Endowment Woes

By Richard Vedder

CONSUMER WARNING: This is a dull blog except for investment/finance geeks. While the typical university endowment lost 15-20 percent over the past year, Harvard and Yale, the two largest, lost 25 percent or more. Have they been acting imprudently or incompetently? The short answer, I think, is no. They have followed a somewhat high risk investment strategy not appropriate for most endowments, but probably reasonable for very large and diverse endowments. Over the past decade, even with the recent downturns, Harvard, Yale and Princeton have outperformed the markets and most other endowment funds. Their average annual rate of return, even with the past year, exceeds 10 percent; since inflation has been around 3 percent, and endowment payouts for those schools averaged perhaps 4 percent, the real endowment has grown nicely --independent of new gifts.

Consider two endowments in 2008 --one of $100 million held by a relatively poor private school, and the other Harvard with $35 billion. Harvard can make 175 investments, some highly risky, that average $200 million each. Suppose 3 of these investments go completely belly up (fall to zero in value) in a given year, but another 5 are "home run" investments that grow in value in a year to $400 million each. On these 8 risky investments combined, comprising less than 5 percent of total endowment, Harvard makes $600 million total --a 43 percent return. A few disasters are expected, and in and of themselves are no big deal for Harvard. They have so many investments, that they can diversify risks and take a lot of them. The poor school does not dare put the minimum $20 million or so needed for some daring investments --say in hedge funds or some commodity plays. Too large a percent of endowment would be at risk. So they make, say, 100 $1 million investments in mostly safe instruments like blue chip stocks, bonds, and maybe a little real estate. They will average a lower return than Harvard in a typical year, and not likely ever seriously outperform stock market or other investment averages if their assets are allocated in a typical fashion. But it is unlikely they will fare significantly worse than investors in the economy as a whole.

Still, the success of these Ivies (and several other wealthy schools) depends on shrewd human judgments and a bit of luck. Investments in timber can go bad just as investments in bank stocks. Hedge fund investing is very risky and potentially costly in an unanticipated downturn. As the big schools find their endowments fall, even they have pressures in order to make the distributions to fund university operations that they would like. Suppose Harvard paid out $1.3 billion annually when its endowment was $35 billion --about 3.7 percent a year. If the endowment falls to $26 billion, it takes a 5 percent pay out rate --a rather high rate -- just to maintain a $1.3 billion annual spending pay-off. In that environment, with relatively little room for error, universities need to move to a somewhat more conservative philosophy, and perhaps reduce spending for current operations a bit.

All of this shows the prudence of using a moving average calculation of endowment value and limiting payouts to slightly below five percent to assure that real endowment principal is being maintained. Instead of a three year moving average, schools might go to five years. Suppose a school's endowment was the following on June 30: 2005= $900 million, 2006= $1,000 million (a billion), 2007= $1,100 million, 2008= $1,300 million, 2009= $1,100 million (a fairly typical pattern). Suppose it uses a 4 percent payout rule on a three year moving average. In the fall of 2007, the 3 year moving average endowment was $983 million,, allowing for $39.3 million in spending. In the fall of 2008, the endowment base goes to $1,133 million, allowing $45.7 spending. After the 2008-09 investment fall, the 3 yr base is still $1,167 million --and spending would be allowed to actually rise for this academic year slightly to $48.3 million despite the recent decline in endowment values. However, if the endowment fails to appreciate this and next year, eventually spending would have to decline by 6-7 percent from current levels. With a five year rule, the possibility of one bad year forcing reductions in endowment spending are reduced significantly.

Since most endowments have many individual accounts (e.g, scholarship funds), some of the newer accounts may fall below the initial value of the gift, and are "under water." It is often customary to forbid spending from such accounts until the initial nominal value of the endowment is achieved. I am not entirely sure that is optimal strategy, but it does help restore endowment value quicker, at the cost of putting more pressure on current operations.

Too many small endowments spend too much seeking so-so investment advice from so-called experts when they would do just as well allocating funds between broad investment categories (e.g., equities, bonds) as the all-university average and put money into indexed funds instead of trying to guess ups and downs of individual securities in which they have small (say under $1 million) investments.

Alumni and donors should monitor investment policies carefully to see that donor intent is honored and that universities are not acting imprudently. By and large, my only complaint in general is that universities spend too much money on conspicuous consumption among development officers and, in some cases, pay too much for mediocre investment advice. But I don't think endowment investment strategy is one of the big scandals in higher education --there are enough other things to worry about more.