Endowment Returns, Endowment Management: Straws in the Wind?

UPDATED. Other institutions’ endowment results—and further budget cuts—suggest the challenges facing Harvard Management Company and the University.

Harvard Management Company (HMC) has resumed its practice from before the acute financial crisis of late 2008: it will not issue interim updates on performance. Instead, it will revert to reporting investment returns on the University’s endowment annually--following the close of the fiscal year each June 30, and the subsequent valuation of assets that are not traded frequently in public securities markets. But other institutions’ pronouncements may suggest trends in endowment performance. In addition, a recent address by HMC president and chief executive officer Jane L. Mendillo gives some sense of the changes under way in managing the endowment.


Why Endowment Performance Matters

How the investments fare matters significantly to Harvard. Distributions from the endowment accounted for 38 percent of operating revenues ($1.44 billion) in fiscal 2009 (and an additional nearly quarter-billion dollars of decapitalizations, the bulk of that associated with the administrative assessment for Allston-related spending). The negative 27.3 percent investment return that year, combined with the spending, reduced the value of the endowment by $11 billion. That, in turn, prompted the current 8 percent reduction in such operating distributions this year (about $115 million) and pending 12 percent further reduction ($160 million) for the next year.

The Corporation has not yet declared a distribution rate for fiscal year 2012. Presumably, it is reserving that decision for later this year--in part to see whether investment returns are sufficiently robust to begin restoring the endowment’s value.

Current-year spending of $1.3 billion-$1.5 billion, of course, reduces the value of the endowment. The arithmetic is unforgiving: Excluding the effect of any gifts, a 10 percent investment return would increase the Harvard endowment’s gross value by $2.6 billion. But with spending at a rate of 5 to 6 percent of the value, the net gain would be only $1.1 billion to $1.3 billion—making up only 10 percent to 12 percent of the fiscal 2009 decline. That balance between appreciation and spending—and therefore the endowment’s long-term value and purchasing power—shapes the Corporation’s thinking. (Note that as of fiscal 2009, HMC's 10-year annualized rate of return is 8.9 percent; its long-term return goal is about 8.25 percent annually. For the same fiscal year, a commonly used index of university costs, the Commonfund Higher Education Price Index, showed a 2.3 percent inflation rate; with 10 percent investment returns and a 5 percent to 6 percent spending rate, real endowment growth is negligible, making the recovery from recent steep losses even more protracted.)

It is noteworthy that in recent days, two other Ivy institutions have imposed new rounds of expense cuts. Dartmouth announced on February 8 that addressing a $100-million structural deficit would require laying off several dozen staff members and repealing its no-loan financial-aid policy for students from families with incomes of $75,000 or more. (Williams College similarly cut back its no-loan policy last week.) Yale, which has phased in its cost reductions, paring its endowment distributions by about 7 percent for this year, announced on February 3 that it will reduce them a further 13.4 percent for fiscal 2011. It imposed a variety of measures—a salary freeze for highly compensated officers, deferred salary increases for managers and professional staff, a 10 percent to 15 percent reduction in graduate school admissions, reconfiguration of vacation and disability leaves, and more—to save $50 million, with additional savings of $100 million for fiscal 2011 yet to be identified by individual schools.


Harbingers of Endowment Performance

Three institutions with sophisticated endowments using some of the same illiquid asset classes that are important parts of HMC’s portfolio have given indications of recent results or expected future performance, and a news report suggests Princeton has revised its outlook, too.

In Yale’s communication, President Richard Levin and Provost Peter Salovey wrote, “Despite the recent partial recovery of public stock markets, the value of the endowment remains below $17 billion, after accounting for the University’s budgeted spending during the current fiscal year.” Many uncertainties affect interpretation of this information: gifts for endowment that Yale may receive this year (it is conducting a capital campaign); whether the disclosed figure reflects only investment returns for the fiscal year to date (as it seems to imply); and whether the spending is for the entire fiscal year or merely the months to date. Nonetheless, if one takes a starting value of $16.3 billion, reduces it by Yale’s likely spending from endowment of about $1 billion this year, and then raises that result to a sum below $17 billion (a crude calculation that does not take timing into account)—it appears that Yale has had, or expects, investment returns of perhaps 9 percent to 11 percent.

