Imagine you're a college Trustee looking at the endowment. You have some investment expertise-a personal portfolio that does well, maybe an investment company. You want to earn 5% to fund annual distributions to support the budget, 2% for inflation, and maybe 2% more to grow the principal. Above all, you want to beat your rivals. It galls you when they sit atop the standings, and you get a strong sense of satisfaction when you're ahead.
Endowment management wasn't always a competitive sport. 150 years ago, colleges would receive lands and estates in bequests, and tending to these meant mainly visiting the properties and collecting rent. Then came John Maynard Keynes and a revolution in endowment management. Keynes saw that the endowment's long time horizon would allow it to make a substantial commitment to more volatile securities. So he shifted his school's portfolio-King's College, Cambridge-away from real-estate and into public equities.
Gradually, institutions in the US adopted this approach, managing their portfolios for total return, taking a percentage of the total endowment for annual support. In fact, there was a vigorous debate in the 70s as to whether portfolio gains could be legally considered "income." But by late in the 20th century, the question had been settled. Private colleges and universities had a clear mandate: earn enough to support the college, compensate for inflation, and grow the corpus-without taking inordinate risk.
Since the 70s public stocks and bonds could have done this. A 60/40 blend of S&P 500 stocks and domestic investment-grade bonds returned 10.4%--just enough: 5% for the school, 3.4% for inflation, and 2% for growth. Along the way, there would have been some headaches-a 20% decline in 2008; a 13% pullback from 1999 to 2002. But you could sleep well, knowing that the college endowment was invested in a broadly diversified mix of liquid stocks and bonds that would grow with the economy.
But that approach didn't do the job the last decade. Over the ten years from 2004 to 2014, that 60/40 blend returned only 7.1%. Enough for distributions, but not enough even to keep up with the 2.3% annual inflation rate. You could enhance returns by allocating more to stocks, but only at the cost of bone-jarring volatility. The stock market fell over 50% in the aftermath of the Internet and housing bubbles.
So colleges have turned to alternatives, investing in global securities, real assets, private equity, and innovative strategies to enhance returns and reduce risk. After all, college endowments are long-term investors. They don't have to be 100% liquid 100% of the time. They can give up some liquidity in exchange for better returns. At least, that's the way it's supposed to work in theory.
How has it worked in practice? The following chart gives a picture:
Using each school's fiscal-year returns, starting in 2004, we see that Yale, Harvard, and Dartmouth did far better than a traditional 60/40 blend for the first three years. During the Financial Crisis, however, all three schools suffered serious setbacks. Building projects were postponed; staff were laid off. It was widely reported that the "Endowment Model"-pioneered by Yale's Chief Investment Officer David Swenson and widely adopted by institutions around the country-was broken.
One of the problems with illiquid investments is that you have to be careful to manage all the demands on your cash. During normal times, this is pretty straightforward. The endowment's contribution to the budget can be planned. But some investments can call for cash contributions at inopportune times, and the Financial Crisis was certainly inopportune.
During the downturn, Harvard actually had to sell some of its illiquid investments. This creates a perverse pricing situation. In order to place an illiquid issue, a manager often has to sell the best quality securities. These can sell at a deep discount to their economic value, while poor-quality assets can remain model-priced and skate along at fair value. These low reference points hurt related high-quality assets, although only the seller suffers any permanent loss.
Harvard also had significant forward commitments that they had to reduce. Dartmouth ran into liquidity problems as well. Harvard and Dartmouth rushed to borrow money in the bond market-during a time when the Financial Crisis made borrowing especially expensive. Both Yale and Harvard lost about 25% in fiscal 2009, while Dartmouth "only" lost 20%, and the benchmark was down less than 15%.
But since the Crisis, everyone has grown-Yale the most, Harvard and Dartmouth close to one another, and the benchmark coming in last. Here's how 5 and 10-year returns look for all the Ivies, as well as the 60/40 blend:
Over the past five years everyone's portfolio has recovered from the downturn. Over the ten years that include the Crisis, Yale and Columbia have the best returns. Let's assume 8% as a baseline requirement-spending plus inflation plus growth. Cornell, Brown, and Penn have just met this standard; Harvard and Dartmouth are just a little higher, and Princeton, Yale, and Columbia hold top honors. The multi-million dollar salaries the schools pay to their investment staff seem well-worth the price. The total value of all Ivy endowments is now more than $100 billion; their cumulative excess return above the 8% bogey over the past decade is more than $15 billion.
But absolute return isn't the full story. Stuff happens; risk matters. We saw this during the downturn. The following is an XY chart of return and risk during the same 10-year period. For the purposes of this analysis, we measure risk using the standard deviation of returns, a measure widely-used in the investment industry and in academic studies.
Here the clear winner is Columbia. They've achieved the best return for the level of risk taken. CIO Narv Narvekar has overseen Columbia's endowment since 2002. He has managed to achieve an 11% return on their endowment with a risk level roughly equal to Dartmouth's.
Part of Columbia's success comes from its structure. Columbia has set up an independent, nonprofit subsidiary, the Columbia Investment Management Company, to oversee its $10 billion endowment. The IMC employs twenty people. They have enough staff to evaluate complex strategies; to do in-depth analysis of outside managers; and they can maintain a level of detachment from the fads and fashions that tend to dominate the world of investment consultants.
Most significantly, Columbia's Investment Management Company has a great deal of independence. Rather than serving as part of the University's administration, or reporting directly to the Trustees, they takes their direction from a Board that includes leading investment professionals from among their alumni, as well as a few senior school officials. This independence is critical to their success. Prior to the Financial Crisis, Narvekar chose to maintain a highly liquid position. This put them in a position to profit from the volatility of 2008-9, rather than be a victim. As a result, Columbia didn't have to make as many drastic cuts. Yale's David Swenson enjoys similar freedom, but that' more a result of his 20+ year tenure in the CIO position and his larger role as a true thought-leader in the investment management industry.
On the athletic field, Columbia is rarely competitive. Dartmouth defeated Columbia 27-7 this Fall-part of the Lions' 19-game losing streak. But their money-management team is first-class-supported by an outstanding governance structure.
So what are some bottom-line lessons from this $100 billion tale?
1. Set your objective based on your needs, not some random benchmark.
2. Stuff happens, so liquidity matters. Giving up liquidity can have unforeseen costs.
3. Risk matters; risk-adjusted returns are the best measure of investment skill.
4. Governance is perhaps the most under-rated factor in investment performance.
Remember this as you set your own investment objectives. It's not how well you do relative to your peers, or even relative to an index. What matters is whether you are meeting your needs, and how well you can sleep at night.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author attended Dartmouth College.