How Actively Managed Ivy League Endowments Got Beaten By The Humble Index Fund

[RusticBohemian]

The NYTs had a great article today on how the actively managed endowments of Yale And Harvard got trounced by a small college in NY that switched half of its investments to vanguard index funds.

https://www.nytimes.com/2017/02/09/business/college-endowment-investment-returns.html

[accolay]

Interesting that

Houghton has been able to lower its spending rate — the amount it withdraws each year to fund operations — to an enviable 4.5 percent, and may be able to lower it further, to 4 percent.

but...conventional "wisdom" strikes again:

Even so, no one expects Harvard — or any other major endowment — to ditch hedge funds anytime soon. Hope springs eternal, and the allure of potentially higher returns is paradoxically more potent the lower the actual returns are.

[uwp]

I find it interesting that they compare the results from one single year.  I wonder what Houghton's results are going back further, Yale publishes an annual report.

https://static1.squarespace.com/static/55db7b87e4b0dca22fba2438/t/578e41ffe58c629352d7560a/1468940803516/Yale_Endowment_15.pdf

Yale 2015 = 11.5%
Yale 2014 = 20.2%
Yale 2013 = 12.5%
Yale 2012 = 4.7%
Yale 2011 = 21.9%

Yale's endowment returned 13.9% a year (over the last 3 decades) up through their 2015 report, so I doubt they are crying about a single year.

Edit: Also, Harvard's numbers (while not as good, are still pretty good... 10.4% over the last 2 decades.
http://www.hmc.harvard.edu/docs/Final_Annual_Report_2016.pdf

We've just had a 5 year stretch where 60/40 US stocks/bonds has been the best spot to be.  Everyone feels really smart going it alone.

[sol]

Major university endowments have been out-performing the index for over a decade now, for a variety of pretty well established reasons.  I'm not surprised they had an off year, but I think that one year is contrary to the pattern.

[accolay]

Better for a small school with an endowment of only 46 million to play it safe with low fees vs. large school with endowment of 35 billion and with 230 endowment staff (Harvard)?

Easier to miss 2 billion when you have 35.

[Malaysia41]

Thomas Piketty's Capital in the 21st Century discusses this. In Part three, chapter "Global Inequality of Wealth in the Twenty-First Century", he notes two reasons why large fortunes see greater returns

... a person with 1 billion euros has greater means
* to employ wealth management
* to take greater risks and be patient

Data shows that large fortunes grow at consistently higher return rates vs average fortunes.

More than 800 public and private US universities manage their own endowments - totaling $400B in assets among them.(p. 447)

Conclusions from public reports on these endowments:

1. The return on US university endowments has averaged 8.2%a year from 1980 to 2010.
2. The return increases rapidly with SIZE OF ENDOWMENT
 - for 60 universities with > $1B , average r=8.8% - twice as much as less well-endowed universities.

You see diversified portfolios across these endowments. That's where the similarity ends. In the larger endowment funds, you see 'alternative investment strategies' such as shares in private equity funds, derivatives, real estate, and raw materials.   These alternative investments represent just 10% of the smaller uni funds, but comprise >60% of the endowments above $1B.

Piketty concludes that it's these alternative investments that enable the largest endowments to obtain 2x the return as smaller endowments - e.g. 10% annual r vs 5%.  This persists year to year.

How is this possible? Piketty explains that it's about economies of scale in portfolio management. Harvard (with $30B in assets) spends $100M a year on management - or .3% per year. OTOH, a $1B fund couldn't afford to pay $100m in management fees - that'd be an unsustainable 10% fee. All of their gains would go to management fees. In practice, no endowments spend > 1% in fees - typically they are under .5%.

I had to read this section a couple times as it seemed to fly in the face of our conventional wisdom here on MMM. However, I think the thing to note is that the difference in returns occurs for fortunes >> $1B - which is way outside of our worlds.

Anyway - that's what I learned about this topic in Piketty's book.

[Metric Mouse]

Thomas Piketty's Capital in the 21st Century discusses this. In Part three, chapter "Global Inequality of Wealth in the Twenty-First Century", he notes two reasons why large fortunes see greater returns

... a person with 1 billion euros has greater means
* to employ wealth management
* to take greater risks and be patient

Data shows that large fortunes grow at consistently higher return rates vs average fortunes.

