Tough Lessons for Harvard and Yale

For years, top universities like Harvard and Yale got straight A’s for their money management skills

Their cutting-edge investment philosophies, which included heavy doses of alterative investments, helped them post stellar numbers and made them models for investors everywhere.

But the crash and bear market have pummeled those funds, which routinely suffered 25%-30% hits. And since universities relied on their endowments to cover day-to-day operations, some of them have put building plans on hold, frozen faculty salaries, and laid off staff to cover the shortfalls from their investments.

That has led many to question the wildly successful “Yale model.” And now a new study by three Dutch researchers suggests these universities may be putting too much of their money into hedge funds and private equity, which have done spectacularly well recently but may underperform in the future.

The revolution in university investment management was spearheaded by two men—Jack Meyer, who ran Harvard Management Company from 1990 to 2005, and David Swensen, Yale’s chief investment officer.

Swensen is a great investor who guided Yale’s portfolio to a 15.9% annual gain in the 20 years ending June 30, 2008, smashing the Standard & Poor’s 500 index and growing the endowment more than tenfold.

He’s also a brilliant thinker, rare in the investment world, with a genuinely innovative approach to managing money. (He discusses his philosophy in this one-hour video.)

Back in 1980, Harvard’s portfolio comprised two-thirds stocks and one-third bonds, and Yale’s was plain-vanilla, too. But Swensen found that a much more adventurous mix could produce higher returns at a lower risk, since certain asset classes didn’t move in tandem with equities.

So, he loaded up Yale’s portfolio with then-exotic assets like oil and gas, timber, and stakes in hedge funds, venture capital, and private equity. By last year, those categories accounted for three-quarters of Yale’s assets (see Table).

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“Alternative assets [provide] an opportunity to exploit market inefficiencies through active management,” the Yale Endowment’s 2008 annual report said. “The Endowment’s long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.”

But that got Yale and other universities into big trouble when the crisis hit.

“The big Ivies have garnered as much as half their budgets from their endowments, [which] makes the endowments vulnerable to further market declines,” Barron’s wrote (subscription required).

“The outlook is challenging for the big Ivy League endowments because many of their investments are in illiquid private-equity and real-estate funds or commodity-related assets such as timberland.”

It’s tough to sell timberland or liquidate private investments when you need cash to cover scholarships or faculty salaries, as Harvard found out when it reportedly failed to get out of some private equity funds earlier this year.

Sounds like some retirees and near-retirees who had too much of their assets in stock, doesn’t it?

These universities may have been too clever by half. By shunning assets Swensen says offer inferior returns over long periods of time—like cash and Treasury bonds—the universities were short of desperately needed liquidity and the “high quality portfolio protection” even he acknowledges Treasuries offer.

Swensen foresaw the problem in his book Pioneering Portfolio Management. “As the importance of the endowment to the budget grew, the consequences of a material decline in endowment spending grew commensurately,” he wrote.

So, maybe a little less exposure to hedge funds and a little more to bonds and cash may have reduced returns but helped Harvard and Yale pay the bills when the crunch came. 

David Swensen declined to comment, and Harvard Management did not make anyone available for an interview.

And now a new study suggests these universities may have to take a second look at their portfolios if they want to do as well in the future as they have done up until now.

Three Dutch researchers, Niels Bekkers of Tilburg University and Ronald Doeswijk and Trevin Lam of Rabobank, have carried out what they believe to be the most comprehensive study of historical data for ten asset classes.

Their paper, “Strategic Asset Allocation,” which has been submitted for peer review but not yet published, employed mean/variance analysis—the same method used by Swensen—to determine which assets add the most value to a portfolio.

Their conclusion: “Real estate, commodities, and high yield add most value to the traditional asset mix,” because they have low correlations with equities and produce the highest return at the lowest risk.

Not private equity or hedge funds?

“If you look at a certain period, private equity and hedge funds offer [diversification benefits, but] over the long run, they do not offer the diversification benefits of real estate, commodities, and high-yield bonds,” author Trevin Lam told me in a telephone interview.

In fact, hedge funds and especially private equity may be due for a fall after a long, long boom. That’s just the principle of “reversion to the mean.” Private equity in particular is facing big challenges as the era of easy credit has come to a sudden end.

“The biggest private equity groups are sitting on a $400-billion…debt mountain that needs to be repaid over the next five years, putting the future of some of the largest buy-out deals in doubt,” the Financial Times reported.

“Private equity groups are being forced to find new ways to pay down this debt ahead of schedule. These include putting new equity into their portfolio companies, selling stakes in businesses to strategic buyers, and buying back debt in their own companies at a discount.”

Translation: leaner times ahead, maybe like what venture capital has experienced since the tech bubble burst in 2000.

But however they do in coming years, these universities have changed investing for everyone.

“I think the single most important thing individuals can do is to shift a large percentage of their assets into alternative assets,” says London-based manager Nicholas Vardy, who writes the Global Guru newsletter and runs a university endowment-like fund using exchange traded funds.

“Personally I have almost all my money in this kind of strategy,” he says.

Indeed, says Lam, “you could replicate our [optimal] portfolio using ETFs”—and Swensen has his own recommendations for individuals, too (see Table).

But just make sure you have some cash in hand, in case of a rainy day. That’s one lesson Harvard, Yale, and other great universities learned the hard way.