The problems with university endowments
If you fancy some iPad reading for the Memorial Day weekend, you could do a lot worse than to download this Tellus paper into GoodReader or similar. It’s titled “Educational Endowments and the Financial Crisis: Social Costs and Systemic Risks in the Shadow Banking System; the lead author, who writes very clearly and readably, is Joshua Humphreys.
I’m still working my way through the whole thing, but my initial impression is very positive. Humphreys points out in great detail, for instance, the downsides associated with giving university endowments charitable status and allowing them to issue tax-free bonds; I don’t know what happened to the tax which was being mooted a couple of years ago, but maybe it’s time to revisit it, especially since opposition to the idea even back then was so weak.
Humphreys also notes that university endowments in many ways exacerbated the financial crisis, as well as doing great harm to their own university budgets and their local economies. Meanwhile, their governing boards tend to be incredibly conflicted, with more than half a dozen trustees on Dartmouth’s board alone having managed investments for the endowment.
Humphreys has his own axe to grind: a long-time advocate of socially responsible investing, he makes the case that “as long-term investors, colleges and universities have an important stake in the sustainability of both the wider financial system and the broader economies in which they participate. Rather than contributing to systemic risk, endowments should therefore embrace their role as nonprofit stewards of sustainability.”
This makes sense to me, especially if university endowments are going to operate under the umbrella of charitable status. But even if they want to continue to chase absolute returns, it’s clear that the endowment model massively overestimated their appetite for illiquid assets. The idea was that because they’re investing with the longest conceivable time horizon, they can put a lot of their money into highly illiquid investments. But then they got bit by the fact that their universities were naturally likely to fall back on endowment monies at precisely the point at which illiquid markets seize up completely. Endowments should be countercyclical buffers, when it comes to universtity finances, not pro-cyclical exacerbators of financial crises.
And they should also be a lot more transparent than they are. Writes Humphreys:
When reported, school-specific data are nonstandardized, inconsistent, incomplete and fragmentary, and scattered across municipal, state, SEC and IRS filings, incommensurable annual reports, and costly proprietary financial databases unavailable to the general public.
There’s no excuse for this. Let’s force endowments to standardize their public reports, and show, rather than tell, just what their highly-paid employees are doing to deserve all their millions of dollars in remuneration. And let’s force them, too, to spend a lot more time concentrating on liquidity risk management, and to cast a skeptical eye on the amount of leverage that these institutions really need. Humphreys finds, for instance, a 2007article by Geraldine Fabrikant about Jack Meyer, containing this astonishing number:
When Mr. Meyer and his team were at Harvard, the endowment was known for making money by betting on small pricing differences between different kinds of securities.
For example, Mr. Meyer and his team might capitalize on the price difference between new Treasury issues and older ones. And to magnify gains, they would leverage those bets as much as 15 to 1.
That sounds very much like LTCM to me, and I think everybody can agree that we don’t want university endowments to be LTCM. And I’m not sure that it’s at all possible, with hindsight, to justify these kind of salaries:
It’s true that if you want massive returns on your endowment, you’re likely to end up paying massive salaries to the people who manage it. But you’re also likely to start spending future endowment gains you don’t yet have, and end up with a billion-dollar hole in the ground. It’s good for universities to be ambitious. But not if their ambitions expand to the point at which they feel the need to start selling off their own donated art just to keep the lights on.