A
Run for Our Money
>> Before
the bubble finally burst...the
numbers reported by a handful of universities almost strained
belief.
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.
©2002 The University
of Chicago® Magazine