More than 800 public and private US universities manage their own endowments - totaling $400B in assets among them.(p. 447)

Conclusions from public reports on these endowments:

1. The return on US university endowments has averaged 8.2%a year from 1980 to 2010.
2. The return increases rapidly with SIZE OF ENDOWMENT
 - for 60 universities with > $1B , average r=8.8% - twice as much as less well-endowed universities.

You see diversified portfolios across these endowments. That's where the similarity ends. In the larger endowment funds, you see 'alternative investment strategies' such as shares in private equity funds, derivatives, real estate, and raw materials.   These alternative investments represent just 10% of the smaller uni funds, but comprise >60% of the endowments above $1B.

Piketty concludes that it's these alternative investments that enable the largest endowments to obtain 2x the return as smaller endowments - e.g. 10% annual r vs 5%.  This persists year to year.

How is this possible? Piketty explains that it's about economies of scale in portfolio management. Harvard (with $30B in assets) spends $100M a year on management - or .3% per year. OTOH, a $1B fund couldn't afford to pay $100m in management fees - that'd be an unsustainable 10% fee. All of their gains would go to management fees. In practice, no endowments spend > 1% in fees - typically they are under .5%.

I had to read this section a couple times as it seemed to fly in the face of our conventional wisdom here on MMM. However, I think the thing to note is that the difference in returns occurs for fortunes >> $1B - which is way outside of our worlds.

Anyway - that's what I learned about this topic in Piketty's book.

Thanks for this.  Shows that everyone likes low expense ratios - at least one thing that can be modeled from this material.

[sol]

Major university endowments have been out-performing the index for over a decade now, for a variety of pretty well established reasons.

What are these reasons?

In addition to what Malaysia noted above, universities have access to a variety of investment types that you and I do not.  Their fortunes are so large that they can buy real estate and private equity in the same way that you and I might buy individual shares of stock.  If I want to invest in commercial real estate I'm going to have all of my eggs in one basket, but if you have a few billion to play with then you can buy a piece of everything.  They also have the added bonus of being able to invest heavily in their own college town community, buying up neighboring properties and building campus expansions, in a way that adds more value than a normal investor can.

There are some additional benefits derived from being non-profit educational organizations, that allow them to get funky with their taxes, but the short answer is just that they are more able to invest in illiquid asset classes with huge minimum buy-in requirements and century-long hold times.  And, you know, spend a few million dollars on paying the brightest investment managers out there to analyze those alternative investments, since they aren't traded (and thus market priced) in the way that normal stocks are.

Some folks have also suggested that universities (like Congressmen) benefit from insider trading, as their alumni offer them inside information about upcoming market events, but this is hard to prove.  Such tips might even be legal, if the tipster isn't personally benefiting from any of the consequent trades.

[CheapScholar]

I work at a private university with a 10B endowment.  Sol got it exactly right.  We are very heavy in real estate, local investment opps, and also private investment opps with partners all over the world.  Although I don't work in the investment office, I have access to a lot of information other people don't have.  It's quite the operation.  Our endowment pool lost .03% last year. But, as stated, our 10 year average kills any index fund. 

We spend 4.5% of our endowment every year to provide for thousands of contractual gift agreements (scholarships, faculty chairs, etc.).  We couldn't do that on index funds. I worked at a smaller school before that did not manage its own investments and the payout rate was 3.75%.

[Fireball]

So, in a nutshell, if you're already very wealthy it's "easier" to become even more wealthy. Yeah, I can agree with that. I say  easier, but not sure it's the word I'm really looking for. You get my drift though.

[Malaysia41]

So, in a nutshell, if you're already very wealthy it's "easier" to become even more wealthy. Yeah, I can agree with that. I say  easier, but not sure it's the word I'm really looking for. You get my drift though.

Yes. That.  Pretty much the whole point of Piketty's book.

[sol]

So, in a nutshell, if you're already very wealthy it's "easier" to become even more wealthy. Yeah, I can agree with that. I say  easier, but not sure it's the word I'm really looking for. You get my drift though.

Yes. That.  Pretty much the whole point of Piketty's book.

That's pretty much the whole point of capitalism.