APRIL 2002: Features (print version)
A Run for Our Money
>> Before the bubble finally burst...the numbers reported by a handful of universities almost strained belief.Written by
Patrick Clinton
Duke averaged annual investment returns of 33 percent for three straight years, growing its endowment from $1.8 billion to $3.6 billion between 1998 and 2000. Notre Dame increased its holdings by an amazing 59.7 percent in 2000; its endowment went from $1.2 billion to $3.2 billion in just three years. Harvard, with a more modest rate of return of 36.1 percent, brought in more than $5 billion in a single year. And the University of Chicago, with a 40.9 percent rate of return for the year, socked away $1 billion in investment returns between June 1999 and June 2000, bringing its total endowment to more than $3.8 billion.
The financial press was agog. Universities weren't the slow-moving, overcautious investors they'd been for decades. Instead, especially in the elite circle of billion-plus endowments, they emerged in the 1990s as among the smartest and most sophisticated of institutional investors. In the world of venture capital they were everywhere, and many made remarkable returns.
When the bubble burst, as everyone knew it would, there was no question that universities would take a hit. But how much? The strategies that led institutions into venture capital and other nontraditional investments were designed not just to take advantage of events like the high-tech run-up of the 1990s. They were also supposed to render the endowments safer from market downturns by diversification. This spring, anticipating the release of preliminary data from the two annual surveys of university endowments, observers waited to see how well those strategies had worked. Would the combination of a battered domestic stock market and a train wreck in venture capital drag the universities down, or would the same tactics that had produced colossal returns for the past four or five years pay off now by protecting endowments from the beating so many investors were taking?
When the survey numbers were released by the National Association of College and University Business Officers (NACUBO) and the college and university investment service Commonfund, the news was not bad at all. Yes, endowments were down, a bit more than 3.5 percent across the board. Of the 41 schools reporting billion-plus endowments in 2000, all but six lost ground-the first time a substantial number of university endowments had experienced a loss since 1974. But in the same period the Standard & Poor's 500 stock index was off 14.8 percent. Among the billion-plus institutions-those most likely to have engaged in sophisticated portfolio tactics-the average drop, according to NACUBO, the more comprehensive of the surveys, was only 1.6 percent, a remarkable achievement in a dreadful market. Even among the harder hit, including Chicago-which lost 8.6 percent, mainly through losses in private-equity investments-the results were still substantially better than the stock market.
Long-term returns, the ones that really count to university investors, were holding in well above the 10 percent or so that many institutions look for. Chicago, for instance, had five- and ten-year average returns of 16.4 percent and 14.2-a respectable performance and one that probably understates how well the University's investment strategy is doing today, in the wake of a series of changes that began in 1998. The value of Chicago's endowment was $3.5 billion as of June 30, 2001, the end of the most recent fiscal year. As of January 1, 2002, it was at $3.2 billion-still a dramatic improvement over the mid-1990s, when the endowment was only about $1.5 billion.
No one denies that 2001 was hard. At the same time it marked a giant step for higher education. Universities missed out on the bull market of the 1950s; they lost their shirts in the 1970s. But thanks to a process of evolution that's been in the works for the past 25 years or so, they've left the roller coaster of the late 1990s comfortably ahead of the game.
THE REVOLUTION STARTED in the 1960s. Until then, the typical university endowment was invested in bonds and stocks chosen for their ability to pay dividends, not for growth potential. The institution held on to the principal and spent the income. It was the way things had always been, but in the face of inflation-and a bullish stock market-one major donor to university endowments was up in arms. "The Ford Foundation saw the real value of investments declining," explains John Kroll, who as the University's associate comptroller is in charge of endowment accounting. "A fund that would pay for 20 scholarships a year in 1920 was only paying for two by the 1960s." Ford issued an influential report urging universities to put more of their money into growth stocks and to adopt rules that would let them pursue a "total return strategy," taking advantage of market appreciation as well as interest and dividends.
The proposal was smart-but not necessarily legal. Endowments were governed by trust law, and under trust law it wasn't clear that universities were allowed to put endowment principal into risky stocks, even as part of a diversified portfolio, or that they would be allowed to spend money earned through appreciation. In most states it was illegal for an institution's trustees to delegate the power to make investment decisions.
The legal problems were essentially solved by the Uniform Management of Institutional Funds Act, a model law submitted to the 50 states in 1972 and since adopted by all but a handful. It set the stage for schools to dive into the ebullient, fast-growing stock market. And dive some did-just in time to get whacked by the bear market of the 1970s. The combined endowments of the Ivy League plus Stanford and Chicago, measured in constant 1967 dollars, were worth $3.16 billion in 1971-72. A year later they had dropped to $2.2 billion, and they continued to erode slowly for most of the decade.
