If you manage a university endowment, the Center for Social Philanthropy has a few choice words for you. The Boston-based organization recently co-authored a scathing report on the “endowment model” of investing along with research organization Tellus Institute.
The authors of the report aren’t that crazy about endowments’ move into alternative investments over the past decade. By using six Boston-area university endowments as a case study, they conclude that endowments were not victims in the financial crisis, but accomplices…
By engaging in speculative trading tactics, using exotic derivatives, deploying leverage, and investing in opaque, illiquid, over-crowded asset classes such as commodities, hedge funds and private equity, endowments played a role in magnifying certain systemic risks in the capital markets. Illiquidity in particular forced endowments to sell what few liquid holdings they had into tumbling markets, magnifying volatile price declines even further. The widespread use of borrowed money amplified endowment losses just as it had magnified gains in the past.
So who corrupted the formerly prudent endowment funds? The report puts the blame squarely on Wall Street for “undermining endowment stewardship.”
But it appears as if you can also blame HR departments for creating a new position to oversee ballooning endowment coffers. The report continues:
The complexity of investments under the Endowment Model has spawned a new class of highly compensated investment officers on campus. Whereas a decade ago, only one of the schools in our study had a chief investment officer (CIO), today five out of six do. CIOs and investment officers from investment banks and consulting firms are now wooed by colleges with some of the highest compensation packages in the nonprofit sector.
It seems that the authors of this report might have been content to leave well enough alone. But recent drops in endowment values and income has led to layoffs, hiring freezes, salary cuts and economic hardship for local communities.
Six Degrees of Desperation
The six endowments making up this survey certainly had a rough time during the financial crisis (chart below from report)
But over the long term, they have still managed to produce significant wealth for their respective institutions according to this chart from the report…
An Endowment with a University on the Side
But regardless of their long-term appreciation, the report makes the point that more of each university’s operating budget is now reliant on Wall Street’s “undermining” influence. The table below from the report shows the percentages of each university’s operating budget that comes from endowment returns…
And therein lays the rub. The report goes into great detail about the economic effect of lay-offs and delayed infrastructure investments at the six universities. (Surely prompting those who attended chronically underfunded universities to conclude “Live by the sword, die by the sword…“)
The (Other) History of the Endowment Model
But readers will find the section on the history of the Endowment Model (a.k.a. “Yale Model”) most interesting. Usually, such histories of endowment investment are written by proponents of alternative investments. This one is a little different. So whether you buy into it or not, it’s definitely worth the read to see things from a different angle. Here’s a taste (our emphasis):
As we shall see below, Harvard’s endowment, first under Walter Cabot in the late 1970s and 1980s and much more concertedly under Jack Meyer during the 1990s, developed very similar diversification and hedging strategies, using alternative assets and complex derivatives. What has made the Yale model distinctive is Swensen’s preference to outsource most of the asset management to external managers, with whom he famously negotiates exceptionally favorable terms for the university…
Regardless of differences in structure or organization, America’s wealthiest endowments provided a new model for other endowments and institutional investors to emulate because their exposure to high-risk alternatives generated enviable long-term returns. And as Modern Portfolio Theory implied and Swensen repeatedly stressed in his annual report on the Yale endowment, they appeared to be beating their benchmarks with less volatility…
It took the financial crisis for many of those responsible for these strategies to take a fuller measure of the risks they were taking by plunging into alternative investments, without adequate regulation or transparency. The Endowment Model of Investing failed to control volatility, and its leading exemplars generated performance far worse during the crisis than investors that focused on security of income over growth…
The Bigger they Are…
After presenting the following historical policy allocations of the Harvard endowment, the report wonders,
Given Harvard’s bruising experience with illiquidity during the financial crisis, it is surprising that a more substantial re-evaluation of the endowment’s reliance on alternatives has not affected its targets…
Harvard Management Company may get the last laugh though. It will be interesting to see how Harvard’s endowment performed in FY 2010 (June 30, 2010 – report to come out in the fall). Many alternative asset classes performed very well coming out of the credit crisis, while domestic equities have been asleep at the wheel since November 2009 (although the S&P500 is up 20%-ish since June 30, 2009. So get ready for another round of absolute return-bashing come autumn).
Footnote: The report also contains an interesting analysis of the FAS157 “Level 1″ (mark to market), “Level 2″ (mark to model), and “Level 3″ (no quotes or agreed-up on models) assets held by each endowment. Guess who has the most illiquid portfolio among the six? Check out page 20 of the reportto find out.
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