Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. The more different you are from the person that defined a rule the less you should follow the rule. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.

Are Industry Super Funds following the wrong strategy?

“The intimate revelations of young men or at least the terms in which they express them are usually plagiaristic and marred by obvious suppressions.”

- F Scott Fitzgerald

Millions of Australians are unknowingly trusting their retirement to an unassuming man from Wisconsin. I’m referring to Dave Swensen. You won’t find Dave Swensen on the investment teams of any of the giant super funds that control the retirement destinies of so many Australian. In fact, you won’t find him anywhere. He passed away in 2021.

Yet what lives on is his brainchild which is known as the ‘Yale model’. Swensen left a career on Wall Street at 31 to take an 80% pay cut to become the Yale University Endowment Manager. His job was to invest an endowment valued at $1 billion in 1985 and grow it for the good of the university.

His approach differed greatly from his fellow endowment managers at the time. And it worked. Between 1985 and his death in 2021 the Yale Endowment returned 13.7% a year. The S&P 500 managed 9.70% over the same period.

The finest form of flattery

Swensen’s unique approach and success attracted attention. Most universities including pre-Swensen Yale had portfolios made up of 60% shares and 40% bonds. In Swensen’s view this was not the right way for an endowment to invest.

Swensen took a unique view of liquidity. While other sought it out he actively avoided it. Liquidity refers to how easy it is to convert an investment into cash. Converting ownership in a large company trading on the ASX into cash is easy. Selling a business you fully own takes more effort, time and expense.

Investors like liquidity. Swensen’s observation was investors like it so much that their pursuit of liquidity results in lower returns. Logically that meant that non-liquid assets would have higher returns as investors sought to avoid it.

The notion is that the value of an investment that is publicly traded and privately held is the same. If investors were willing to pay more for something like liquidity which had no influence on the underlying value of the investment it was an exploitable inefficiency. Swenson profited from the inefficiency by being one of the few investors who would buy private assets.

He diversified widely into the private assets that many investors ignored. Simplistically put, he bought companies, infrastructure, real estate, commodities and land that didn’t trade on an exchange but had the higher returns of growth assets. He largely rejected asset classes with low levels of returns like bonds.

Endowments across the US started to copy his approach. Members of his team were hired to run endowments at other universities. Investment companies proliferated that offered access to private assets. Money poured into Private Equity, Venture Capital, unlisted real-estate, private credit and countless other iterations of private assets.

That brings us to our home girt by sea. The large Industry super funds have embraced the Yale model. Collectively they invest more than 25% of their portfolios in private assets. Even individual investors are increasingly being marketed private assets. To paraphrase Groucho Marx, now that we have been asked to join the private assets club do we really want to be members?

Is the Yale model still viable?

If it worked for Swensen and Yale - why wouldn’t it work for everyone else? To imitate success is a time-tested technique. Sales of books on Buffett attests to our inclination to follow the greats.

Yet there is no such thing as pure replication. Nothing can be cloned. It must be adapted to our personal circumstances and current conditions. And our adaption of what worked for someone else cannot break the underlying thing that made it work.

I think the Yale model worked well in 1985. I don’t think it will be as successful going forward. Swensen’s success is widely attributed to the illiquidity premium gained from private assets. That seems like a straightforward explanation. Except that Yale attributed 60% of their investment success to manager selection and only 40% to asset allocation to private assets.

Assuming Yale is correct – and who would know better – that means that simply allocating funds to private assets is not a formula for success.

Can you pick a manager as well as Swensen?

Yale has a huge endowment and a certain cachet. That provides access to skilled managers. Individuals can’t access managers with similar skillsets. The largest industry super funds also have large pools of money which provides access to managers.

However, Yale invented this model and had first pick of whatever manager they wanted. First mover advantage can be lasting when there is a limit to how much money a manager can invest. Longstanding relationships can be built and maintained.

Finally, there are certain people that are just gifted. Swensen is almost universally proclaimed as one of the best ever at selecting managers. Not every investor can pick shares like Buffett. Why do we assume it is easy for others to pick managers like Swensen?

In a recent article on Firstlinks Larry Swedroe referenced the work of Brian Chingono and Dan Rasmussen who pointed out that the dispersion of performance between the top performers and bottom performers in private assets is much wider than in public markets. Getting a good manager is paramount.

