Have you ever wondered how the rich invest? Well, look no further than seeing how the ~$42 billion Yale endowment fund invests its money.
Endowments invest like many of the world’s wealthiest people and retirees. Both want income to fund their operations or lifestyles indefinitely. Both want to outperform their peers. And ultimately, both want consistently strong absolute returns, regardless of what the markets are doing.
After all, the first rule of financial independence is to never lose money. The second rule of financial independence is to never forget the first rule. As soon as you start losing money consistently, your dreams of living a life of freedom dissipate.
If you want to know how the rich invest, then analyzing university endowments makes sense. If you plan on retiring and living off your investments, studying university endowments is also insightful. At the end of the day, you want your investments to outlast you and provide for generations to come.
Understanding Endowment Funds And How The Rich Invest
Years ago, one of my tenants joined the Stanford University endowment as an analyst. So I asked her about their alternative investment allocation. She responded, “It’s well over 50%.”
I was surprised because I don’t know many regular folks who have that high of an allocation in alternatives. Maybe 5-20%, but certainly not 50%+. Currently, my alternative investment asset allocation is around 15%. I have a target to raise it to 20% in the new year.
My tenant said, “They’ve got no problem investing a majority of their assets in alternatives because they don’t need the liquidity. The endowment has invested in alternatives for a long time already. Further, they are comfortable with the risk profile. Finally, they’re only shooting for a 5% – 6% annual return. Most endowments are this way.”
I thought her response was interesting because it somewhat parallels my investment goals. More than 50% of my net worth is illiquid due to my long-term property investments, private equity/fund investments, and pre-tax retirement accounts such as my 401k, SEP IRA, and Rollover IRA.
If I could get a guaranteed 5% – 6% overall net worth return every year, I’d probably take it. Once you build a large enough financial nut, small percentages make a big difference. For example, a 6% return on a $5 million portfolio is a healthy $300,000.
And as we all know, earning $300,000 without any effort is enough to provide a middle-class lifestyle for a family in a big city.
How The Rich Invest: Yale University Endowment
The Yale Endowment helped pioneer alternative investing in hedge funds, private equity, real estate, and so forth.
In 1990, Yale became the first institutional investor and university endowment to define absolute return strategies as a distinct asset class, beginning with a 15% target allocation. Absolute return strategies is code word for hedge funds. Hedge funds look to provide a positive return in both bull and bear markets.
Who did Yale look towards first for absolute return strategies? Tom Steyer’s Farallon Asset Management based right here in San Francisco. Ex-presidential candidate, Tom Steyer received his bachelor’s degree from Yale.
Before starting Farallon in January, 1986, he worked at Morgan Stanley, Goldman Sachs in the risk arbitrage department under Bob Rubin, and Hellman & Friedman in private equity.
In 1987 Steyer approached David Swensen, Yale’s CIO, to manage a portion of Yale’s endowment for no fee to prove himself. After Farallon’s initial success, other college endowments followed Yale’s example. By then, hedge funds were now charging 2% of assets under management and 20% of the profits.
Although Steyer is worth about $2 billion, as an environmentalist, he still drives an eight-year-old Honda Accord to the tennis club.
Yale Asset Allocation Breakdown
Here is Yale’s 2021 planned asset allocation as stated in their latest newsletter. This is where the rest of us can learn how the rich invest their money for even more money. The asset allocation breakdown is similar for 2022. See if you notice anything interesting.
Yale targets a minimum allocation of 30% of the endowment to market-insensitive assets (cash, bonds, and absolute return). Such assets will outperform in a bear market and underperform in a bull market.
The university further seeks to limit illiquid assets (venture capital, leveraged buyouts, real estate and natural resources) to 50% of the portfolio.
Yale’s asset allocation is so diversified compared to the typical investor who might only invest in stocks and bonds. The reason for Yale’s diversification is due to their size, access, experience, time horizon, and need for stability.
When you’ve got to fund your school’s operating expenses every year, the need for more stable returns and passive income is a must.
Below is what Yale had to say about their own asset allocation in a previous investor report.
Over the past 25 years, Yale dramatically reduced the Endowment’s dependence on domestic marketable securities by reallocating assets to nontraditional asset classes.
