor-tunity for generating excess returns, the University favors managers withexceptional bottom-up fundamental research capabilities.

In constructing the domestic equity portfolio, Yale pays little atten-tion to benchmark allocations. In fact, the current portfolio consists of avariety of specialists seeking to apply in-depth knowledge to concentratedportfolios of securities. The combination of a number of idiosyncraticmanager portfolios bears little resemblance to broad-based marketindices. While such a portfolio almost guarantees short-term deviationfrom market returns, the focused application of deep knowledge to thesecurity selection process sows the seeds for longer-term investmentsuccess.

Yale’s portfolio is typically biased toward small-capitalization stocksthat are cheap in relation to fundamental measures such as book value,earnings, or cash flow. Such stocks generally outperform the market overthe long term, albeit with higher volatility of returns. Patient investorsreap rewards for taking uncomfortable positions in out-of-favor sectorsand securities. Yale’s overweighting of small-capitalization stocks o"ersbetter opportunities for managers to generate excess returns becauselarger-capitalization stocks tend to be better followed and more e!cientlypriced than small-capitalization stocks.

When engaging active managers, Yale structures relationships thatalign the University’s interests with its managers’ interests. Too manymoney managers profit by gathering assets at the expense of generatingstrong investment returns. Significant manager co-investment alignsinterests, as does a manager’s desire to behave as a true fiduciary.

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Yale often develops new investment management relationships withpromising “young and hungry” principals or with experienced groupsworking independently for the first time. Newer organizations typicallyhave a modest amount of assets under management and something toprove. As investment management organizations progress through theirlife cycle, Yale monitors relationships carefully to ensure that interestscontinue to coincide, that assets under management remain at reasonablelevels, and that managers stay motivated and capable.

The Investments O!ce monitors the size of actively managed port-folios, shifting capital both to rebalance market sector exposure and totake advantage of tactical opportunities. Capital allocation to individualmanagers takes into consideration the sector exposures of the domesticequity portfolio, the degree of confidence Yale possesses in a manager,and the appropriate asset size for a particular strategy. When the Univer-sity perceives compelling undervaluation in a sector of the market, Yalemay allocate additional capital to existing managers and, perhaps, hirenew managers to take advantage of the opportunity.

Yale’s domestic equity portfolio contains a group of intelligent anddedicated managers with high integrity, sound investment philosophies,strong track records, superior organizations, and competitive advantages.In spite of the di!culty of identifying mispriced securities, by employinga su!ciently long time horizon, the University expects to benefit from thee"orts of its domestic equity managers.

Given the e!ciency of the U.S. equity market, the University’s per-formance in the asset class has been remarkable. Over the ten years end-ing June 30, 2010, Yale’s domestic equity portfolio returned 6.7 percentper annum, outperforming the Wilshire 5000 by 7.4 percent annuallyand generating $1.13 billion in value added relative to the portfolio’sbenchmark.

J. Colin SullivanAssociate General Counsel

Kenneth R. Miller ’71Associate General Counsel

Exterior of Saybrook College dining hall.

Market return studies indicate that highlevels of equity market exposure benefitlong-term investors. However, the associ-ated risks come through less clearly. Signi-ficant concentration in a single asset classposes extraordinary risk to portfolio assets.Fortunately, diversification providesinvestors with a powerful risk managementtool. By combining assets that vary inresponse to forces that drive markets,investors create more e!cient portfolios.At a given risk level, properly diversifiedportfolios provide higher returns than lessdiversified portfolios. Conversely, throughappropriate diversification, a given levelof returns can be achieved at lower risk.Harry Markowitz, known as the father ofmodern portfolio theory, maintains thatportfolio diversification provides investorswith a “free lunch,” since risk can bereduced without sacrificing expectedreturn.

Yale’s Endowment pioneered diversi-fication into alternative asset classes likeabsolute return, real assets, and privateequity. By the mid 1990s, Yale achievedmost of the gains in portfolio e!ciencyavailable from a diversified, equity-ori-ented approach. Today, the Universityboasts one of the most diversified institu-tional portfolios, with allocations to sixasset classes with weights ranging from 4.0percent to 33.0 percent. Yale’s allocations of7.0 percent to domestic equity and 4.0 per-cent to fixed income cause only 11.0 percentof the University’s assets to be invested intraditional U.S. marketable securities. Incontrast, the average endowment has overa third of its assets in U.S. stocks, bonds,and cash.

Sticking with portfolio diversificationcan be painful in the midst of a bull mar-

ket. When mindless momentum strategiesproduce great returns, market observerswonder about the benefits of creating awell-structured portfolio. Consider thestock market bubble at the turn of the mil-lennium. In the five years ending June 30,2000, the S&P 500 returned an amazing23.8 percent per year, trouncing the perfor-mance of foreign developed and foreignemerging markets, which returned 9.7percent and negative 1.1 percent per year,respectively. During the same period, themedian educational endowment returned16.6 percent annually. Simply owning theS&P 500 would have generated a wealthmultiple of 2.9 times, while the averageendowment lagged with a multiple of 2.2times.

By the late 1990s, many investors ques-tioned the wisdom of owning any assetsother than U.S. equities, especially high-flying technology stocks, asserting theinherent superiority of American compa-nies and the inevitable dominance of hightech businesses. Not surprisingly, U.S.equity markets eventually collapsed. Whenthe bull market came to a halt in the springof 2000, Yale was in an extremely strongposition to generate handsome returns.Strong performance by the absolute returnand real assets portfolios, which had laggedoverall Endowment performance in the late1990s, bolstered Endowment returns.

Just as roaring bull markets encouragediversification skeptics, so do acute finan-cial panics. Based on the substantial declinein Yale’s Endowment during the recentfinancial crisis, some observers questionedthe University’s diversified, equity-orientedapproach. Particular criticism focused onthe Yale model’s failure to protect theEndowment in the early months of the

financial crisis. The criticism, while super-ficially true, falls short in two ways: (1) ina financial crisis (the market crash in 1987,the Long-Term Capital Management failurein 1998, the Internet bubble collapse, andthe downturn in 2008) all risky assets fallin price as market participants seek thesafety of government bonds, leaving gov-ernment bonds as the only diversifyingasset that works; and (2) when evaluatedover a reasonably long time frame, theopportunity costs of holding governmentbonds impose a significant drag on portfo-lio returns.

The fact that diversification among avariety of equity-oriented alternativeinvestments sometimes fails to protectportfolios in the short run does not negatethe value of diversification in the long run.Consider an investor in Japanese equitiesin 1989. An equity-oriented undiversifiedportfolio invested in the Nikkei at the endof 1989 su"ered a decline of 73 percentover the subsequent two decades. Diversi-fication matters.

The University’s discipline of stickingwith a diversified portfolio has contributedto the Endowment’s market-leading long-term record. Going forward, Yale expectssuperior results from its diversifiedapproach to investing. The University’starget portfolio produces an expected real(after-inflation) annual return of 7.2 per-cent with a risk (standard deviation ofreturns) of 14.7 percent. In contrast, theundiversified institutional standard of 70percent stocks and 30 percent bonds pro-duces expected real annual returns of 4.8percent with risk of 15.2 percent. Yale’sdiversified portfolio promises higherexpected returns with lower risk.

Diversification and Its Long-Term Benefits

14 Aerial view of Cross Campus area showing Sterling Memorial Library at far right.

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Fixed income assets generate stable flows of income, providing greatercertainty of nominal cash flow than any other Endowment asset class.The bond portfolio exhibits a low correlation with other asset classes andserves as a liquidity reserve and as a hedge against financial accidents.While educational institutions maintain a substantial allocation to fixedincome instruments and cash, averaging 15.3 percent, Yale’s target alloca-tion to fixed income and cash constitutes only 4.0 percent of the Endow-ment. Bonds have an expected real return of 2.0 percent with risk of 10.0percent. The Barclays Capital 1-5 Year U.S. Treasury Index serves as theportfolio benchmark.

