Those who believe in the virtues of passive indexing will generally pooh-pooh the idea that one can beat the market. But the truth is, a small percentage of people do beat the market over the long term. Putting aside the statistical flukes (retail investors who get lucky), you can still observe a group of people who have managed to beat the market over a long period of time, with a very large amount of money. Besides Warren Buffett, several Ivy League endowment managers have consistently beat the market by a large margin, with billions of dollars at stake. Of course, this is made possible partly because many investing instruments are available to larger institutional investors that retail investors cannot access. But according to these managers, the trick for individual investors isn’t active trading: it’s better asset allocation. Here’s how you can build your own “Ivy League endowment fund” using ETFs.

Mebane Faber: It’s the Beta, Stupid!

Mebane Faber is the author of The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. In an interview with Hard Assets Investor, Mr. Faber explains that individual investors won’t be able to replicate the alpha that endowment managers achieve, simply because they won’t have access to the same opportunities (e.g., hedge funds). According to Mr. Faber, investors should instead take a cue from the allocation formula traditionally utilized by by endowment fund managers. He believes that by allocating less to equities, individuals can reduce their beta–volatility–and thus achieve higher returns in the long run.

[Without hedge funds, you're left with] five asset classes: U.S. stocks, foreign stocks, real estate, bonds and commodities. There are a lot of caveats, but the allocation that endowments have historically made to these is approximately 20% in each… And you can do that using major indexes for each asset class, each of which is investable with an ETF: S&P 500 (U.S. equities), MSCI EAFE (foreign equities), NAREIT (real estate), 10-year Treasuries (bonds) and S&P GSCI (commodities).

According to the article, that model portfolio has a 0.8 correlation to the endowment portfolios, so you’re basically getting their beta but not their alpha. Such a portfolio would be less susceptible to the wild market swings we’ve seen in the past few years, indeed. [For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven day trial to ETFdb Pro].

The Tiger Woods of Endowment Management: David Swensen

Yale’s Money Guru Shares Wisdom with Masses at NPR.org details the model portfolio recommended by Yale’s endowment manager, David Swensen. (Incidentally, the portfolio also got a mention in the recent bestseller, I Will Teach You to Be Rich.) Why is Mr. Swensen’s recommendation so appealing? Well, for starters, he’s beat the market by a wide margin over a long period of time. (The article, written in 2006, refers to an average 16 percent annual return over 21 years.) He’s also considered the top university endowment manager in the world. For individual investors, he recommends the following model portfolio. Note that his portfolio allocation implies that by going light on equities, but having significant bond and real estate holdings, you can get strong returns with less overall risk than you can with a stock-heavy allocation.

Swensen’s Model Portfolio (Using Vanguard ETFs):

Domestic Equity (30 percent) : Vanguard Total Stock Market Index Fund (VTSMX)

: Vanguard Total Stock Market Index Fund (VTSMX) Emerging Market Equity (5 percent) : Vanguard Total International Stock Index Fund (VGTSX)

: Vanguard Total International Stock Index Fund (VGTSX) Foreign Developed Equity (15 percent) : Vanguard Emerging Markets Stock Index Fund (VEIEX)

: Vanguard Emerging Markets Stock Index Fund (VEIEX) Real Estate Investment Trusts (20 percent) : Vanguard REIT Index Fund (VGSIX)

: Vanguard REIT Index Fund (VGSIX) U.S. Treasury Notes and Bonds (15 percent) : Vanguard Treasury Funds (VFISX, VFITX, VUSTX)

: Vanguard Treasury Funds (VFISX, VFITX, VUSTX) U.S. Treasury Inflation-Protection Securities, or TIPS (15 percent): Vanguard Inflation-Protected Securities Fund (VIPSX)

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If you look around, you can find other endowment-style model portfolios geared towards individual investors, but some themes are consistent: passive indexing, intelligent asset allocation, and an eye on minimizing costs. Once again, ETFs prove to be an efficient tool to implement a proven investment strategy.

Further Reading on Endowment Portfolio Allocation

If you’re interested in reading more about “endowment style” portfolios, I recommend you read the following articles: