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.