Although burned, universities didn't turn back. Over the next few years, they cranked up the horsepower of their investment committees, hired talented managers, and drew on the investing expertise of trustees and alumni.
The goal was diversification. If the 1960s proved that a portfolio of bonds wasn't sufficiently diversified, the 1970s proved the same for stocks. The savviest investors started looking for other places to put their money. One of the first places they turned was to venture-capital funds. These companies, which let investors take a stake in a pool of start-up businesses, were a good fit for well-connected, long-horizon players like universities. Persuading trustees took effort, says William Massy, an economist who saw the process firsthand as vice president of finance at Stanford in the 1970s. "We had a lot of discussion with our board before we were allowed to do these things. Early on it was a problem," he explains. "These things were not liquid, you were tying up your money for seven years or more, and it was also difficult to determine what the real market value of these portfolios was. It was really a finger-in-the-wind kind of thing and had to be. But we got past all of that."
If universities embraced venture capital-and natural resources, hedge funds, and much more-it's partly because, for a while at least, everything worked. "You saw a bull market in the '90s like you'd never seen before," says John Griswold, a senior vice president at Commonfund and executive director of Commonfund Institute, the organization's research and educational arm. "You had a good bond market, a good stock market, almost anything you did with equities or bonds was pretty good, and in some cases absolutely phenomenal. Venture, private equity, emerging market debt, were all pretty marvelous places to be. If you stuck with it and did your rebalancing religiously, so that you took some off the winning bets and put it on the laggards, you really did well." The trick was to diversify, with investments that didn't correlate with each other. It's an idea that Griswold jokingly calls the "free-lunch principle," but it's better known as Modern Portfolio Theory, and it was first developed (in a place with a long suspicion of free lunches) as the dissertation of Harry Markowitz, PhB'47, AM'50, PhD'55, a future Nobel Prize winner then pursuing his doctorate at Chicago.
UNIVERSITY FOLK OFTEN talk about endowment as if it were a distinct financial entity-a pot of money in the president's office to be cautiously dipped into from time to time. The reality is much messier. Take Chicago's endowment: it consists of 2,200 separate funds, each with its own purpose and rules and history. The biggest is the $410 million Rockefeller General Endowment Fund, the direct descendant of $14 million of the $35 million in contributions made by John D. Rockefeller between 1889 and 1915.
Some funds are free to be used as the University wishes. Others have extremely specific purposes. One of the smallest ($4,128.84) was established by a gift of $250 in 1912 to provide a prize for the student earning the largest number of points at the Intercollegiate Track Meet (or, today, its historical successor, the University Athletic Association conference championship). Though the funds are pooled for purposes of investment, they have to be accounted for individually to ensure that donor wishes are followed and that principal is kept intact. Of Chicago's $3.5 billion, $592,766,000 can never be spent-including exactly $13,858,833.04 of the Rockefeller fund.
Rather than allow individual programs, departments, or schools to manage their own investments, most universities put all their endowment money-and occasionally other funds that the institution has decided to treat as if it were part of the endowment-into investment pools. The University of Chicago's, created in 1972, is called the Total Return Investment Pool (TRIP). A sort of in-house mutual fund, TRIP and the endowment are almost, but not quite, synonymous: TRIP includes some funds not considered part of the University endowment. The divisions and schools own shares in TRIP, receiving annual payouts based on the size of their stakes.
Chicago calculates payout with a formula used by many universities: 5 percent of the average value of the endowment over three years, skipping the most recent year. Five percent was the figure recommended by the Ford Foundation in its original proposal for endowment reform-chosen to approximate the yield of bonds at the time. Over the years 5 percent has proven to be just about on target as a figure that maximizes payout while protecting the endowment's real buying power.
In 2001 revenue from Chicago's endowment accounted for 10.7 percent of its operating budget. That's up from 7.5 percent in 1991 as a result of both new gifts and growth of the value of TRIP investments, but there is still room to improve. At Yale endowment revenue was more than 20 percent of the budget in 1999-2000, compared to about 10 percent a decade earlier. Harvard's budget last year included about 30 percent endowment revenue, and Princeton's an enviable 37 percent.
How well TRIP performs is the daily concern of the University's 15-person investment office, tucked unobtrusively into the Gleacher Center, the downtown facility of the Graduate School of Business. Chicago hasn't gone as far as some of its peers in making the investment office independent (Harvard, Duke, and others have spun their investment offices off as separate, wholly owned businesses, partly to enable them to pay the salaries demanded by top investment professionals), but there's a bit of symbolism to the location: off the main campus, away from the administrators and faculty who depend on the office for a share of their budget, almost invisible.
The man who presides over the operation, vice president and chief investment officer Philip Halpern, came to Chicago in July 1998 after a stint as treasurer at the California Institute of Technology, plus four years of managing $35 billion in investment and retirement funds for the Washington State Investment Board. His appointment was part of a broader set of reforms designed to improve the efficiency and quality of the University's investments.
Phase one of the reform had come a few years earlier-a drastic reduction in the size of the trustees' investment committee. The committee had been one of the larger trustee committees ("It beat the audit committee," jokes Halpern). Stripped down to a handful of people with investment expertise, its current membership includes chair James Crown, general partner in Henry Crown and Company; Andrew Alper, AB'80, MBA'81, former managing director of Goldman Sachs and now president of the New York City Economic Development Corporation; John Corzine, MBA'73, U.S. Senator from New Jersey and former co-CEO of Goldman Sachs; Richard Franke, retired chair and CEO of Chicago's John Nuveen Company; Eric Gleacher, MBA'67, a New York-based investment banker perhaps best known as the founder of the merger-and-acquisition department of Lehman Brothers; and J. Parker Hall III, chair and managing director of New Salem Capital, L.L.C. The nontrustee members are David Booth, MBA'71, chair and CEO of Dimensional Fund Advisors, and Martin Leibowitz, AB'55, SM'56, chief investment officer for TIAA-CREF, the world's largest managed investment fund.
Phase two, which began when Halpern arrived, was to shift the office away from hands-on management. "Prior to my arrival, the investment office did all the security selection in-house except for a few private partnerships," Halpern explains. "We did all of our bonds, we had two real-estate professionals that would go around the country buying properties, and we had stock portfolio managers. And the performance was OK, it wasn't stellar, it wasn't terrible, it was OK."
Direct management has become fairly rare among the largest university endowments, and for good reason. It's labor intensive, and if you want good results, you have to hire some very expensive talent. Harvard, the school with the most vigorous commitment to direct management, has an investment staff of close to 200, and it has an incentive system that has resulted in some of the managers being paid enormous sums (a year ago three managers were paid more than $10 million each) to the ongoing distress of many faculty members.
Far more common among the big endowments is the strategy Chicago uses. The investment committee develops a plan for asset allocation-that is, it decides how much of the endowment will go into stocks, how much into bonds, how much into venture capital, and so forth. The investment office then works with outside managers to place the money according to the plan.
In placing the funds, Halpern follows what he calls a "barbell" strategy, concentrating on low-risk and high-risk, high-effort investments and generally staying away from areas in between. The strategy is all about resources; Halpern wants to avoid putting effort into areas where effort isn't likely to improve performance. "We're very, very conservative in certain areas where we don't have a competitive advantage," he says. "Our bond portfolio is almost all treasury and agency bonds. We don't take credit risks, we don't invest in corporations. Our U.S. equity portfolio is mostly indexed." The strategy frees up staff time and energy to explore areas where Chicago has a potential advantage-mostly in so-called "alternative" investments, including venture capital, private equity, hedge funds, and the like.
"Advantage" to Halpern comes down to three things: Chicago's reputation, its expertise, and the investment committee's newly slimmed-down governance structure, which allows fast decision making.
All three are important, but in the vital game of hiring the best managers and joining partnerships with the best returns, reputation is especially vital. "Most of the best managers don't want all the money they can attract," explains trustee and investment banker Eric Gleacher. "Their performance goes down if they take in too much. So they close up." Universities, with their financial expertise and long investment horizons, have a real advantage in getting through the door. The elite schools have an extra chip to play: "The managers use us when they go out and do their deals, saying, 'Look at our investor base-we have Yale, we have Chicago, we have Stanford.' We put a stamp of credibility on that firm."
Getting into the best partnerships and working with the best managers is important, but according to William Massy, "Virtually all of the investment gurus now say that the bulk of variation of returns these days comes from asset allocation." Chicago's allocation, like those of most of its peers, has grown more complex and diverse. When Halpern arrived the endowment was about 45 percent U.S. equities (a high figure for an endowment Chicago's size). Bonds were about 15 percent, while international investments, real estate, private equity, and natural resources each accounted for about 10 percent. Today U.S. equities are down to 22 percent of the endowment. That one decision to reduce equity exposure, which was implemented during market peaks, saved the University $150 million.
Private equity is up to 20 percent, while international equities, absolute-return investments (a form of hedge-fund investment that brings predictable and consistent shorter-term returns), and U.S. bonds each make up 15 percent. The rest consists of real assets like natural resources and timber and high-yield bonds. Overall, again like its peers, Chicago has chosen a strategy of giving itself more opportunities to lose money-and more opportunities to win big.