The illiquidity premium

That leaves the 40% of the outperformance that Yale attributed to asset allocation. This was Swensen’s underlying thesis that returns on private assets would be boosted by an illiquidity premium. Given his investment objectives he didn’t care about liquidity, so he collected a premium by buying private assets.

This is investing 101. To get better results you need to do something different than most investors. And you need to do it well. You buy when ‘blood is running in the streets’. You sell when greed is rampant. You get the point.

The problem is that what was revolutionary in 1985 is no longer revolutionary. According to Pitchbook 24 trillion USD is invested in private assets at the end of 2023. That is up from 9.7 trillion USD in 2012. I couldn’t find reliable stats from 1985 but we can assume it was a lot less. There is more money and more professional investors looking for deals in private assets. This increased attention undoubtedly has competed away a portion of the illiquidity premium.

There is no observable data point showing the illiquidity premium. However, one way to explore the impact of competition from the flood of money going into private assets is the changing valuation of private equity deals over time. According to McKinsey the purchase price to EBITDA (earnings before interest, taxes, depreciation and amortisation) multiple has increased from 6.5 in 2009 to 11.9 in 2024.

Buyout valuation

Source McKinsey

All valuation levels have gone up. However, in that same timeframe the price to earnings ratio of the S&P 500 increased by only 44% compared to 83% for the price to EBITDA of private equity deals. The comparison is not perfect with the two different datapoints. But the difference is also profound enough to make those details inconsequential.

Michael Hunstad, chief investment officer for global equities at Northern Trust Asset Management weighed in on the illiquidity premium. An article in Institutional Investor describes his view as follows, “He questions why investors should expect to get extra compensation for an inconvenience and risk that has been well advertised. Home buyers, for example, don’t earn a premium for locking up their money in an illiquid house that can’t be immediately sold.”

This makes sense. Outperformance in investing comes when there is a difference between expectations and what actually transpires. Since everybody now accepts and is comfortable with the long holding periods in private assets how can there be a premium? The investing edge that Swensen exploited can’t exist when everybody is doing the same thing.

Final thoughts

In 1969 Warren Buffett famously closed his original partnership and gave the money back to his investors. Despite an envious track record Buffett came to the realisation that the deep value approach he was using would no longer work. The world had changed.

Buffett would end up changing his approach and would prosper for many years. Yet his decision is illustrative of the simple wisdom of Keynes when he said, “When the facts change, I change my mind. What do you do, sir?”

I am not predicting the end of private assets. That would be foolhardy. There are too many reasons why they make sense for large institutional investors. And there is one big reason the investment industry loves private assets – the fees for managing money are significantly higher than public markets.

My argument is that the free lunch offered by private assets is over. Just like every other part of investing you need to do something different to get a different result. Simply holding private assets is no longer different. The top managers will still get the best results. Everybody else will get average results and pay huge fees to do so.

As access to private assets continues to become democratised I think you should stay away. You will not have access to the best fund managers. You will pay huge fees. The conventional wisdom about private assets just doesn’t hold up scrutiny.

The illiquidity premium and the source of Swensen’s investment edge are not the only rationale for investing in private assets. There is also the notion that they offer better risk adjusted returns. The key to this argument is the notion that private assets are less volatile than their publicly traded counterparts. I don’t buy this argument either. I will cover that next week. 

Please share any thoughts or topic suggestions with me at [email protected]  

Get Mark's insights in your inbox

Read more of Mark's articles

Read previous editions of Unconventional wisdom

What I've been eating

I like many types of sausage. I love several more. But chorizo is my favourite. Chorizo is a fermented, cured and smoked pork sausage. Paprika gives it a deep red colour. Spanish pigs traditionally were slaughtered on St Martin’s Day on November 11th. The legs of the pigs would be made into Jamon iberico. The trimmings and off-cuts would become chorizo. Chorizo became popular during the reign of Charles IV. Other notable facts about Charles IV are that he was cuckolded by his Prime Minister and was deposed by the French. At least he retains his association with chorizo. The below version is from a great restaurant called Bessie’s in Surry Hills.

Chorizo