December 21, 2018
The New York Times highlighted the findings of a remarkable study last week. The study, by Markov Processes International, examined the 10-year returns of the endowments of the eight Ivy League schools. The study found that all eight endowments had lower returns than a simple mix of 60 percent stock index funds and 40 percent bonds. In some cases, the gap was substantial. Harvard set the mark with its annual returns lagging a simple 60/40 portfolio by more than 3.0 percentage points.
This finding is remarkable because these endowments invest heavily in hedge funds and other “alternative” investments. A main feature of these alternative investments is the high fees paid to the people who manage them. A standard hedge fund contract pays the fund manager 2 percent of the assets under management every year, plus 20 percent of returns over a target rate.
If Harvard’s $40 billion endowment was entirely managed by hedge funds, they would get $800 million in fees, plus 20 percent of the endowment’s earnings over some threshold. This means that even if the hedge funds completely bombed, as seems to have been the case over the last decade, they would be pocketing $8 billion over the decade for costing the school money.
This should have people connected with Harvard and the other Ivy League schools up in arms. It is common for hedge fund partners to make more than $10 million a year and some pocket over $100 million. These exorbitant paychecks are justified by the outsized returns they get for university endowments and other investors. But how do you justify this sort of pay when they are making bad investment calls that actually lose the universities money?
And, just to be clear, the Markov comparison was overly generous to the universities. Their benchmark comparison of a portfolio of 60 percent stock and 40 percent bonds is in fact far safer than the alternative investments they hold. If they actually equalized risk, the comparison portfolio might be 80 percent or even 90 stock, making the Ivy league endowment returns look even worse.
The Ivy League schools are not the only big institutional investors who are turning to alternative investments. State and local pension funds also play this game in a big way. The beneficiaries are more often private equity partners, but the basic story is the same: people who make themselves very rich by playing financial games. And, as with the hedge fund folks and the Ivies, they do not provide the promised returns.
And, there is considerably more money at stake with public pension funds. The cumulative size of the Ivy League endowments is just under $140 billion. While this is hardly chump change, state and local government pension funds have more than $8 trillion in assets. Most of this money is not in alternative investments, but if just 10 percent were placed with private equity funds and other alternatives, it would come to $800 billion.
There is much to dislike about the behavior of these financial actors. They routinely play games with the tax code and bankruptcy law to increase returns. It is standard practice for private equity funds to leverage their companies as much as possible to take advantage of the deduction for interest on corporate income taxes.[1]
They also strip valuable assets, such as the real estate on which stores and restaurants sit, so that they can book a quick profit while leaving the companies they control more vulnerable to a business downturn. Bankruptcy is a common tool, which they use to get out of not only interest payments on debt (presumably lenders knew the risks they were taking), but also pension and health care obligations to workers, and payments to suppliers.
For these reasons, it would be understandable if socially minded investors, like universities and state and local governments, decided to steer clear of such morally and legally questionable funds. But it turns out the choice is even simpler. These funds lose their investors money, compared to less questionable alternatives.
So the issue is why do these institutions keep throwing away money? My guess, and it really is just a guess, is that it is a combination of inertia and the political and social power of the financial industry.
In terms of inertia, people can point back to a period where the hedge funds did produce outsized returns, as did the private equity funds. People can think that the last decade or so is just an aberration and that the good times will return.
While I can’t predict the future, there is a simple story that would imply the opposite. Both hedge funds and private equity funds prospered by finding seriously undervalued assets and then leveraging heavily to maximize their return. When there were few actors in the field, it was possible for some number of funds to make large returns this way. But now that there are many actors, with trillions of dollars to invest, seriously undervalued assets are few and far between.
This means that most hedge funds and private equity funds won’t be able to make outsized returns going forward. The high fees to the fund managers are a direct drain on returns that would otherwise more or less match the market average.
And just to be clear, we are talking about a 10-year period in which hedge funds have failed to match the market average. (It’s a similar story with private equity.) This is a long period, it’s not just a case of these funds having a bad year or two.
But moving beyond inertia, if we look to the universities, many of the managers of the hedge funds they invest in are alums of the Ivy League schools. They are often big contributors to these schools and are likely friends with top administrators and board members. It would be really rude not to give them the university’s business when it comes to managing the endowment.
In the case of pension funds, private equity managers typically make a point of doing great sales pitches to the pension fund boards, most of whom are not financial professionals. This can include expensive dinners and other perks as part of the sales pitch. In addition, private equity partners often are major contributors to political campaigns, where they support allies in getting government business.
It is difficult to break these patterns of investment now that they have become firmly entrenched. One big step in this direction would be requiring full transparency both on the terms of contracts and also the returns offered by each investment. The endowments and pension funds all have this information so it is simply a matter of making it fully accessible to the public.
Typically, these funds insist that their investors keep the terms of their contract secret. The argument is that they are giving the investor a special deal, which they could not do if the terms were public since they then would have to give the same deal to everyone else. Needless to say, all the investors are not getting a special deal. This is simply a way to avoid accountability.
Full accountability should be a straightforward demand that state and local governments could require of their pension funds. Anyone should be able to go on the state’s website and see the basic terms of each contract a pension fund signed with private equity fund, hedge fund, or other investment manager. They should also be able to see the returns as the data become available so that it will be clear whether a fund gained or lost money on the deal.
Universities should be expected to adopt the same practice. In fact, it is reasonable to expect universities to take the lead in this area. Most schools like to envision themselves as providing a service to society, not as self-serving operations intended to enrich top administration. Why should they not set an example in good governance by fully disclosing the terms of their contracts with hedge funds?
At the end of the day, if the hedge funds are really producing extraordinary returns, they will be able to boast about their insight in finding financial wizards. But if their hedge fund friends are trailing the market, and therefore costing the school money, they will face considerable pressure to end the contracts.
I remember a few years back a group of students at Swarthmore, where I went college, were pushing the school to divest its holdings in fossil fuel companies. Their hope was to help build a stigma around fossil fuel use, which would hopefully lead to stronger measures to reduce greenhouse gas emissions. The logic was similar to the movement to divest from companies that did business with South Africa back in the 1970s and 1980s. I wrote a letter in support of their efforts.
The students shared with me the counter-argument by those opposed to divestment. They argued that the measure would have little practical impact while leading to lower returns on the endowment.[2] Since the endowment was used in part to support financial aid, they said this could jeopardize the school’s ability to bring in lower and middle class students. I admit to being somewhat sensitive to this argument since I had gotten a very generous financial aid package from Swarthmore, without which I would not have been able to go there.
In the demand for openness in investment contracts, there is no issue of students being deprived of financial aid. In fact, the story is the opposite. Because the endowments are losing money from going with the hedge fund gang, their decisions are effectively depriving low and middle class students of financial aid.
That means there is not much of a moral dilemma in getting the Ivies and other universities out of hedge funds, or at least requiring openness on their contracts. That is, there’s not much of a moral dilemma unless the people running the hedge funds are your friends.
[1] This deduction was limited, with some major loopholes, under the Trump tax bill.
[2] Ironically, this debate was taking place when oil prices were still close to $100 a barrel. They soon plunged to around $40 a barrel. The endowment would have benefitted enormously if it had taken steps to divest its fossil fuel holdings at the time. (FWIW, I had no idea oil prices were about to plunge.)
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