IN A 1990 ARTICLE in the University of Chicago's Journal of Legal Studies, Henry Hansmann, a Yale law professor who studies the economics of nonprofit institutions, took a skeptical look at the very concept of university endowments. Why did universities save so much of their income instead of spending it more or less currently? One common answer to that question, he said, is the idea that endowments preserve intergenerational equity-we shouldn't rob from our children and grandchildren to support ourselves. But does that argument hold up? "There is every reason to believe that, over the long run, the economy will continue to grow in the future as it has in the past and that future generations of students will therefore be, on average, more prosperous than students are today, just as today's students are more prosperous than their predecessors," he argued. "[I]t would seem more equitable to have future generations subsidize the present"-perhaps by encouraging universities to borrow rather than save.
Hansmann's ideas were challenging, but not even he expected universities to start spending their endowments anytime soon. The reason is partly a matter of economics: if you could make 10 percent a year on your investments and borrow at 5 percent, how likely would you be to pay for essentials by selling off your portfolio? A more important cause has to do with human nature and institutional habits and talents. Donors like the idea of perpetuity: Tell a John D. Rockefeller that you plan to spend his millions on a yearlong outburst of teaching, learning, and research like the world has never seen, and he'll show you the door. Tell him you can make his money immortal, and he's hooked. Considering what his money can accomplish and what it can grow into over the course of a century or more, hooking him is a goal well worth pursuing.
Universities, for their part, are brilliant at creating things to do with money. They're much less good at making hard choices between those things. (Ask any administrator at budget time.) The endowment system both encourages and discourages risk taking. (Can we have a new professorship? Sure, but it will cost two million dollars up front. Has our research in X come to nothing? No problem, we didn't spend any of the principal.) The economist Howard Bowen, who also served as the president of three very different educational institutions-Grinnell College in Iowa, the University of Iowa, and California's Claremont Graduate Center-is remembered for "Bowen's Law," which described the economics of higher education as a matter of converting money into goods like knowledge, learning, and reputation.
Left to their own devices, universities will inevitably follow the boiled-down formulation of the law that's a watchword among higher-education economists: they raise all the money they can and spend all they raise. The endowment system, with its focus on preserving spending power in perpetuity, adds some discipline to the process-and a safety net.
Thus endowments will continue to be an essential part of an institution's financial life and an important yardstick in measuring institutional prestige and power. Size has its benefits. In the three-year period from 1999 to 2001, schools with billion-dollar endowments had an average investment return rate of 12.8 percent. The average for all schools was 6.7 percent. Likewise, while the billion-plus club lost 1.6 percent on its investments last year, the average institution lost 3.6 percent.
For its first 50 years Chicago had the largest endowment of any U.S. university. Today, its $3.5 billion puts it in the same league as Rice, Duke, Penn, Northwestern, and a half dozen others. Ahead are Columbia's $4 billion, MIT's $6 billion, Stanford and Princeton's 8, Yale's 11, and Harvard's 18.
"It's one thing to have 3 and a half billion. It's another thing to have 20," says Eric Gleacher. "To be on the cutting edge of research and intellect in the world you need capital. And I think that's one of the reasons American education is unique. You go to the U.K. or Europe and private support for universities is almost nonexistent. That's why they don't have the same educational system we do. Funding is important. And having an endowment where you maximize the investment proceeds is important."
"I think the overall job of the trustees is to oversee the University on an intergenerational basis, so its quality, its mission, and its service to the academy-and even more broadly to the world-are maintained," notes investment committee chair James Crown. "While other parts of the University are busy trying to build intergenerational intellectual capital, the intergenerational financial capital of this and all universities resides in the endowment. People describe it many ways, as the University's bank account, as its safety net, as its allowance, as the undergirding for current spending. But the bigger it is the safer and more flexible the University is."
And so, back at the Gleacher Center, Philip Halpern and his staff are diligently maximizing. There's a new investment in Russia, the University's first, that seems to be doing well. "Knock on wood, we timed it right," says Halpern. "It's gone up about 25 percent in just about seven weeks. It could go down too." The private-equity component is down again, a huge write-off. The hedge funds are turning over a steady 1 percent a month. There are partnerships to look at, due diligence to perform, the allocation to fine-tune.
"Investment is very simple," says Halpern. "You're just playing with probabilities. And you try to increase the probability of doing well and decrease the probability of things going badly. But you're never going to be 100 percent right, and you're never going to eliminate all risk. Sometimes you're going to toss the coin, and it's going to come out tails. You decide what your discipline is, and you try to keep with it, and hopefully it will pay off in the long run."
Patrick Clinton is a freelance writer in New Jersey, the former editor of University Business magazine, and the father of Daniel Clinton, '05.
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