The Neglected Cost Discipline of the Prudent Investor
“ A trustee may only incur costs that are appropriate and reasonable in relation to the assets , the purposes of the trust , and the skills of the trustee … Wasting beneficiaries ’ money is imprudent .”
— Uniform Prudent Investor Act ( UPIA )
In 1994 , the National Conference of Commissioners on Uniform State Laws approved the Uniform Prudent Investor Act ( UPIA ) and recommended enactment by the states . By December 31 , 2023 , nearly 50 states had codified the UPIA into law .
A key component of the UPIA is the application of the Prudent Investor Rule . Most trustees embrace the diversification principles implicit in the UPIA ’ s interpretation of the Prudent Investor Rule , but few appreciate the cost principles . Yet , as revealed in the above quote , cost management is a critical responsibility that is clearly articulated in the UPIA .
Evaluating costs is especially important for trustees who enter the opaque and expensive realm of alternative investments . Fees in these asset classes far exceed those charged by actively managed funds in traditional asset classes , much less lowcost index funds . For example , VC and private equity funds routinely collect a 2 % management fee and 20 % of profits above a specified return hurdle . Over the life of such funds , fees can easily exceed more than 3 % per year .
For nearly 30 years , few trustees have questioned whether the benefits of alternative investments are worth the incrementally higher costs — even as mounting evidence consistently reveals they are not . For example , in June 2024 , the Boston College Center for Retirement Research published a paper that cited four studies , all of which concluded that the average public pension plan substantially underperformed a passively managed portfolio with comparable exposures .
Performance like this was impossible to hide . In 1997 , Professor Josh Lerner published a Harvard Business School case study profiling Yale ’ s strategy . Three years later , Swensen shared even more detail in his seminal book , Pioneering Portfolio Management .
Tragically , most investment plan trustees — and especially the investment consultants who advise them — misinterpreted Swensen ’ s advice . They concluded that blunt allocations to VC , buyouts and hedge funds were the sole driver of Yale ’ s performance . Few appreciated that it was the rare strength and stability of the people making the decisions that constituted the true secret of their success .
Over the subsequent 25 years , endowments , foundations and public pension plans substantially increased allocations to alternative asset classes . Nearly all were oblivious to the fact that the flood of capital all but guaranteed subpar returns for most investors .
The Alternative Asset Class Cycle is Revealed
“ Until 1858 , every year saw an increase in the number of ships devoted to whaling ; but the great numbers of whale hunters had done in the sea something very like that which other hunters afterward perpetuated on land . The herds of whales had been decimated .”
— Boyden Sparkes and Samuel Taylor Moore ( 1930 ) unconventional strategy that included a heavy equity bias , highly selective use of active managers and larger allocations to VC and buyouts .
The strategic shift was innovative and extremely well-executed , but it also benefitted from fortuitous timing . Swensen and Takahashi were early allocators to VC and buyouts , and they also benefitted from a shift to higher equity exposure at the front-end of an extended bull market . Luck does not diminish their overall achievements — the Yale team has also consistently selected high-performing active managers — but it amplified their performance advantage .
Consultants Open the Floodgates
Yale ’ s unconventional strategy was highly successful . For the 13-year period ending June 30 , 2000 , the Yale endowment returned approximately 15.7 % per year versus approximately 11.6 % for the median endowment .
The passage of 45 years has revealed the fundamental dynamics of the alternative investment cycle . It begins with the opening of a temporary void in capital markets . For example , the demand for startup capital after World War II prompted the formation of the VC industry and the end of the Great Inflation triggered the rise of buyouts . When these voids appear , capital providers have a real , but temporary , opportunity to generate above average returns because demand for capital far exceeds supply . But the supply / demand imbalance eventually reverses with the passage of time .
The next phase begins after peers witness the returns of early adopters and
www . MoAF . org | Fall 2024 | FINANCIAL HISTORY 13