Yale is not particularly attracted to fixed income assets, as they havethe lowest historical and expected returns of the six asset classes thatmake up the Endowment. Still, fixed income plays an important role inthe Endowment by providing a liquidity reserve to support portfoliomanagement activities. To ensure access to liquidity, the Endowmentinvests primarily in high-quality instruments backed by the full faith andcredit of the U.S. government.

The market for government bonds is the most e!cient and liquidin the world, making it di!cult for active managers to outperform thebenchmark net of fees. In fact, most active managers play a cynical game,consciously exposing client assets to greater-than-benchmark risk andclaiming that the incremental returns represent superior performance.As the bond managers pocket fees for providing a disservice, clients losein more than one way. In addition to the out-of-pocket costs paid foractive management, clients lose the protection a"orded by high-quality,non-callable fixed income instruments.

One way in which active managers “outperform” a fixed incomebenchmark is by overweighting credit-sensitive issues. Under normal cir-cumstances, corporations meet their contractual obligations, providing aspread over the U.S. Treasury return to investors willing to accept creditrisk. However, in times of crisis, just when investors most need the pro-tection provided by fixed income portfolios, markets discount the valueof corporate promises-to-pay, impairing the defensive character of bondinvestments.

Another method employed by active managers is to increase theoptionality of fixed income holdings. By holding callable corporate ormortgage-backed securities, bond managers again increase returns undernormal circumstances. Yet, when interest rates decline, companies andhomeowners repay callable debt to refinance existing obligations at lowerrates. Just when declining rates ought to boost bond portfolio value, thepresence of callable instruments dampens portfolio appreciation andundermines the fundamental reason for holding bonds.

Most active management strategies hurt investors by failing to gen-erate risk-adjusted excess returns and by diluting the hedging characteris-tics of high-quality, non-callable bond investments. Investors holdingpure fixed income—obligations of the U.S. government—best meet theliquidity provision requirements for bond portfolios.

Fixed Income

Michael E. FinnertyAssociate Director

Carrie A. AbildgaardAssociate Director

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Sensible investors focus on the superior diversifying characteristicsof government bonds, holding only the amount necessary to providesu!cient liquidity for portfolio management activities. If portfoliosinclude the minimum allocation necessary, investors free up assets todiversify into alternative asset classes, achieving volatility reduction with-out sacrificing return. A low allocation to high-quality fixed incomereduces the costs associated with holding bonds during normal circum-stances and periods of unanticipated inflation, the environments in whichfixed income positions tend to impair portfolio performance. Tailoringthe bond portfolio to emphasize fixed income’s essential diversifying char-acteristics increases expected benefits, while reducing the long-term costsof holding bonds.

In spite of an aversion to market timing strategies, credit risk, andcall options, Yale manages to add value consistently in its internal man-agement of the bond portfolio. Primarily by identifying overlooked secu-rities, over the past decade the Investments O!ce produced returns of 0.3percent per year above its composite benchmark. Simply avoiding payinga premium for the most heavily traded, so-called on-the-run securitiesprovides a sensible starting point for portfolio construction. Returns areenhanced by identifying occasional opportunities to purchase full faithand credit obligations of obscure government agencies at spreads of up toa full percentage point over Treasuries. Creative, patient portfolio man-agement leads to superior investment results without impairing the port-folio protection characteristics of high-quality fixed income.

Lisa M. Howie ’00, ’08 m.b.a.Associate Director

Suzanne K. WirtzAssociate Director

The Yale Bowl, completed in 1914, with a seating capacity of more than 61,000.

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Foreign Equity Foreign equity investments give the Endowment exposure to the globaleconomy, providing diversification and the opportunity to earn outsizedreturns. This diversification, quantitatively reflected in the foreign equityportfolio’s expected correlation of 0.68 to domestic equities, reduces theEndowment portfolio’s level of risk. Additionally, the large number ofunderfollowed companies listed in foreign markets and the ine!cienciesin their pricing create opportunities to earn above-market returnsthrough active management.

Yale targets 4.0 percent of its portfolio to foreign developed equitiesand 2.5 percent to emerging market equities. Yale dedicates 2.5 percent ofthe portfolio to opportunistic foreign positions, with the expectation thatholdings will be concentrated in markets, such as China and India, thato"er the most compelling long-term opportunities. While Yale’s total tar-get foreign equity allocation is 9.0 percent, the average educational insti-tution allocates 18.1 percent to the asset class. Expected real returns fordeveloped equities are 6.0 percent with a risk level of 20.0 percent, whileemerging and opportunistic equities both have expected real returns of7.0 percent with risk levels of 22.5 percent. The foreign equity portfolio isbenchmarked against a composite of 44 percent developed markets, mea-sured by the Morgan Stanley Capital International (msci) Europe,Australasia, and Far East Index; 28 percent emerging markets, measuredby the msci Emerging Markets Index; and 28 percent custom oppor-tunistic index, measured by a blend of the msci China, msci ChinaA-Shares, and msci India Indices.

Country allocations heavily influence overall performance in foreignequities. Unfortunately, forecasting country returns proves di!cult andgenerally provides an unreliable source of value added. Even thoughcountry valuations of overseas markets sporadically move to extremesthat o"er identifiable top-down opportunities to generate excess returns,Yale’s managers predominantly focus on generating outperformancethrough bottom-up security-specific investments. Although some ofYale’s managers have global mandates, Yale recognizes the value of man-agers who specialize regionally. A regional mandate facilitates the execu-tion of intensive company research, creating an edge over less focusedglobal funds.

Emerging markets tend to be less e!cient than developed markets,resulting from a lack of liquidity, scant research coverage, and a dearthof sophisticated local investors. Periodic inflows and outflows of institu-tional capital to and from emerging markets exacerbate these ine!cien-cies. Emerging markets provide a considerable set of investment opportu-nities, particularly in companies well positioned to benefit from rapidlygrowing and changing economies. This combination of dynamic busi-nesses and less e!cient markets creates a wealth of opportunities forYale’s managers to add value.

Although Yale’s foreign equity managers pursue a broad range ofinvestment mandates, they share a commitment to high-quality research.The University’s managers conduct deep due diligence to build di"er-entiated insights on the companies in their investment universe. Compre-hensive, fundamental research gives rise to an analytical edge and allowsmanagers to identify undervalued securities at discounts to fair value.Yale’s long time horizon enables foreign equity managers to invest incompanies that will compound value over several years.R. Alexander Hetherington ’06

Senior Associate

Celeste P. BensonSenior Portfolio Manager

Investors frequently encounter opportuni-ties to generate excess returns from accept-ing illiquidity. Of course, pursuing everypremium return associated with illiquidassets and thereby creating a completelyilliquid portfolio is neither reasonable norrealistic. Sensible investors preserve su!-cient liquidity to meet the full range ofportfolio commitments, bolstered by acomfortable cushion. Yale’s Endowmentmust maintain the ability to fund spendingto support current University operations,to satisfy commitments to contribute capi-tal to investment partnerships, to capitalizeon attractive investment opportunities, andto provide support for the University’sfinancing activities.

Yale’s allocation to private equity andreal assets investments has grown steadilyover the past twenty-five years, as theUniversity’s long-term time horizonenabled it to take advantage of opportuni-ties to add substantial value in less liquidalternative assets. As the Endowment’sasset allocation has evolved, the importanceof understanding and monitoring Yale’sliquidity profile has increased. The evapo-ration of liquidity during the recent eco-nomic and financial market turbulencehighlights the importance of prudent liq-uidity management. Yale carefully monitorsits liquidity, stress-testing the University’ssources and uses of capital under a varietyof market conditions and a number ofoperating scenarios.

