Common Sense: A Hard Landing for University Endowments

Their investing success along with their vaunted academic reputations led many financial experts to conclude that Harvard and its peers at the pinnacle of higher education had solved an age-old conundrum: how to generate higher returns with lower risk.

An investment stampede ensued as other universities, giant pension funds and even individuals slavishly copied their strategy, which stressed diversification along with high-cost, often illiquid alternative investments like hedge funds, venture capital and private equity funds. Today, it’s hard to find a college or university that stuck with the older and far simpler allocation between stocks and bonds. Hedge funds alone currently have what is estimated at over $2 trillion in assets, much of it from large institutions.

College and university endowment returns for the most recent fiscal year, which ended June 30, are starting to roll in. And in many cases, they warrant a grade of C at best, and in some cases, an F. Harvard reported a 0.05 percent loss and a drop in its endowment of over $1 billion in the same period, even as a simple Standard & Poor’s 500-stock index fund gained about 5.5 percent. Harvard’s endowment decline is more than the entire endowments of roughly 90 percent of all colleges and universities.

Even more startling, data compiled by the National Association of College and University Business Officers for the 2011 fiscal year (the most recent available) show that large, medium and small endowments all underperformed a simple mix of 60 percent stocks and 40 percent bonds over one-, three- and five-year periods. The 91 percent of endowments with less than $1 billion in assets underperformed in every time period since records have been maintained. Given the weak results being reported this year, that underperformance is likely to be even more pronounced when the fiscal year 2012 results are included.

The impact is significant. Universities depend on returns on their endowments to finance operations, pay faculty and administrative salaries, provide scholarships and pay for building projects. Harvard said it planned to spend $172 million this year on need-based scholarships. Many colleges budget 4 to 6 percent of the endowment’s value for current spending. At Harvard, funds from the endowment account for 35 percent of the university’s annual budget.

“The compelling simplicity of a 60/40 strategy is very hard to beat,” Timothy J. Keating, president of Keating Investments in Greenwood Village, Colo., and author of two reports on endowment performance, told me this week. “Many investors would be much better served with a simple 60/40 strategy, or at least a core where you have low-cost index funds. When you understand the role of transaction fees, it’s a very high mountain to scale.”

Those fees for so-called alternative investments can be enormous. Hedge fund and private equity fund managers typically keep 20 percent or more of the gains, which is known as carried interest, and a percentage of assets under management. Private equity, real estate and natural resources partnerships may also impose an array of transaction fees on top of performance fees. “The audacity of Wall Street at extracting fees never ceases to amaze me,” Mr. Keating said.

Simon Lack, a founder of SL Advisors in Westfield, N.J., and a hedge fund insider — he allocated capital to hedge funds during his 23 years at JPMorgan Chase — caused a stir earlier this year with his book, “The Hedge Fund Mirage,” in which he calculated that the hedge fund industry as a whole lost more money in one year (2008) than it had made in the previous 10 years. “If all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good,” he asserted. And he maintained that nearly all the hedge funds’ gains had gone to hedge fund managers rather than clients.

“If you look at the data, hedge funds have underperformed a simple 60/40 stock/bond mix every year for the past 10 years,” Mr. Lack told me this week. “They did well in the downturn of 2000-2. But that’s when assets under management were less than half what they are now. There’s no disputing that as assets have grown, performance has declined.”