Big university endowments have the blues. Investment returns have been scarce in recent years, and fiscal year 2016 was particularly disappointing.
You can understand the concern. Universities rely on their endowments for a big chunk of their operating budget. If they aren’t growing, they're shrinking.
My Bloomberg colleague Mohamed El-Erian is bracing for more disappointment, and he’s not counting on the Trump rally to bail out endowments. His advice to universities is to raise more money and cut spending.
I’m not convinced that the low returns in recent years portend more of the same going forward, but nothing sparks conversation like sagging investment returns. So here’s my suggestion: Universities should seize the opportunity to engage their stakeholders -- alumni, faculty and students -- about the Big Question. Namely, what is the point of the endowment in the first place?
Harvard University would be a good place to start. As Bloomberg News reported, Harvard commissioned the consulting firm McKinsey & Co. to examine its endowment in 2014. According to McKinsey’s April 2015 report, the endowment’s employees complained to McKinsey that the endowment is “lazy, fat and stupid.” That’s clearly a wild mischaracterization, but it says something about the frustration at Harvard.
It’s been a tough few years at the Harvard endowment. As I pointed out in August, the endowment trailed a simple 60/40 portfolio of U.S. stocks and bonds by 1.3 percent annually over the five years ended in June 2015.
Then Harvard released its endowment report for 2016, and the results were even uglier. The endowment was down 2 percent during the 12 months through June, which widened Harvard’s losing streak to the 60/40 portfolio to 3 percent annually over five years through 2016. On a $36 billion endowment, that’s roughly $1 billion of foregone growth every year.
All that bad news has kicked up discussion at Harvard, but it’s not necessarily constructive.
For one thing, I think the conversation may be focused on the wrong questions. Two issues that figure prominently in McKinsey’s report are compensation and benchmarks. Some at Harvard are no doubt dismayed that 11 of the endowment’s portfolio managers were paid $65 million in 2014. Granted, that’s a huge sum, but it represents just 0.18 percent of a $36.4 billion portfolio at the time. Perhaps compensation should be lower, but compensation in 2014 resembled fees on an index fund more than a hedge fund.
A good portion of that compensation is a bonus for beating benchmarks. McKinsey’s report suggests that Harvard’s benchmarks were easy to beat. But close to half of Harvard’s endowment is invested in private assets, and it’s not clear what the right benchmarks are for those types of investments. Sure, you can make benchmarks harder to beat, but that’s just a back door for cutting compensation. It doesn’t necessarily mean the benchmarks are any more appropriate.
It also looks as if an important constituency at Harvard -- the students -- might sit out the discussion. The Harvard Crimson called the current state of the endowment “unacceptable” but then proclaimed that “College students have no business telling seasoned analysts and managers where to invest the endowment.”
On the contrary. Before a single investment decision is made, someone has to determine the endowment’s investment objective. Harvard’s stakeholders are as qualified for that task as anyone, including the endowment’s managers. And a well-articulated objective goes a long way to determining the investments chosen for the endowment.
One objective, for example, might be to provide for Harvard’s spending needs. According to the Harvard Management Company, that can be accomplished with a real return of 5 percent annually.
That objective wouldn’t require much effort. A 60/40 portfolio of U.S. stocks and bonds has returned 8.5 percent annually from 1926 through November (those are total returns for the S&P 500 and five-year U.S. Treasuries), while inflation was 2.9 percent annually over that period. Harvard effectively has an infinite investment period, and there’s no reason to believe that future returns will be materially different over the long term.
Harvard wouldn’t need a team of high-priced portfolio managers to achieve that objective. It would simply require a handful of low-cost index funds and one manager to occasionally rebalance the portfolio.
Sound far-fetched? It’s not. The Nevada Public Employees’ Retirement System -- a $35 billion fund roughly the size of Harvard’s endowment -- is doing just that. The Nevada system’s fund is invested in passively managed funds and rebalanced no more than once a year. Steve Edmundson, the fund’s one-man manager, says the strategy is to “keep costs low and not try beating markets.”
A different objective, on the other hand, might be to rack up market-beating returns and vanquish foes such as Yale and Princeton’s endowments. To have any chance at all, Harvard will need to 1) make bets on active managers and most likely private investments, 2) hire a large team of handsomely paid employees to find those investments and monitor them, and 3) accept that those investments will occasionally lose to the market or to peers. All of that should sound familiar.
Endowments touch every aspect of a university, and all stakeholders should have a voice in the endowment’s objective. If everyone's on board, it will make it easier to live with the occasionally disappointing years.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
(Updates endowment return chart with latest data.)
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