2002: Features (print version)
Run for Our Money
the bubble finally burst...the
numbers reported by a handful of universities almost strained belief.
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.
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
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?
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.
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.
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.
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.
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.
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.
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.
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
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.
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.
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.
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
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.
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.
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
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
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
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."
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
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
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.
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.
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."
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.
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.
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
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.
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.
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.
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.
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
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
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."
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.
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."
Clinton is a freelance writer in New Jersey, the former editor of University
Business magazine, and the father of Daniel Clinton, '05.