The University has both internal andexternal sources of liquidity at its disposal.Even a portfolio characterized by high per-

centages of long-term assets contains moreliquidity than might be immediately appar-ent. Yale’s holdings in marketable bondsand equities, absolute return positions, realassets (real estate, oil and gas, and timber),and private equity (leveraged buyouts andventure capital) generate a fair amount ofnatural internal liquidity. For instance,bonds pay interest, stocks pay dividends,real estate produces rents, energy reservesprovide both returns on capital and returnsof capital (through depletion), and privateequity partnerships distribute proceedsfrom realizations. The Investments O!cecarefully forecasts how these distributionswill change under a range of economicscenarios.

Holdings of marketable securities pro-vide a source of non-disruptive liquidity,namely liquidity generated in a mannerthat does not change the Endowment’sasset class exposure. For example, bondsand stocks can serve as collateral for repur-chase agreements (repos) and securitylending, respectively. The owner of thesecurities generates liquidity through pro-ceeds produced by the repo and securitylending activity, while retaining the eco-nomic exposure associated with thesecurities.

External borrowing represents anothersource of non-disruptive liquidity. Forexample, for nearly two decades Yale hastapped the commercial paper market toprovide funds to support operations andcapital projects. During the recent financialcrisis, the University had access to nearly$2 billion of commercial paper funding. In

November 2009, after the crisis subsided,Yale issued $1 billion in five-year fixed-ratetaxable bonds. The deal was oversub-scribed and Yale achieved attractive pricing.The issuance proceeds funded new andexisting capital projects and generated asubstantial amount of University liquidity.

Yale’s Endowment can also generate dis-ruptive liquidity, namely liquidity createdin a manner that changes the Endowment’sasset class exposure. Outright sales ofbonds or stocks generate liquidity, but alterportfolio characteristics. Withdrawals fromabsolute return managers provide an addi-tional source of disruptive liquidity. Wholeor partial sales of private equity and realassets represent a third, albeit quite unap-pealing, means of confronting liquiditysqueezes. Even under the best of circum-stances, sales of illiquid partnerships takeplace at meaningful discounts to fair value.In the heart of a financial crisis, sales ofilliquid holdings generally occur at dra-matic discounts to fair value, producingliquidity that is both expensive anddisruptive.

Liquidity matters, even to portfolioswith modest spending requirements andlong-term horizons. By implementingmechanisms to tap a variety of internal andexternal sources of liquidity, endowmentmanagers provide the means for educa-tional institutions to satisfy the full rangeof portfolio commitments. Careful moni-toring and forecasting of Yale’s liquidityensures that the University will meet itscash needs, even during periods of marketstress, without disrupting the portfolio.

Liquidity

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Liquid Assets53.3%

Quasi-Liquid Assets24.6%

Illiquid Assets21.8%

Average Endowment LiquidityJune 30, 2010

Liquid Assets21.3%

Illiquid Assets57.8%

Quasi-Liquid Assets21.0%

Yale Endowment LiquidityJune 30, 2010

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Yale’s preference for regionally focused managers that perform bot-tom-up, fundamental analysis may cause Yale’s country, sector, and secu-rity allocations to diverge significantly from those of broad global indices.Yale’s managers have identified stocks throughout the capitalization spec-trum that are cheap in relation to fundamental measures such as bookvalue, earnings, or cash flow. Small-capitalization stocks, lying below theradar screen of large institutional funds, have historically o"ered greateropportunities for active managers to add value. In recent years, however,Yale’s foreign equity managers have found ine!ciencies even in large-capitalization stocks and premier companies.

The Investments O!ce continuously monitors the size of activelymanaged portfolios, shifting capital both to rebalance market exposuresand to take advantage of tactical opportunities. Capital allocation to indi-vidual managers takes into consideration the degree of confidence Yalepossesses in a manager, the country allocation of the manager’s portfolio,and the appropriate size for a particular strategy. In addition, Yale willexploit compelling undervaluations in a country, sector, or strategy byallocating additional capital or, on occasion, by hiring a new manager.

In general, Yale’s managers do not hedge currencies, since a modestamount of exchange rate exposure actually improves overall portfoliodiversification. However, managers will occasionally incorporate insightson exchange rates into security selection decisions, such as by favoringexporters in countries with weakening currencies. In extreme circum-stances, some of Yale’s managers will selectively hedge foreign exchangeexposure.

The University’s performance in foreign equities has been outstand-ing. Over the ten years ending June 30, 2010, Yale’s foreign equity portfo-lio returned 13.8 percent per annum, easily besting the annualized 5.9 per-cent return of the asset class’s composite benchmark, generating $1.17 bil-lion in value added relative to the portfolio’s benchmark.

Jonathan Rhinesmith ’08Senior Financial Analyst

Matthew S.T. Mendelsohn ’07Senior Financial Analyst

Interior of Ingalls Rink. Designed by Eero Saarinen, the rink was completed in 1958 and recently renovated.

Private Equity

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Private equity o"ers extremely attractive long-term risk-adjusted returncharacteristics, stemming from the University’s strong stable of managersthat exploit market ine!ciencies. Yale’s private equity investments includeparticipations in venture capital and leveraged buyout partnerships. TheUniversity’s target allocation to private equity of 33.0 percent far exceedsthe 10.2 percent actual allocation of the average educational institution. Inaggregate, the private equity portfolio is expected to generate real returnsof 10.5 percent with risk of 27.7 percent.

Yale was among the first institutional investors to participate in thenow widely pursued asset class of private equity, making its first commit-ment to leveraged buyouts in 1973 and to venture capital in 1976. TheUniversity participates in private equity through partnerships managedby the nation’s leading private equity firms, including venture capitalistsGreylock Partners, Kleiner Perkins Caufield & Byers, and Sutter HillVentures and buyout specialists Bain Capital, Berkshire Partners, ClaytonDubilier & Rice, and Golden Gate Capital.

Yale’s private equity program is regarded as one of the best in theinstitutional investment community and the University is frequently citedas a role model by other investors. Since inception in 1973, Yale’s privateequity portfolio has generated a 30.3 percent annual return. Over the pastten years, it has produced a 6.2 percent annual return, outpacing the S&P500 by 7.8 percent per annum. The success of Yale’s program led to a 1995Harvard Business School case study, “Yale University Investments O!ce,”by Professors Josh Lerner and Jay Light. The popular case study wasupdated in 1997, 2000, 2003, and 2006.

Yale’s private equity assets concentrate on partnerships with firmsthat emphasize a value-added approach to investing. Such firms workclosely with portfolio companies to create fundamentally more valuableentities, relying only secondarily on financial engineering to generatereturns. Investments are made with an eye toward long-term relation-ships—generally, a commitment is expected to be the first of several—and toward the close alignment of the interests of general and limitedpartners.

Of particular note has been the success of Yale’s venture capital man-agers, which have helped start some of the nation’s leading companies.In the 1970s and 1980s, Yale participated in a number of start-ups thathelped define the technology industry, including Compaq Computer,Oracle, Genentech, Dell Computer, and Amgen. The high-flying 1990sincluded lucrative investments in Amazon.com, Yahoo, Cisco Systems,Red Hat, and Juniper Networks. Yale’s more recent investments inGoogle, Facebook, LinkedIn, Twitter, and Zynga illustrate the home-run potential of venture capital investing; for example, the University’s$300,000 investment in Google generated $75 million of gains after thecompany went public in 2004.

While lacking the dramatic appeal of venture investments, Yale’sleveraged buyout investments have delivered high returns with remark-able consistency. Notable transactions in which Yale participated throughits leveraged buyout firms include Snapple Beverage, AutoZone, LexmarkInternational, Kinko’s, Carter’s, Domino’s Pizza, and Bare Escentuals.

Michael R. Schmidt ’08Senior Financial Analyst

John V. Ricotta ’08Senior Financial Analyst

Real Assets

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Increasingly, Yale has invested in private equity abroad. The Euro-pean leveraged buyout market provides appealing investment opportuni-ties and Asian venture capital presents explosive potential, albeit with theincreased risks of investing in developing countries with less well-estab-lished laws and markets. India and China, in particular, represent areasof great opportunity for private equity investors.