In 1990, over 70% of the Endowment was committed to U.S. stocks, bonds, and cash. Today, domestic marketable securities account for less than 10% of the portfolio, while foreign equity, private equity, absolute return strategies, and real assets represent nearly nine-tenths of the Endowment.
The heavy allocation to non-traditional asset classes stems from their return potential and diversifying power. Today’s actual and target portfolios have significantly higher expected returns and lower volatility than the 1990 portfolio.
Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management. The Endowment’s long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.
Absolute return strategies are expected to generate a real return of 5.25 percent. Unlike traditional marketable securities, absolute return investments have historically provided returns largely independent of overall market moves.
Since its 1990 inception, the portfolio exceeded expectations, returning 11.2 percent per year with low correlation to domestic stock and bond markets.
Over the past two decades, the Endowment returned a cumulative 1,152 percent relative to the Cambridge median of 402 percent, an outperformance of 5.1 percent per annum.
Minimal Domestic Equities
Back in 2018, Yale’s domestic equity allocation was just under 10%. Today, Yale is shooting for a domestic equity allocation of only 2.25%! In comparison, most of us probably have most of our investment portfolio in equities and most of our equities in domestic equities. A 2.25% domestic equities allocation hardly moves the needle.
Also interesting is Yale’s 11.75% foreign equity exposure. In most cases, individuals invest most of their public equity in their home country. This is also known as “home country bias.” Yale finds more opportunity abroad.
Real estate, my favorite asset class to build wealth, has a target 9.5% asset allocation. Although not particularly high, it is 4X higher than the domestic equity allocation.
Finally, about 65% of the fund is invested in Absolute Return, Venture Capital, and Leveraged Buyouts. The Yale endowment fund is essentially a fund investing mostly in other funds. Further, none of these funds are passive index funds like how most of us invest.
Yale Endowment Spending
Ever wonder what universities use their massive endowment funds for? Despite Yale’s massive $31.2 billion endowment, it’s still not enough to cover the school’s entire operating budget. In fact, Yale’s endowment only covered about 30% of its 2015 operating budget. I’m sure the coverage will be similar in 2021.
Meanwhile, the endowment fund portion is allocated roughly one quarter to Professorships, one quarter to Miscellaneous specific purposes (??), on quartered to Unrestricted (??), and the rest to Scholarships, Maintenance, and Books.
The Miscellaneous and Unrestricted categories, making up more than half the endowment fund allocation are great mysteries. This is where a lot of private, eye-raising decisions are made.
Individuals can easily replace Maintenance, Professorships, Books, Scholarships, etc with Housing, Food, Travel, Taxes, Charity, etc as part of their investment fund allocation.
How The Rich Invest: With An Open Mind
I hope this post gives you a glimpse into how the rich invest. Understanding how the rich invest helps give us better insights into how we can invest. You can even follow investments by rich members of Congress to make more money.
There is sometimes negative commentary about alternative investments. It usually comes from people who’ve never invested in alternatives before. It’s as if we automatically attack what we don’t understand.
Yet, the largest endowments and the wealthiest individuals like to invest a good portion of their assets into alternatives and actively managed funds.
Please keep an open mind with a focus on learning new things. There’s a reason why the rich are rich and tend to stay rich! If you want to be truly rich, you’ve got to look beyond just index funds.
However you like to invest, please keep on building passive income for financial independence. The more passive income you can generate to cover your desired living expenses, the better.
Personally, I always like to invest in laggards or investments that are not mainstream. Stocks have done wonders for us so far. Therefore, I’m much more bullish on rental properties. Rental properties and commercial real estate should catch up and rebound in the new year.
Invest In Real Estate Alternatives
One of the best ways to go long rental properties and commercial real estate is Fundrise and CrowdStreet. Both are the leading real estate crowdfunding platforms today. Crowdfunding enables regular investors to invest in real estate once reserved for ultra-high net worth individuals or institutions.
Fundrise focuses on private real estate funds for investors to get diversified exposure in various real estate types across the country. Fundrise was founded in 2012 and is one of the largest real estate marketplaces today. Investing in a diversified fund is the more conservative way to go.
CrowdStreet focuses on individual commercial real estate investments in 18-hour cities. 18-hour cities are secondary cities like Austin, Memphis, and Charleston, where valuations are lower and net rental yields are higher. With work from home as permanent trend, there should be some positive demographic momentum towards 18-hour cities.
