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Follow-up to “When Genius Failed: Harvard Layoffs”

This post is a quick follow-up to our post earlier this week “When Genius Failed: Harvard Layoffs.”  Not all universities saw their endowments decimated in 2008.  Many, in fact, did quite well.

The Wall Street Journal had two excellent pieces in yesterday’s paper bashing the “Yale Model” of running university endowments.  On New York college Cooper Union in “One College Sidesteps the Crisis,” John Hechinger writes,

John Michaelson, who heads Cooper’s investment committee, said other schools could benefit from taking a lower-risk investing approach. He is especially critical of what has been known as the “Yale model.”Yale University profited from pioneering moves away from U.S stocks into often illiquid alternative investments, such as private equity, commodities and timber. Yale’s strategy avoided losses in the tech-stock collapse.But Mr. Michaelson of New York private-equity firm Imperium Partners says Yale’s approach, widely emulated in recent years, places too little emphasis on colleges’ annual cash needs and is “deeply flawed.”

So, why might the Yale model be flawed?  In “Ivy League Endowments Finally ‘Dumb,’” we see that the Ivy League endowment funds earned outsized returns throughout most of the 2000s, but that these returns were only made possible by large holdings of illiquid asset classes like hedge funds, private equity and other alternative investments.

How big were these illiquid positions?   For large endowments over $1 billion, the average was 57% of the portfolio, and at Yale the number was an almost incredible 70%  Yes, Yale had 70% of its endowment in illiquid alternative investments!

The hedge fund industry will never go away, of course.  Many hedge funds do exactly what they say they do; they hedge, offering investors the potential for “alpha” returns rather than “beta.”   Similarly, there is a place for private equity and even exotic investments like artwork or timberland within a large institutional portfolio.  But clearly, the Ivy League love affair with alternatives reached excessive levels that made no sense and left the universities at financial risk.   How can an institution that relies on income from investments to fund its day-to-day operations have 70% of its assets in illiquid investments?  This is clearly a dangerous asset/liability mismatch.

The returns they achieved, particularly in the later years, appear now to be the result of a herd mentality.  Large investors poured into alternatives, creating a mini-bubble of sorts.   Now, with the bubble burst and the universities short of cash, a return to a more traditional (and more modest) asset allocation is likely.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy