Tuesday, December 02, 2008

The Financial Laws of Gravity Hit Universities

By Richard Vedder

With rare exception, what goes up must come down. That is not always true in finance --invest and reinvest your money in conservative investments (e.g., bank CD's or inflation proof government bonds) and you will likely see slow, steady growth in your holdings. If you buy equities, you will see more volatile returns, higher on average over the long run, but with the possibility of significant and major short-term losses.

Endowments used to take reduction in volatility and preservation of capital extremely carefully, investing in blue chip stocks, bonds, and, occasionally, modestly in real estate. No hedge funds. No private equity funds. No derivatives.

In the past decade or so, universities, always thinking they are wiser and smarter than mere mortals among the Great Unwashed, have gone in big for risky investments --especially the larger endowments. Thus for years Harvard and Yale were the envy of the higher education world. Rates of return often hit 5 to 10 percent points higher than the average of all investors.

Now the chickens are coming home to roost. Bloomberg reports (yesterday) that private equity firms are facing a huge problem with sell off of university endowment investments. As Steve Kaplan, a finance professor at the University of Chicago put it, "Many endowments overcommitted to private equity." I expect some large endowments will show huge losses for the current quarter. Harvard invests upwards of 15 percent of its endowment in private equity funds, which have had valuations out of line in an upward direction with underlying equity holdings. A double whammy is occurring --a loss in the premium associated with private equity investments along with a sharp decline in underlying equity holdings. The little schools with their money in indexed funds, cash, and bonds are probably going to outperform the giants with the multi-million dollar investment managers.

Question: will donors be forgiving if rates or return for endowments fall far below those for safer investments? Stay tuned.


capeman said...

Stay tuned for what? The universities did very well with their risk-taking, now it's time for them to take a hit. At least they're doing better than what's left of our so-called financial system.

The institutions that played it safe were getting very mediocre returns, and some of them were severely criticized for it. Now it's their turn to crow (for a while).

I would say that the Harvard etc. donors did very well with their "investments". I would be surprised if Harvard etc. are going to suffer, except of course for the fact that the donor base is going to be hurting. But everyone is going to be hurt when it comes to future donations.

Cowboy said...

Capeman – I don’t necessarily disagree with you, I think the situation with Harvard and other “Big Endowment” schools is a bit more serious then what I get from your comments.

I don’t see this as a “David versus Goliath” contest.

I don't believe that it can be said that Harvard has done very well to-date. One could probably say, "Harvard was doing well - especially over the past 10 years through 2006.


“Harvard's $40 billion endowment is getting clobbered. The Ivy League school faces ‘unprecedented endowment losses,’ as its investments decline and its alumni get poorer. The school will keep many of its programs intact, such as allowing students from low income households to attend free of charge. It's just going to tighten its belt, like everyone else.”


”Nov. 11 (Bloomberg) -- Harvard University's $36.9 billion endowment may face `unprecedented' losses as America's richest school joins Ivy League peers and other U.S. institutions buffeted by the economic slowdown.”

But now they (Harvard) are running from their private equity fund investments for fifty cents on the dollar. And they (and others in risky investments) are finding out that their money is not there - the funds are not liquid enough to keep up with pace of Harvard's divestments... Not to mention the aggregate.

Hedge funds are locked up to prevent any divestiture.

Harvard lost $350M in only one hedgefund investment (Sowood Capital Management), which is a drop in the bucket for Harvard - but it is indicative of the risk that in the end has not paid off. It highlights the risks that colleges are taking in nontraditional investments like hedge funds and private equity.

I think we should “stay tuned” because there is more to come in my opinion. And how that affects schools and how they adjust is going to be interesting.

I honestly do not have anything against Harvard or any other school. I do however, have a problem with endowment managers who decided to join in the stupidity, mis-management, corruption, lies, and constructing numerous "house of cards" investment schemes. And I feel the same way about the rest of the idiots that taxpayers are bailing out now - with more in line and more to come.

Cowboy said...

I made a mis-statement in the previous post. I can't stand Cal - Berkely.