The success of Yale and other long-time investors in private equityhas attracted numerous new investors to the field. Vastly larger sumsof capital were raised in the 2000s, prompting concerns about futurereturns. Because the recent financial crisis has dampened many investors’appetites for illiquid asset exposure, Yale sees a better future for the assetclass. The hallmark of Yale’s successful private equity program has beenlong-term relationships with the very best venture capital and leveragedbuyout managers. By aligning itself with premier firms, the Universityhopes to continue to generate attractive returns to support Yale’s educa-tional mission.

Real estate, oil and gas, and timberland share common characteristics:sensitivity to inflationary forces, high and visible current cash flow, andopportunity to exploit ine!ciencies. Real assets investments provideattractive return prospects, excellent portfolio diversification, and a hedgeagainst unanticipated inflation. Yale’s 28.0 percent long-term policy allo-cation significantly exceeds the average endowment’s commitment of 11.6percent. Expected real returns are 6.0 percent with risk of 15.5 percent.

Holdings of real assets o"er risk and return characteristics wellsuited for the Yale Endowment. Real assets investments provide claims onfuture streams of inflation-sensitive income, supplying protection againstunanticipated inflation and playing an important diversifying role in theportfolio. In addition to attractive diversifying characteristics, real assetspresent tremendous opportunities for superior managers to add value andoutperform industry averages. The illiquid nature of real assets and theinformation-intensive aspects of the transaction processes favor skilledand experienced investors.

To take advantage of ine!cient real estate, oil and gas, and timber-land markets, the University seeks talented and motivated investmentmanagers with proven ability to create value independent of underlyingmarket or commodity price movements. Believing that the basic returnfrom real assets investments can be augmented by operational expertise,Yale looks for firms with superior operating capabilities, as opposed togroups with only financial engineering skills. Yale’s strong preference is towork with operators that focus on a geographic region or property type,or both, believing that specialized managers with deep market knowledgeand experience gain an important edge over more di"use organizations.

Yale attempts to create strong, long-term partnerships in which theinterests of the University and its investment managers are closelyaligned. Yale requires investment managers to own a meaningful eco-nomic interest in every deal, encouraging thoughtful acquisitions, carefuloversight, and timely dispositions. Yale targets employee-owned firmsto ensure that incentive compensation benefits the individuals doing thework and that general partner co-investment comes principally from thepartners of the firm. Yale demands that its partners maintain reasonablelevels of assets under management, encouraging pursuit of only the mostTess A. Dearing ’09

Financial Analyst

Cain P. Solto" ’08Senior Financial Analyst

Until the mid 1960s, the University limitedthe Endowment’s annual contribution tothe operating budget to investment yield—the interest, dividend, and rental incomegenerated by the Endowment. In 1967, rec-ognizing that simply spending yield couldresult in too high or too low a spendingrate and could bias investment decisionstoward securities with high yield but lowappreciation potential, Yale adopted a totalreturn spending policy. Under the totalreturn policy, the University supportedoperations with current yield plus a pru-dent portion of the appreciation of Endow-ment market value.

Concurrent with the decision to employa total return concept, Yale instituted aformal method, called the “UniversityEquation,” to calculate the total amountthat could responsibly be spent from theEndowment. The method set spending in agiven year by adjusting the previous year’sspending by the di"erence between theUniversity’s long-term investment return(measured over the prior twenty-yearperiod) and the current percentage of theEndowment being spent. Higher long-term returns would lead to higher annualspending, while lower long-term returnswould lead to reduced spending. Unfortu-nately, the University Equation did notadjust rapidly enough to changes inEndowment market value. As a result, inthe 1970s, when inflation increased andmarket returns dropped, the Universityspent an unsustainably high portion of theEndowment to support current operations.

In 1977, recognizing that the rate ofspending was eroding the real value of theEndowment, the Yale Corporation voted tocap spending at the existing level (adjustedfor inflation) until the spending rate wasbrought in line with the expected real(after-inflation) return from the Endow-ment. The Endowment’s expected realreturn was taken to be 4.5 percent, consis-tent with historical experience.

In 1982, upon bringing spending to anappropriate level, the Corporation adopteda spending rule that attempted to releasesubstantial income for current scholars andpreserve purchasing power of the Endow-ment for future generations. Under thenew rule, Endowment spending amountedto the weighted average of 70 percent ofthe previous year’s spending, adjusted forinflation, plus 30 percent of the targetedlong-term spending rate of 4.5 percent

applied to the Endowment’s market value.The 70 percent weight on prior year spend-ing promised budgetary stability, while the30 percent weight on market value pro-vided purchasing power sensitivity.

Since 1982, the spending rule has beenadjusted five times. In 1992 the Corpor-ation authorized an increase in the long-term spending rate from 4.5 percent to 4.75percent. In 1995 Yale adopted a furtherincrease in the target rate to 5.0 percent. In2004 the Corporation increased the spend-ing rate to 5.25 percent and changed thesmoothing rule from 70/30 to 80/20. Theincreases in spending rates resulted fromimprovement in Endowment portfoliocharacteristics. The change in weightassigned to budgetary stability stemmedfrom recognition that increased budgetarydependence on Endowment incomerequired greater stability in flows ofEndowment income to support operations.

The final two adjustments were madein 2007. Both were intended to address aperiod of spending at rates substantiallybelow Yale’s target due to exceptionalinvestment performance. The first revisionmodified the calculation used to adjust the

spending level because it was determinedusing prior fiscal year data. The secondrevision established a cap and floor withthe cap set at 6.0 percent and the floor setat 4.5 percent. While the cap and floorstructure does not preclude contemporane-ous spending rates below the sensiblethreshold of 4.0 percent or above the rea-sonable limit of 6.5 percent, the new struc-ture materially reduces the likelihood ofsuch extreme outcomes. Both modifica-tions operated as if the changes were madeas of fiscal 2002 and included one-timecompensating distributions (special divi-dends) made in fiscal 2008 and 2009.

Unfortunately, action (in the form ofspecial dividends) to address the problemof underspending came right before theonset of the financial crisis. Had Yale sim-ply followed the spending policy in place in2004, the University would have benefitedfrom year-over-year increases in spendingdistributions, even through the financialcrisis. Instead, the special dividendsinflated spending levels and caused Yaleto cut distributions from Endowment toreturn to sustainable spending levels.

History of Yale’s Spending Policy

22

Yale’s Endowment Spending Rate 1950-2010

0

1%

2%

3%

4%

5%

6%

7%

8%

9%

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 20101950Spending Rate

To assess the e!cacy of various combina-tions of investment and spending policies,the Investments O!ce developed a modelthat uses simulations to evaluate theimpact of a range of policy combinationson Yale’s Endowment and operating bud-get. Using “Monte Carlo” techniques, themodel employs random numbers to pro-duce portfolio return patterns consistentwith assumptions regarding asset classexpected return, risk, and correlation char-acteristics. The resulting path of simulatedreturns determines Endowment values andspending levels, based on the modeledinvestment and spending policies. Thou-sands of simulations provide a robust pic-ture of the potential e"ectiveness of anygiven policy combination.

The two most important criteria used toanalyze the results of various policies are(1) the likelihood of a significant, sustainedintermediate-term drop in Endowmentsupport for the operating budget; and(2) the likelihood of a dramatic long-termreduction in Endowment purchasingpower. A significant decline in support forthe operating budget is defined as a realreduction of 10 percent over a five-yearperiod. A dramatic decline in Endowmentpurchasing power is defined as a 50 percentdrop over a fifty-year horizon.

The Monte Carlo simulations representa substantial extension of (and improve-ment over) conventional mean-varianceoptimization techniques. Mean-varianceanalysis simply identifies a set of e!cientportfolios, namely portfolios with the high-est return for a given level of risk or portfo-lios with the lowest risk for a given level ofreturn. The mean-variance framework pro-vides no intuitive mechanism for portfoliochoice and fails to incorporate the impactof spending policy. In contrast, by extend-ing the analysis with Monte Carlo simula-tions, decision makers enjoy the opportu-nity to assess the trade-o" between easilyunderstood criteria: stable operating bud-get support (probability of losing 10 per-cent of Endowment spending) and pur-chasing power preservation (probability oflosing 50 percent of Endowment purchas-ing power).

Empirically, financial economists findthat market returns exhibit fat tails—agreater frequency of extreme results—thanwould be found in normal distributionswith the same mean and variance. ThoughMonte Carlo simulations often use nor-mally distributed random numbers, Yaleaddressed this weakness by running simu-lations that transition between di"erent

world states, each with its own distinctunderlying normal distribution. Definingvarious world states, such as bear and bullmarkets, allows Yale to improve specifica-tion of the asset class characterizations. Forexample, by increasing the likelihood of abear market state, Yale can control theskew and fatness of the left tail in the over-all distribution, improving the descriptionof financial market reality relative to anunadjusted normal distribution.

Monte Carlo simulations applied to theEndowment’s current target asset allocationand spending policies indicate a 28 percentchance of real spending falling by morethan 10 percent over a five-year span.Although the Endowment’s real growthrate is expected to outpace the 5.25 percenttarget spending rate, a roughly 17 percentchance exists that the purchasing power ofthe Endowment would drop by more than50 percent after fifty years. The only meansto improve spending stability and purchas-ing power preservation would be to lowerYale’s target spending rate.

Using the metrics of stable operatingbudget support and purchasing powerpreservation, the Endowment demon-strated substantial improvement overthe past twenty years. As Yale improveddiversification by allocating more of theEndowment to the alternative assetclasses of absolute return, private equity,and real assets, risks plummeted for bothspending and purchasing power degra-dation. In 1990, when alternative assetclasses accounted for only 15 percent of theEndowment, Yale faced a 40 percent chanceof real spending dropping 10 percent overfive years and a 49 percent chance of real

Endowment values diminishing by 50percent over fifty years. By 2000, whenabsolute return, private equity, and realassets accounted for nearly 60 percent ofthe Endowment, disruptive spending droprisk fell to 31 percent and purchasing powerimpairment risk declined to 27 percent.1

Investment and spending policies ofother educational institutions provide moredisturbing results. Using Monte Carlo sim-ulations and the typical endowment spend-ing rule (5 percent target rate applied to athree-year moving average of endowmentvalue), the Investments O!ce estimatesthat the average endowment faces a 35 per-cent chance of a 10 percent spending dropover five years and runs a 28 percentchance of losing half of its purchasingpower over a fifty-year period.

In the simulations, the median purchas-ing power of the average endowment afterfifty years amounts to only 85 percent of itsbeginning purchasing power. In general,educational institutions spend at rates fartoo high to be supported by undiversifiedportfolios that contain far too many low-returning assets. Yale’s simulations showrelatively significant probabilities of cir-cumstances that would be traumatic foreducational institutions, highlightingthe tenuous balance between protectingEndowment purchasing power and main-taining a steady and substantial streamof spending.1 As both spending policies and capital marketsassumptions have changed between 1990 andtoday, the Investments Office used today’s policyand assumptions to calculate the disruptive spend-ing drop risk and purchasing power impairmentrisk using the historical asset allocations of 1990and 2000.

Monte Carlo Simulations

23Gateway to Silliman College.

Xinchen Wang ’09Financial Analyst24

attractive opportunities and forcing managers to create wealth throughthe generation of high returns rather than the collection of large annualmanagement fees.

Yale’s investment strategy compels the University to support emerg-ing investment management groups that are not well-known, brandname companies. Even though newly formed groups typically includeseveral highly experienced and talented founding partners, backing start-ups exposes the University to managerial and organizational risk as theindividuals attempt to jell as a team and the management company seeksto reach break-even. In spite of the risks, the University benefits enor-mously from the close relationships forged with organizations that theInvestments O!ce introduced to the institutional funds managementbusiness.

Yale prefers real assets investments that generate a current cash yield,whether from property rents, reserve production, or sustainable timberharvests. The presence of a substantial cash yield makes the total returnon investment less sensitive to the length of the holding period andreduces valuation risk. Yale attempts to garner a margin of safety by pay-ing a low purchase price. In real estate deals, Yale pursues investments inwhich asset pricing is at a discount to replacement cost; in oil and gas,reserve acquisitions at a discount to long-term normalized pricing; andin timber, forestland at a substantial discount to standing timber value.

In the real estate portfolio, Yale has developed a deep roster ofinvestment managers focused on multiple property types and geogra-phies. Because local supply and demand dynamics play a large role indetermining market returns, much of the real estate portfolio is located insupply-constrained areas. Reflecting the University’s bias toward focusedmanagers, the portfolio’s largest managers are niche players, concentrat-ing on narrowly defined areas. Specialized managers with excellent mar-ket knowledge add enormous value, supporting the notions that realestate is not a commodity and that values can vary tremendously evenbetween neighboring properties.

In the oil and gas and timber arenas, price changes in the underlyingcommodity strongly influence investment returns. Unfortunately, macro-economic and political factors drive commodity prices, making themextremely di!cult, if not impossible, to forecast. Rather than depend onuncertain future price increases, Yale’s natural resource investments mustmeet return targets in flat price environments. If commodity prices rise,Yale’s natural resource portfolio will generate handsome performanceeven as other parts of the Endowment su"er from the higher costs ofbasic materials and energy.

In the oil and gas portfolio, Yale emphasizes the low-risk purchase ofhigh-quality proven reserves. In finding managers that evaluate and oper-ate assets more e!ciently than large oil and gas companies, Yale generatessubstantial returns without depending on higher-risk exploration strate-gies. A portion of the energy portfolio is allocated to private investmentsin which investment managers take meaningful stakes in energy explo-ration, production, or service companies with attractive growth prospects.

When investing in timberland, Yale concentrates on the purchaseand sustainable management of natural forests in the United States.While generally slower growing than plantation forests, natural foreststend to be priced less e!ciently and to o"er more opportunities for

Nilesh V. Vashee ’09Financial Analyst

David S. Katzman ’10Financial Analyst

25

skilled managers to add value through silvicultural activities, selectiveharvests, and wood merchandising. Like value stocks in the marketablesecurities world, slower growing forests sometimes can be purchased foroverly discounted prices because of lack of interest by other investors.

In real assets, like other asset classes, Yale seeks value and behaves ina contrarian manner. Investments reflect compelling opportunities andthe University’s ability to find suitable managers, regardless of activity inthe broad market. This approach has generated strong investment perfor-mance and important diversification to the Endowment. Over the tenyears ending June 30, 2010, the portfolio returned an annualized rate ofreturn of 10.9 percent, surpassing the benchmark return of 9.8 percent.Correlations with other asset classes over the last decade have rangedfrom a low of 0.23 with the fixed income asset class to a high of 0.42 withthe domestic equity asset class.

Yale EducationalUniversity Institution Mean

Absolute Return 21.0% 24.6%Domestic Equity 7.0 17.1Fixed Income 4.0 15.3Foreign Equity 9.9 18.1Private Equity 30.3 10.2Real Assets 27.5 11.6Cash 0.4 2.8Data as of June 30, 2010

Matthew L. Ramadanovic

Asset Allocations

Thad C. Brown ’92

Yale directs active management e"orts toless e!ciently priced asset classes andemploys less aggressive approaches formore e!ciently priced assets. Given equalexpenditure of time and e"ort, active man-agement promises greater rewards in theinfrequently traded, illiquid world of pri-vate assets than in the heavily traded, liq-uid world of fixed income.

