The recent market meltdown has resulted in a huge backlash against Wall Street's rocket scientists and the complex models upon which much of their highly leveraged risk taking was based. But it also has challenged the assumptions behind the relatively conservative investment policies of top U.S. university endowments. Yale, Harvard and Stanford had consistently returned more than 15% per year over the last decade. And even after the onset of the credit crunch in the summer of 2007, the Harvard endowment gained 8.6%, Stanford rose 6.2%, and Yale climbed 4.5% through June 30, 2008. That compares with a drop of 15% in the S&P 500 over the same time period. But over the last 12 months, ambitious campus expansions at Harvard, Yale and Stanford have been put on hold as their endowments have plummeted by 25%-30%. The story of how and why this happened offers important lessons for you in managing your own "personal endowment."

The Yale Model: The "Babe Ruth of Investing"

The success of top university endowments can be traced directly back to the efforts of a single man, Yale's David Swensen. As the Yale endowment's chief investment officer for two decades, David Swensen has earned a reputation as the "Babe Ruth" of the endowment investment world. After taking over the Yale endowment in the mid 1980s, Swensen had boasted 15.6% average annual returns through 2007 and no down years going back to 1987. His approach had earned Yale an extra $14.4 billion over 20 years, compared with the returns of an average U.S. university endowment. It also made Swensen (indirectly) one of the world's largest philanthropists.

So, how did Swensen single-handedly change the rules of institutional investing? In 1985, around the time Swensen took over, more than 80% of Yale's endowment was invested in domestic stocks and bonds. But Swensen, an economics PhD, observed that no asset allocation model ever actually recommended that allocation. As long as their correlation with U.S. stocks and bonds was low, adding unconventional assets to your portfolio would both reduce your risk, and increase your return. This led Yale to emphasize private equity and venture capital, real estate, and hedge funds that offer long/short or absolute return strategies, raw materials, and even more esoteric investments like storage tanks, timber forests, and farmland. Until last summer, this approach worked almost like magic.

Swensen reduces all investment performance to three factors: asset allocation, market timing and security selection. Among these, asset allocation is by far the most important. Consider that since 1925 (through the end of 2007), every dollar invested in T-bills yielded $19; U.S. bonds, $72; U.S. large cap stocks, $3,077; U.S. small cap stocks, $15,922. That's why textbooks tell you that asset allocation accounts for over 90% of investment returns. Swensen actually argues that asset allocation actually accounts for more than 100% of returns. How is that possible? Active trading and, therefore, commissions, spreads and advisor fees all cost money, and impair your investment returns.

Swensen believes that market timing is a mug's game. Investors are emotionally driven and invest at precisely the wrong time. Advertised returns are particularly deceptive. The annual returns for mutual funds are "time-weighted." But "dollar-weighted" returns are what you actually earn as an investor. And since investors chase hot stocks, dollar-weighted returns tend to be much worse. The time-weighted return of the top 10 internet funds between 1997 and 2002 was -1.5%. Not bad, considering the dot-com crash. But their dollar weighted returns were -72%. And that was before a tax bill of 24% for earlier gains. Dollar weighted returns are also why so many investors in Bill Miller's Legg Mason Opportunity Fund are nursing huge losses, despite the fund doubling since early March. Lured by Miller's long-term track record, they came late to the investment party.

Swensen is equally critical of securities selection. Investors who believe that they can "pick the right stock" are suffering from the Lake Woebegone effect, where everyone is "better than average." Mutual fund companies like to point out that indexes outperform actively managed funds by only .3% -- roughly the amount of their average fees. But that ignores survivorship bias. Bad mutual funds either close or their track records are merged into good ones. This makes active managers look better than they are. In 2000, it was reported that the average U.S. mutual fund was down 3.1%. By 2005, that record had magically morphed into a gain of 1.2% for 2000 -- simply through shuffling funds and dropping bad performers.

The Yale Model: Alive and Kicking

The recent poor performance of the Yale endowment has naturally put Swensen on the defensive. Yet Swensen is adamant about the viability of the model over the long run. He points out that the single worst thing you can do is avoid risky assets after a market crash. Had you invested at the market bottom during June 1932 in U.S. small caps, you would have gained 159,000x your money. More importantly, poor decisions today can have hugely negative effects on your future. At the time of the market crash in 1929, the endowments of Harvard and Yale were roughly the same size. But Yale's trustees got spooked and invested heavily into "safe" bonds for the next five decades, while Harvard tilted more toward stocks. The result? Over the next 50 years, in relative terms, Yale's endowment shrunk to half the size of Harvard's. The same logic applies to your own portfolio.

Yale's recent challenges do not dilute Swensen's basic message: the importance of focusing on "big picture" asset allocation decisions. At my firm, Global Guru Capital, I run an investment program that replicates the investment strategy of the Yale model through the use of ETFs. Although the investment program underperformed the broader S&P 500 in the first two months of the year, it has substantially outperformed the S&P 500 on the rebound, and it is up 13.4% versus 9.33% for the S&P 500 over the same period. The lesson? The single most important thing you can do to improve your investment returns today is to diversify your assets out of U.S. stocks and bonds and into asset classes like commodities, real estate, and global stocks and bonds through the wide range of ETFs now available. And you can implement Yale's successful investment strategy right now at a click of mouse.

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