“I don’t know how big it is. Don’t know who runs it. Don’t know how much the pay-out ratio is,” third-year College student Vincent Zimmern said about the University’s endowment. A look at the basics behind college investing and elite universities’ methods may illuminate the University’s endowment investment for students like Zimmern.
To begin, the IRS identifies university endowments as tax-exempt under the federal tax code. According to “The Foundation: A Great American Secret” by Joel Fleishman, four funding sources primarily support endowments financially: fees for services, investment income, grants from the government and gifts. Generally, Fleishman writes, services and investment income provide about 40 percent of the total revenue, while 25 percent of the support comes from private individuals. Funds from each source often come with certain guidelines. While government grants usually require many regulatory restrictions on spending policies, alumni and private donations may be geared toward a specific purpose that might temper the broad goals of schools. Thus, the most significant objective for endowment support is to help institutions achieve greater autonomy in the face of these specific guidelines.
For an endowment to operate as a non-profit foundation, its operational goals are unique: to qualify as tax-exempt and avoid paying a significant sum to Uncle Sam, a foundation needs to pay out 5 percent of its total asset to charitable causes. This means that if the University maintained its non-profit status and did not actively pursue an investment program, it would have to either increase students’ tuition significantly or ask for outside money, neither of which is particularly popular. If the University fails to do so, the asset base of the school will be permanently damaged. It is thus clear that endowment investment constitutes a vital component of higher education.
A typical investment manager in private industry usually has an investment horizon of 5 to 10 years — some hedge funds max out their profits in the first few years and then liquidate entirely. In contrast, an endowment constantly seeks to balance between maintaining long-term capital preservation and fulfilling annual budgetary requirements (5 percent or more). In his book “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment,” Yale Endowment Manager David Swensen summarizes the core principle of an endowment investment goal precisely: “the existing endowment can continue to support the same set of activities that it is now supporting.”
Essentially, most endowments are designed to exist forever, at least in theory; therefore, an endowment needs to meet the needs of both current and future students. Responsible financial guardians need to extract enough money from the endowment to advance current activities and need to maintain the discipline of restricting current budgetary outlay to preserve capital in the long run. Given a fixed amount of money, allocating more funds to current students necessarily cuts the funding for future students. Endowments must generate meaningful investment income in order to perpetuate themselves.
The University of Virginia Investment Management Company manages the University’s $5.1 billion asset. UVIMCO CEO Chris Brightman said “UVIMCO’s primary objective in managing the pool is to maximize long-term real return commensurate with the risk tolerance of the University.” To calculate this real return, it helps to understand the spending needs of the University. The investment report found on UVIMCO’s Web site states that the University withdraws 5.7 percent of the total endowment annually (5.0 percent for University spending, 0.5 percent for administrative expenses and 0.2 percent to cover the cost of UVIMCO). The estimate of recent inflation is 3.3 percent. This means that UVIMCO aims to return at least 9 percent (withdrawals plus inflation) to preserve the endowment value.
Traditionally, universities allocate 65 percent of their annual withdrawals to stocks and 35 percent to bonds. This asset mix in the long term delivers about an annualized 8 percent return; however, stock performance is very volatile. Crashes are still an integral part of the stock market. In 1987, the Dow Jones Industrial Average wiped out more than 20 percent of its value in one day. In 2000, many investors saw their portfolio evaporate as the Internet bubble blew up. Most recently, the U.S. stock market has been severely damaged by the credit crisis. Thus, the conventional institutional investment portfolio fails to meet the investment goal of the University.
While colleges do not need to compete with one another for profits because their primary mission is to educate, financial status is directly correlated with the prestige of schools. Wealthier schools usually dominate the upper echelon of the college rankings. Brightman said “UVIMCO strives to manage pool assets to provide long-term real returns that compare favorably with the returns of endowments of other outstanding schools.” Better investments help enhance the overall rankings of schools, and as newer and more profitable investment vehicles become available, investment returns from stocks cannot help a school to stay competitive.
So what “cutting-edge” investments enable Harvard University, Yale University and the University to deliver superior endowment income? The answer is revealed in the unique asset allocation that elite schools employ. Unlike the average portfolio, Yale or the University’s endowments allocate large amounts of money in alternative assets. This mysterious group of vehicles usually includes private equity and absolute return (hedge funds). Private investments’ most distinguished feature is their typical extraordinary profitability compared to stocks and bonds. More importantly, the differences in performance between the top alternative investment managers and mediocre managers are profound. In fact, the best performance is heavily concentrated in a handful of elite hedge funds and private equity shops, like Citadel and Blue Ridge Capital. Because private investments are not publicly traded, the top managers are usually very exclusive. The most successful hedge funds and private equity groups require huge up-front capital commitment and work only with clients whom they already know and trust. So, only the wealthiest and most prestigious institutions gain access to the most profitable managers.
There is one more catch: Most hedge fund and private equity managers are reluctant to reveal their investment strategies to the public because those pieces of information are their reason for success. Those managers will likely lose their competitive edge if their investment strategies become public, because everyone else could just copy them. This is why the elite schools usually have less endowment transparency than others.
Interestingly, none of the 20 schools with the largest endowments disclose the actual names of the underlying managers. The University’s endowment disclosure is very comparable to these other top schools.
Let’s compare the University to Dartmouth, a college that recently received a high transparency rating from The Sustainable Endowments Institute. The Dartmouth 2007 annual report contains only 8 pages while the UVIMCO Report runs about 18 pages. The difference in the page number is not merely a matter of conciseness in language, but a distinction in transparency.
Unlike Dartmouth’s report, the UVIMCO report includes a CEO letter that gives an in-depth account of the current economic condition and how it has affected University endowment. Moreover, the University’s report reveals the comparative investment performance between our endowment and the policy benchmark up to 20 years. In contrast, Dartmouth only shows its performance against its benchmark up to five years. Last but not least, UVIMCO discloses a substantial amount of information about its investment strategy and performance for every single asset class that the University has money in, such as stocks, hedge funds, private equity, real assets, bonds, even derivatives. Such detailed information simply cannot be found in the Dartmouth report.
While it might be true that UVIMCO reveals less information than the majority of university endowments in America, the University has done a commendable job reporting its endowment policies compared to other prestigious universities. If students do not know much about our endowment usage, it is because they simply have not taken the time to check the UVIMCO Web site, which contains a great deal about investment strategies, policies and other provisions. A word of caution: If we fail to act with prudence when disclosing information pertaining to our underlying managers, the best hedge funds or private equity funds will simply stop working with us.
In order to enhance the humanitarian objectives of high education, the people in charge of their organizational financing need to balance current budgetary needs with long-term capital preservation. Endowments need to generate healthy and steady investment returns. As universities and colleges today face mounting competition among one another, it is reasonable to expect that endowment investment programs will continue to gain recognition and attract top talent from other industries.
Paul Chen is a short fund manager in the McIntire Investment Institute. He can be reached at yc6k@virginia.edu.
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