In the absence of direct measures ofmarket e!ciency, active manager behaviorprovides clues about the degree of oppor-tunity in various markets. In those marketswith limited opportunities for active man-agement, managers deviate little from themarket portfolio, tending to obtain market-like returns. Why do managers in e!cientmarkets “hug” the benchmark? In a worldof e!ciently priced assets, consider thebusiness consequences to investmentmanagers who hold portfolios that di"ermarkedly from the market portfolio. Largeoverweights and underweights in securityholdings cause portfolio results to vary dra-matically from the benchmark. Underper-forming managers lose clients, su"ering apunishing loss in assets. Overachieversgain clients (and public adulation), yetbecause e!cient markets price securities

accurately, success will be transitory. Sincee!cient markets present no significantmispricings for active managers to exploit,good results stem from luck, not skill.Eventually, luck runs out and results disap-point. Over time, managers in e!cientmarkets gravitate toward “closet indexing,”structuring portfolios with only modestdeviations from the market, ensuring bothmediocrity and survival.

In contrast, active managers in lesse!cient markets exhibit greater variabilityin returns. In fact, many private marketslack benchmarks for managers to “hug,”eliminating the problem of closet indexing.Ine!ciencies in pricing allow managerswith great skill to achieve great success,while unskilled managers post commensu-rately poor results. Hard work and intelli-gence reap rich rewards in an environmentwhere superior information and deal flowprovide an edge.

The degree of opportunity for activemanagement (at least as measured by man-ager behavior) relates to the distribution ofactively managed returns in a particularasset class. Any measure of dispersion pro-vides some sense of the richness of activemanagement opportunities. The spread in

returns between the first and third quar-tiles in collections of actively managedportfolios illustrates the notion that moree!ciently priced assets provide less oppor-tunity for active managers and that lesse!ciently priced assets provide moreopportunity.

The accompanying chart shows activemanager returns for various asset classesfor the decade ending June 30, 2010. U.S.Treasury securities, arguably the moste!ciently priced assets in the world, tradein staggering volumes in markets domi-nated by savvy financial institutions. TheTreasury market provides the benchmarkfor all other fixed income trading. Sincenobody (with the possible exception of theFederal Reserve) knows where interestrates will be, few managers employ interestrate anticipation strategies. Without poten-tially powerful di"erentiating bets on inter-est rates, institutional portfolios tend toexhibit market-like interest rate sensitivity,or duration. As a result, managers generallylimit themselves to modest security selec-tion decisions, causing returns for mostactive managers to mimic benchmarkresults. The spread between first and thirdquartile results for active bond managers

Degree of Investment Opportunity

26

Dispersion of Active Management ReturnsAsset Returns by Quartile. Ten Years Ending June 30, 2010

Asset Class First Median Third RangeQuartile Quartile

U.S. Fixed Income 5.9% 5.6% 5.2% 0.6%

U.S. Large-Capitalization Equity 2.5 (0.0) (2.0) 4.5

Absolute Return 6.3 4.2 1.4 4.9

U.S. Small-Capitalization Equity 8.5 5.6 2.1 6.5

Venture Capital 3.7 (2.6) (8.7) 12.4

Leveraged Buyouts 20.3 12.0 4.3 16.0

Real Estate 20.8 11.3 (4.1) 24.8

measures an astonishingly small 0.6 per-cent per annum for the decade.

Less e!ciently priced securities trade inwider ranges. Stocks provide more di!cultpricing challenges than bonds. Instead ofdiscounting relatively certain fixed incomecash flows, valuation of equities involvesdiscounting more-di!cult-to-project cor-porate cash flows. The greater volatility inequity markets also contributes to thewider active manager spread. Large-capi-talization domestic equities represent thenext rung of the e!ciency ladder, with arange of 4.5 percent.

Absolute return strategies, which gener-ate returns independent of markets andlack an investible benchmark, demonstrateless e!ciency than fixed income and large-capitalization equity securities, with arange of 4.9 percent between top and bot-tom quartiles. In all likelihood, survivor-ship bias in the absolute return data under-states the true spread of manager results.If failed managers, with their poor results,were included, the reported dispersionwould increase.

Domestic small-capitalization stocksshow a larger gap, with a range of 6.5 per-cent per annum between top and bottom

quartiles. The progression of degree ofopportunity across types of marketablesecurities makes intuitive sense.

Illiquid assets show substantially largerspreads, with venture capital at 12.4 percentper annum, leveraged buyouts at 16.0 per-cent per annum, and real estate at 24.8 per-cent per annum. Lacking a benchmark tohug, managers of illiquid assets succeed orfail by dint of their abilities, not by action(positive or negative) of the market.

Selecting top managers in private mar-kets leads to much greater reward thanidentifying top managers in public mar-kets. In the extreme case, over the pastdecade, choosing a first-quartile fixedincome manager added only 0.3 percentper annum relative to the median result. Incontrast, the first-quartile real estate man-ager added 9.5 percent per annum relativeto the median. Ironically, identifying supe-rior managers in the relatively ine!cientlypriced private markets proves less challeng-ing than in the e!ciently priced marketablesecurities markets.

In the ultra-e!cient bond market, Yaleholds a portfolio with market-like interestrate sensitivity, occasionally making care-fully controlled security selection bets.

At the opposite end of the spectrum, theInvestments O!ce devotes considerabletime and e"ort to identify opportunities inthe far less e!cient private equity market.The Endowment bond portfolio, struc-tured with respect for market e!ciency,produced a 0.4 percent per annum excessreturn over the past two decades. In con-trast, Yale’s private equity positions boast a30.6 percent per annum return over the lasttwenty years, far exceeding the 16.6 per-cent per annum results of a pool of privateequity managers compiled by CambridgeAssociates. While both the bond portfolioand the private equity portfolio benefitedfrom superior active management, theabsolute contribution from superior resultsin the ine!cient world of private equity farexceeded the contribution from superiorresults in the e!cient world of governmentbonds. Careful consideration of the degreeof market opportunity when structuringportfolios makes an important contributionto Yale’s investment performance.

27

-15%

-10%

-5%

0

5%

10%

15%

20%

25%

30%

U.S. FixedIncome

U.S. Large-Capitalization

Equity

AbsoluteReturn

U.S. Small-Capitalization

Equity

VentureCapital

LeveragedBuyouts

RealEstate

First Quartile Median Third Quartile

Dispers

ionof

Retur

ns

Alternative Asset Returns Exhibit Significant DispersionAsset Returns by Quartile. Ten Years Ending June 30, 2010

28

4Spending Policy The spending rule is at the heart of fiscal discipline for an endowed insti-tution. Spending policies define an institution’s compromise between theconflicting goals of providing substantial support for current operationsand preserving purchasing power of Endowment assets. The spendingrule must be clearly defined and consistently applied for the concept ofbudget balance to have meaning.

The Endowment spending policy, which allocates Endowment earn-ings to operations, balances the competing objectives of providing a sta-ble flow of income to the operating budget and protecting the real valueof the Endowment over time. The spending policy manages the trade-o"between these two objectives by using a long-term spending rate targetcombined with a smoothing rule, which adjusts spending in any givenyear gradually in response to changes in Endowment market value.

The target spending rate approved by the Yale Corporation currentlystands at 5.25 percent. According to the smoothing rule, Endowmentspending in a given year sums to 80 percent of the previous year’s spend-ing and 20 percent of the targeted long-term spending rate applied to themarket value two years prior. The spending amount determined by theformula is adjusted for inflation and constrained so that the calculatedrate is at least 4.5 percent, and not more than 6.0 percent of the Endow-ment’s inflation-adjusted market value one year prior. The smoothingrule and the diversified nature of the Endowment are designed to miti-gate the impact of short-term market volatility on the flow of funds tosupport Yale’s operations.