Both platforms are free to sign up and explore. I’ve personally invested $810,000 in real estate crowdfunding to diversify, earn income passively, and capitalize on heartland real estate. Real estate is one of the best inflation hedges and beneficiaries. Every single rich person I know has a large real estate portfolio.
Stay On Top Of Your Investmeents
To get rich, you need to stay on top of you investments. Sign up for Personal Capital, the web’s #1 free wealth management tool. It will allow you to x-ray your portfolio for excessive fees, give you a snap shot of your asset allocation, and provide suggested allocation weightings based on your objectives.
After you link all your accounts, use their Retirement Planning calculator. It pulls your real data to give you as pure an estimation of your financial future as possible.
I’ve been using Personal Capital since 2012 to manage my money. In this time, my net worth has skyrocketed partially thanks to better money management.
Readers, why do you think the rich invest so differently from mainstream investors? With a 65% allocation toward active funds in alternatives, Yale has a completely different investment philosophy. What are some alternative investments you are looking at right now? How do you plan to make your investments last for generations? How The Rich Invest is a Financial Samurai original post.
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Jess McDowell says
I just started reading “Wise Money” by Daniel Wildermuth. The idea is to help individual investors, not necessarily accredited investors, to invest like the Yale, Harvard, Stanford, etc. endowments. So far it has been very interesting.
It makes me feel better to see Yale at 11% foreign equity. I know that I shouldn’t do this but I have a fair amount of my 401k invested in Fidelity target funds and they are relatively heavy in foreign equity.
Frugal Bazooka says
Interesting post and I appreciate you using creative ideas to find new investment strategies, however I find the idea of tax free endowments for universities that exclude 94% of the applicants the height of elitist nonsense…esp a school like Yale (and Harvard and most other Ivy League bastions of the rich and famous) that has for years churned out anti-capitalist, anti-American academic propaganda. Besides making a killing in capital markets they also specialize in teaching students that capital markets are evil. I know most of that kind of nonsense is limited to the college of social studies, but the hypocrisy of these institutions is galling. If that wasn’t bad enough there is now a “plan” for working Americans to subsidize student loans to the tune of 50k per student? Here’s a better plan…force Yale and any other universities that have an endowment fund to pay off their student loans from the endowment before building a new rec center or student union. That’s an investment in education I can get behind.
As far as following the investment lead of a Yale univ that has endless recurring tax free donations from wealthy alums and therefore little to no actual risk of ever being behind the eight ball financially…no thanks.
Wealth from Options says
I wonder if they use leverage in their equities position to “ratchet” their fixed income. “The Floor-Leverage Rule for Retirement” has 85% in safe or fixed income which provides the “floor.” Leverage is used on the remaining 15%. Excess returns in the leveraged portion are then used to ratchet up the floor, permanently increasing future income. Interesting concept that I plan to look into more.
I’ve long tried to gradually move to an endowment style portfolio. I even have it as a tag on my blog. The toughest area probably is venture capital. I have access to what seems to be a good venture investor here in Australia, but I can’t imagine giving them 23.5% of my net worth to manage. That seems too risky, so would need to find more good managers if I wanted to copy Yale exactly. So, I actually have a target of about 5% in venture capital and 5% in buyout at the moment. My target allocation to long Australian equity is 15%, 12.5% foreign equity (including US). But 21.5% to hedge funds (there are quite a lot of listed hedge funds. Two of my funds in this space are unlisted). Gold is 10%, real estate 10% (underinvested here), art 5% (only 1.5% so far), 10% to bonds (overinvested there still), 5% futures, and adding cash, I think that’s it.
Financial Samurai says
You could view Yale’s $31 billion endowment fund as its entire net worth when making asset allocation calculations. Or, you could view the endowment fund as a percentage of Yale’s overall net worth. After all, Yale itself has a value among other things Yale owns.
No problem with 23% if I have say 5 potentially good managers to give it to. I’m just making the usual point that the more alternative you get the more important managers are and the more variable results are. You identify someone who was good but then blows up… For individual investors who aren’t very rich it’s tougher to access multiple potentially good managers in each asset class. So getting to a Yale like allocation without betting a lot on a few managers is hard. But if I can find a second good venture manager I’d be more than happy to increase from 5% to 10%. Especially as in Australia early stage venture has effectively negative tax.