Sunday, March 15, 2015

"Yale" versus "Norway" model of asset allocation

Many like to categorize investment management approaches. Give a strategy or approach a simple name that can describe the relevant behavior with a shorthand description and you can jump-start a discussion. 

There are circulating two very different approaches to asset management these days, the "Yale" model and the "Norway" model for the Norwegian Government Pension Fund Global (GPPF). Each model has a significantly different approach to portfolio construction. There has not been enough testing to determine which is better. Many portfolios are a hybrid and to truly distinguish the differences you need a lot of data, but each is based on different assumptions on how markets work and how returns can be generated in the marketplace. It is important to understand the difference and make a judgement on which best suits your mind-set.

The "Yale" model has been the rage for a number of years given its strong long-term performance over the last 20+ years. While I may not do it justice, the Yale model is based on diversification and a focus on capturing alpha that can be found in illiquid or unique investment opportunities. The early descriptions centered on equal allocations across six asset classes: domestic equities, international equities, emerging markets, real estate, bonds and TIPS. There was also a focus on low costs, private equity and the idea that liquidity should not be emphasized.

The Yale investment focus is on equity-like returns through venture capital, private equity, natural resources, foreign equity, and real estate. The current focus is to have, over the long-run, half the assets in illiquid investments. Generalizing, there is a strong focus on alpha generation and finding the right manager who may have skill at extracting return from the markets. The Yale model has always emphasized equity returns over bonds, skill and alpha production over beta exposure, and illiquidity for a premium over liquid assets. 

Today, domestic marketable securities account for approximately one-tenth of the portfolio, while foreign equity, private equity, absolute return strategies, and real assets represent nearly nine-tenths of the endowment.


The "Norway" model emphasizes some core beliefs: markets are generally efficient, a strong commitment to diversification,  tracking of earning risk premium and market factors, close tracking of benchmarks, close tracking of managers especially in illiquid investments, focus on operational risk management, and clarity on responsible investing and good governance, 

The model focuses on beta exposure and minimizing costs. There is a clear emphasis on finding  the right benchmarks and tracking error against benchmark over pure alpha generation. There is a greater focus on exploiting risk premiums over pure skill. There is a greater emphasis on public companies and less on alternatives for alpha generation. There is a limit on ownership stakes and a bias to index-like returns. There is more emphasis on factor returns and less on the illiquidity premium. The model tries to avoid agency problems. 

A global macro manager will be more comfortable with the Norway model. The emphasis on beta and risk premia is very different than alpha and illiquidity. The investor who follows a Norway model should be more willing to have exposure in  manager who adjusts beta in an effort to take advantage of return tilts.

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