0

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$1,200

$1,400

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 20101950 Spending Inflated Spending from Post-1950 Endowment Gifts Inflated Actual Spending

Milli

ons

Spending Growth Surpasses Inflation 1950–2010

29

The spending rule has two implications. First, by incorporating theprevious year’s spending, the rule eliminates large fluctuations, enablingthe University to plan for its operating budget needs. Over the last twentyyears, the standard deviation of annual changes in spending has been lessthan two-thirds that of annual changes in Endowment value. Second, byadjusting spending toward the long-term target spending level, the ruleensures that spending will be sensitive to fluctuating Endowment marketvalues, providing stability in long-term purchasing power.

Despite the conservative nature of Yale’s spending policy, distribu-tions to the operating budget rose from $281 million in fiscal 2000 to$1,108 million in fiscal 2010. The University projects spending of $986million from the Endowment in fiscal 2011, representing 38 percent ofrevenues.

Joyce Jepsen

Helen Betts

Aerial view of Harkness Tower.

Accurate and timely valuations serve manyimportant functions in the investment andmanagement of Endowment assets. Valu-ations help determine spending levels,Endowment unit values, asset allocationtargets, and investment performance.Sensible valuation policies enhance confi-dence in portfolio management and facili-tate fiduciary oversight.

Spending policies specify the trade-o"between protecting assets for the benefit offuture scholars and providing stable oper-ating support to the University. An accurateEndowment valuation plays an importantrole in achieving inter-generational fair-ness. An undervalued Endowment disad-vantages the scholars of today, as too littlemoney is released to the operating budget.Conversely, an overstated Endowment dis-advantages future generations of Elis, astoo much is put toward current use.

Correct valuations are vital in the for-mulation and maintenance of Endowmentasset allocation. Studies have shown thatasset allocation is the primary determinantof fund performance. If the true value ofcertain asset classes is misstated, the Uni-versity may unintentionally be holding amisallocated pool of assets, adverselya"ecting its ultimate performance.

The University’s policy is to recordinvestments at fair value, defined byFinancial Accounting Standards Board(fasb) Topic 820, formerly codified infasb-157 as the “price that would bereceived to sell an asset or paid to transfer aliability in an orderly transaction betweenmarket participants.” For marketable secu-rities in the domestic equity, foreign equity,absolute return, and fixed income portfo-lios, holdings are marked using closingprices or quotations from major stockexchanges and over-the-counter markets.

Illiquid investments, such as those heldin the private equity and real assets portfo-lios, are much more di!cult to value giventhe lack of a publicly quoted system. Ingeneral, Yale uses valuations provided bythe general partner to account for illiquidassets. fasb Accounting Standards UpdateNo. 2009-12 allows the Endowment toemploy general partner valuations withoutadjustment provided that the net assetvalue of the underlying investments isdetermined in accordance with Topic 820.However, in rare situations the InvestmentsO!ce may report valuations di"erent fromthose provided by managers if there is astrong reason to believe that reported

figures di"er measurably from true eco-nomic value.

According to Topic 820, three valuationtechniques are generally accepted in thedetermination of fair value: marketapproach, income approach, and costapproach.

The market approach, or comparablesales analysis, uses recent transactions ofcomparable assets to derive a range of mar-ket-based pricing metrics that are appliedto non-marketed assets. The incomeapproach, or discounted cash flow analysis,converts a stream of repeated future cashflows to a single present value at a requiredrate of return for the asset. The costapproach, or replacement analysis, is basedon the estimated cost required to replace anasset; that is the price at which a marketparticipant would be indi"erent betweenacquiring an asset and constructing a sub-stitute of comparable utility.

The private equity portfolio consists ofleveraged buyout and venture capitalinvestments. Most leveraged buyout firmsprovide Yale with quarterly statements thatreflect the fair value of underlying invest-ments. For public companies held withinthe portfolio, general partners may dis-count public market quotes to reflect trad-ing restrictions. For private companies,values are determined using multiples ofoperating cash flow or earnings for compa-rable public companies or recent transac-tions involving comparable privatecompanies.

Most of Yale’s venture capital firmsemploy similar valuation techniques toproduce quarterly reports. Early stage com-panies tend to be valued at cost. Should acompany complete a major round of exter-nal financing, Yale’s managers most oftenmark up or mark down their investment tothe valuation at which the financing wascompleted. For more mature positions thathave not raised recent third-party financ-ings, comparable company analysis hasbecome increasingly common. Like theirpeers in the leveraged buyout world, ven-ture capital firms sometimes take liquiditydiscounts on publicly traded stocks in theirportfolio.

The real assets portfolio consists of realestate, timberland, and energy investments.Real estate valuations rely on the appraisalprocess as the primary method for deter-mining fair value. The two most importantvaluation techniques employed in theappraisal of real property are comparable

sales studies and discounted cash flowanalyses. Comparable transactions yield aseries of pricing data that serves as a rea-sonable basis for the valuation of realestate. However, transactions involvingsimilar properties contemporaneous withthe measurement date are rare, necessitat-ing subjective adjustments to account fordi"erences in timing, property quality, andlocation. During periods of relatively lowtransaction activity, real estate appraisalrelies on the income approach. Thismethod, however, is no more accurate thanthe assumptions used for rental growth,vacancy, operating expenses, capital expen-ditures, and exit multiples. Timberlandassets are valued primarily through anappraisal process using valuation tech-niques developed for real property. Simi-larly to real estate, appraisers use both themarket approach and the income approach,with the latter representing the more pre-valent method for Yale. Appraisals per-formed using the income method examinethe size, species mix, and growth rate ofthe timber on the property, as well as thepotential value from development rights,easement sales, and recreational leases.

The valuation of privately held oil andgas assets hinges on projected hydrocarbonproduction and expenses (operating andcapital), expected commodity prices, andthe cost of capital employed to discountfuture cash flows to their present value.Production and expense forecasts are theresult of well-by-well analysis by oil andgas engineers and are subject to annualthird party audits. Price projections dependon the futures markets for both oil andnatural gas. Discount rates are a functionof interest rate levels and the risk premi-ums associated with producing oil andgas assets.

Several problems arise from the valua-tion of illiquid assets. The infrequency ofappraisals and lack of current data result invalues that reflect past, rather than current,market conditions. The timing mismatchgenerally causes private values to lagbehind their public counterparts. Further-more, periodic valuation naturally mutesvolatility, dampening short-term changesin value and complicating evaluation of therisk profile of the asset.

Analysis of disposition proceeds (acqui-sitions, public o"erings, bankruptcies, etc.)compared to the previous June 30 carryingvalues for illiquid assets over the last tenyears shows a conservative bias on the part

30

Illiquid Asset Valuation

of illiquid asset managers, with notableexceptions after significant equity marketcorrections in 2001 and 2009. In 2001, dis-position proceeds came in at 47 percent ofJune 2000 Internet bubble valuations, andin 2009, disposition proceeds came in at 92percent of the pre-crisis June 30, 2008 car-rying value. Fortunately, disposition activ-ity in 2001 and 2009 was significantly

lower than in other years, leading to anaverage ratio over ten years of approxi-mately 160 percent, indicating that theaverage disposition value exceeded thecarrying value by 60 percent.

The Investments O!ce recognizes boththe importance of accurate valuation andthe complexity of the process. Yale periodi-cally reviews internal valuations and inde-

pendent third party appraisals in detailwith its partners to understand the funda-mental inputs involved in the process. Bypaying careful attention to illiquid assetvaluation, the University improves day-to-day management of the overall portfolioand increases understanding of the charac-ter of individual manager portfolios.

31Spires of Yale Law School, completed in 1931, designed by James Gamble Rogers.

Yale has produced excellent long-term investment returns. Over the ten-year period ending June 30, 2010, the Endowment earned an annualized8.9 percent return, net of fees, surpassing annual results for domesticstocks of -0.7 percent and domestic bonds of 6.5 percent, and placing itin the top one percent of large institutional investors. Endowment out-performance stems from sound asset allocation policy and superior activemanagement.

