A Not Terribly Bright Idea for Harvard
A group of 11 Harvard alumni has a plan to boost the university’s straggling endowment, but it’s not the magical fix the members imagine.
In an open letter to Harvard’s new president, Lawrence Bacow, the group recommends that the endowment move at least half its assets to a low-cost S&P 500 index fund. It’s a “radical new endowment strategy,” the alumni acknowledge. Harvard, along with other big university endowments, pioneered and still uses the so-called endowment model of investing, which calls for investments in high-priced hedge funds and private assets alongside traditional stocks and bonds.
A radical step is necessary, the alumni say, because Harvard faces a “fiscal crisis” from a new tax on wealthy university endowments. According to Bloomberg News, Harvard estimates that “the new 1.4 percent tax would have cost the endowment $43 million last year.” The group’s plan would use the money saved on well-compensated managers to pay the tax.
It’s smart to spend less on fees, but let’s be serious: There are no fiscal problems at Harvard. It boasts the largest university endowment in the U.S., a $37.1 billion hoard as of the end of the 2017 fiscal year. That's $9.9 billion larger than the second-largest endowment of rival Yale University. To put that in perspective, the difference between the two schools’ fortunes is larger than the endowments of all but 10 other universities.
The real problem is that the collective ego of the “nation’s greatest university” has been punctured in recent years. The endowment’s performance in fiscal year 2017 ranks dead last among the 88 largest endowments that have reported their results, according to Bloomberg data. It’s not just one year. Harvard’s three-year, five-year and 10-year returns rank 73, 66 and 55, respectively.
It’s easy to see why the group hangs its hopes on an S&P 500 index fund. For one thing, it’s famously cheap -- as little as 0.04 percent year -- and lower fees substantially increase expected returns. Of the 776 U.S. stock large-cap blend mutual funds that have been around a decade, only 14 percent beat the S&P 500 net of all fees over the last 10 years through January, according to Morningstar data. Gross of fees, however, 60 percent beat the index.
The S&P 500 has also been a formidable foe for Harvard. The endowment has beaten the index in less than half of rolling 10-year periods since the Harvard Management Company began managing the endowment in 1974. And nearly all of those victories ended between 2001 and 2014, a stretch that coincides with Jack Meyer’s legendary tenure as CEO of the endowment from 1991 to 2005
There’s no guarantee, however, that Harvard will capture the returns of the S&P 500. Consider that the investor share class of Vanguard’s 500 Index Fund returned 9.7 percent annually over the last 10 years through January, including dividends. And yet the average investor in the fund captured a return of just 5.4 percent, according to Morningstar.
The reason, of course, is that investors hopelessly chase returns, buying after a recent period of good performance and selling after a bad one. The penalty for bad behavior can dwarf the negative impact of fees.
And the more volatile an investment, the worse investors behave, and vice versa. Vanguard’s Total Bond Market Index Fund returned 3.6 percent annually over the last 10 years through January, while investors captured a return of 3.1 percent -- a far better outcome than stock investors achieved.
That should ring a bell. The Harvard alumni write that “wealthy individuals and institutions would have been much better advised, beginning in 2008, to have put their money in the S&P 500 index than to entrust it to hedge fund managers.” It’s not just hedge funds. The S&P 500 has outpaced nearly every other investment over the last decade. Any portfolio that owned more than just large-cap U.S. stocks during the period struggled to keep up.
That includes Harvard’s endowment, which returned 4.4 percent annually over the last 10 years through June 2017, while the S&P 500 returned 7.2 percent. Even Yale’s endowment, which many consider the gold standard of university portfolios, trailed the S&P 500 by 0.6 percentage points annually. In fact, of the 88 largest university endowments that have reported results through 2017, just five managed to beat the S&P 500 over the last 10 fiscal years.
Investing Harvard’s endowment in the S&P 500 would only intensify the temptation to chase performance because the S&P 500 is more volatile than Harvard’s endowment. The endowment’s standard deviation has been 12.3 percent from fiscal years 1974 to 2017, compared with 16.8 percent for the S&P 500. That’s because the endowment is more diversified than the S&P 500, and its private assets aren’t subject to the price swings of public markets.
I’ve long said that university endowments can achieve great results using a diversified set of low-cost funds. But if Harvard’s alumni are still tempted to bet the school’s treasure on the S&P 500, they should ask themselves how they’ll feel when the endowment tumbles 46 percent, as it would have from April 2000 to September 2002, or 53 percent from November 2007 to February 2009. My guess is the S&P 500 won’t seem like such a savior after all.
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Daniel Niemi at email@example.com