Yale’s long-term superior performance relative to its peers andbenchmarks has created substantial wealth for the University. Over theten years ending June 30, 2010, Yale added $0.6 billion relative to itscomposite benchmark and $7.9 billion relative to the average return ofa broad universe of college and university endowments.

Yale’s long-term asset class performance continues to be outstanding. Inthe past ten years every asset class posted superior returns, outperformingbenchmark levels.

Over the past decade, the absolute return portfolio produced anannualized 11.1 percent, exceeding the passive benchmark of the One-YearConstant Maturity Treasury plus 6 percent by 1.3 percent per year andbesting the active benchmark of hedge fund manager returns by 5.1 per-cent per year. For the ten-year period, absolute return results exhibitedlittle correlation to traditional marketable securities, although correlationhas risen in recent years.

For the ten years ending June 30, 2010, the domestic equity port-folio returned an annualized 6.7 percent, outperforming the Wilshire5000 by 7.4 percent per year and the Russell Median Manager return by6.8 percent per year. Yale’s active managers have added value to bench-mark returns primarily through stock selection.

Yale’s internally managed fixed income portfolio earned an annu-alized 6.3 percent over the past decade, exceeding the Barclays CapitalTreasury Index by 0.3 percent per year and the Russell Median Manager

32

5Investment Performance

Performance byAsset Class

0

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Endowment Mean of Broad Universe of Colleges and Universities Inflation

Yale’s Performance Exceeds Peer Results2000 to 2010, 2000=$100

33

return by 0.6 percent per year. By making astute security selection deci-sions and accepting a moderate degree of illiquidity, the Endowmentbenefited from excess returns without incurring material credit or optionrisk.

The foreign equity portfolio generated an annual return of 13.8percent over the ten-year period, outperforming its composite benchmarkby 8.0 percent per year and the Russell Median Manager return by 7.9percent per year. The portfolio’s excess return is due to astute countryallocation and e"ective security selection.

Results from Yale’s non-marketable assets demonstrate the valueof superior active management. Private equity earned 6.2 percent annuallyover the last ten years, underperforming the passive benchmark ofUniversity inflation plus 10 percent by 7.7 percent per year, but outper-forming the return of a pool of private equity managers compiled byCambridge Associates by 2.4 percent per year. Since inception in 1973, theprivate equity program has earned an astounding 30.3 percent per annum.

Real assets generated a 10.9 percent annualized return over theten-year period, outperforming the passive benchmark of Universityinflation plus 6.0 percent by 1.1 percent per year and the active bench-mark of real assets manager returns by 1.5 percent per year. Yale’s outper-formance is due to successful exploitation of market ine!ciencies andtimely pursuit of contrarian investment strategies.

-2%

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Absolute Return Domestic Equity Fixed Income Foreign Equity Private Equity Real Assets

Yale Return Active Benchmark Passive Benchmark

Active BenchmarksAbsolute Return: csfb/Tremont CompositeDomestic Equity: Frank Russell Median Manager, U.S. EquityFixed Income: Frank Russell Median Manager, Fixed IncomeForeign Equity: Frank Russell Median Manager Composite,Foreign Equity

Private Equity: Cambridge Associates CompositeReal Assets: ncreif and Cambridge Associates Composite

Passive BenchmarksAbsolute Return: 1-year Constant Maturity Treasury + 6%Domestic Equity: Wilshire 5000Fixed Income: BarCap 1-5 Yr TreasuryForeign Equity: 44% msci eafe Index, 28% msci em Index,28% Opportunistic Benchmark (custom China/India blend)

Private Equity: University Inflation + 10%Real Assets: University Inflation + 6%

Kimberly E. Stewart

Kelsie Newsom

Yale Asset Class Results Beat Benchmarks2000–2010

Since 1975, the Yale Corporation Investment Committee has been respon-sible for oversight of the Endowment, incorporating senior-level invest-ment experience into portfolio policy formulation. The InvestmentCommittee consists of at least three Fellows of the Corporation andother persons who have particular investment expertise. The Committeemeets quarterly, at which time members review asset allocation policies,Endowment performance, and strategies proposed by Investments O!cesta". The Committee approves guidelines for investment of the Endow-ment portfolio, specifying investment objectives, spending policy, andapproaches for the investment of each asset category.

34

6Management andOversight

Richard C. Levin ’74 ph.d.PresidentYale University

G. Leonard Baker ’64Managing DirectorSutter Hill Ventures

Stefan Kaluzny ’88Former Managing DirectorGolden Gate Capital

Henry F. McCance ’64Chairman EmeritusGreylock Management

Joshua Bekenstein ’80Managing DirectorBain Capital

William I. Miller ’78ChairmanIrwin Management Company

Douglas A. Warner iii ’68ChairmanFormer ChairmanJ.P. Morgan Chase & Co.

Ranji Nagaswami ’86 m.b.a.Chief Investment AdvisorCity of New York

Dinakar Singh ’90ceo and Founding Partnertpg-Axon Capital

Fareed R. Zakaria ’86Hostcnn

Current Members

InvestmentCommittee

pantone 5455c

35

The Investments O!ce manages the Endowment and other Universityfinancial assets, and defines and implements the University’s borrowingstrategies. Headed by the Chief Investment O!cer, the O!ce currentlyconsists of twenty-five professionals.

Investments O!ce Sta" David F. Swensen ’80 ph.d.Chief Investment O!cer

Dean J. Takahashi ’80, ’83 mppmSenior Director

Peter H.Ammon ’05 m.b.a., ’05 m.a.Director

Alexander C. BankerDirector

Alan S. FormanDirector

Timothy R. Sullivan ’86Director

Stephanie S. Chan ’97Associate General Counsel

Deborah S. ChungAssociate General Counsel

Kenneth R. Miller ’71Associate General Counsel

J. Colin SullivanAssociate General Counsel

Carrie A. AbildgaardAssociate Director

Michael E. FinnertyAssociate Director

Lisa M. Howie ’00, ’08 m.b.a.Associate Director

Suzanne K.WirtzAssociate Director

Celeste P. BensonSenior Portfolio Manager

R. Alexander Hetherington ’06Senior Associate

Matthew S.T. Mendelsohn ’07Senior Financial Analyst

Jonathan Rhinesmith ’08Senior Financial Analyst

John V. Ricotta ’08Senior Financial Analyst

Michael R. Schmidt ’08Senior Financial Analyst

Cain P. Solto" ’08Senior Financial Analyst

Tess A. Dearing ’09Financial Analyst

David S. Katzman ’10Financial Analyst

Nilesh V. Vashee ’09Financial Analyst

Xinchen Wang ’09Financial Analyst

Sources

Much of the material in this publicationis drawn from memoranda produced bythe Investments O!ce for the YaleCorporation Investment Committee.Other material comes from Yale’sfinancial records, Reports of theTreasurer, and Reports of the President.

Pages 6-7Yale data from George W. Pierson,A Yale Book of Numbers: HistoricalStatistics of the College and University1701-1976 (New Haven: YaleUniversity Press, 1983) and YaleO!ce of Institutional Research.

Pages 11-25Educational institution asset allocationsfrom Cambridge Associates.

Page 26Domestic and foreign equity, absolute return,and fixed income numbers are based on bnyMellon data; venture, leveraged buyout, andreal estate numbers are based on CambridgeAssociates data.

Page 32The Endowment’s annual return for theten years ending June 30, 2010 ranks inthe top one percent of institutionalfunds as measured by the sei LargePlan Universe.

Photo Credits

Cover photo: Michael Marsland,Yale O!ce of Public A"airs.

Photographs of Committee members onpage 34: courtesy of the individual members.

Other photographs by Michael Marsland,Yale O!ce of Public A"airs.

Design

Strong Cohen/D. Pucillo

36

Opposite: The Yale shield, from Sheffield-Sterling-Strathcona Hall.

Left: Gargoyle at Yale Law School.