The University of Virginia Investment Management Company does report results quarterly. Through the first six months of fiscal 2009, its “long-term pool” had a time-weighted return of 11.8 percent. Significantly, returns on public-equity investments were nearly 30 percent, and on equities overall 14.6 percent; real assets—both real estate and natural-resources holdings—had negative returns; and fixed-income, absolute-return (hedge fund) and cash returns were 11 percent. (HMC’s “policy portfolio,” the overall guideline for its long-term investments, currently allocates about one-third of holdings to public equities--divided equally among domestic, foreign, and emerging-markets stocks--and 13 percent to private equities; 14 percent and 9 percent, respectively, to commodities and real estate; 16 percent to absolute-return strategies; and 15 percent to fixed-income and cash holdings.)

Williams College, with a smaller but diversified portfolio of $1.4 billion, has published a useful history and forecast of endowment value and spending from the mid 1990s to the end of this decade, giving the institution’s economic and financial forecasts. It shows:

• a peak endowment value of about $1.9 billion two years ago, now reduced to about $1.4 billion;

• peak spending from the endowment declining from $94 million in fiscal 2009 to $73 million in fiscal 2011;

• gradual but continuous recovery of endowment values starting in fiscal 2011, but reaching only about $1.7 billion to $1.8 billion in fiscal 2019 or 2020; and

• a return to the $80-million annual rate of spending from the endowment no sooner than fiscal 2018.

Finally, Bloomberg reported on February 10 that Princeton now anticipates 10 percent investment gains for its endowment this year, compared to an earlier expectation of flat performance.


Mendillo's Metrics

When HMC reported fiscal 2009 results, CEO Jane Mendillo suggested that the organization would be rethinking its investment parameters and strategies. In late January, she addressed the National Association of College and University Business Officers’ endowment-management forum in New York City. In a talk titled “Positioning Today’s Endowment Portfolio for the Future,” she observed that “the complexities involved in managing an endowment portfolio have increased dramatically.”

In planning for the future, Mendillo said, managers must be aware that as educational institutions’ reliance on their endowments to fund operations has risen, the attention paid to endowment investment returns has been heightened—as has the focus on fundraising and endowment gifts.


She drew several lessons from the 2008 market meltdowns, among them that:

• the correlations among different kinds of assets can be higher than expected, raising doubts about the utility of diversification (to control market risk);

• without timing markets per se, investment professionals should be able to detect irrational pricing, as for the dot-com stocks in 2000-2001 and private-equity investments in early 2008;

• maintaining sufficient liquidity is “essential”; and

• as institutional reliance on endowment funding rises, portfolios need to be structured accordingly.

Those hard lessons point to “tougher” assessments of risk, across more measures of risk, Mendillo said. “For many years, illiquidity has been our friend,” as endowments earned extra returns from pursuing alternative investments (private equity, commercial real estate, various kinds of hedge funds, natural resources); now, much greater emphasis must be put on liquidity. Finally, a single-minded focus on long-term financial returns no longer suits the needs of the universities on whose behalf endowments are invested.

HMC, she said, is in the process of adapting its policy portfolio. It will turn away from ever more fine-grained asset categories, instead grouping all classes of equities, for example, or of real assets, together for better coordination and flexibility in investing. Within those classes, she said, HMC will also examine investments along the spectrum from nearer-term to longer-term commitments—an important component of managing the portfolio to assure sufficient liquidity, as determined by HMC and the University working together. As a result of such changes, Mendillo said, HMC is now able to explore public and private investment opportunities in areas such as commodities, and to apply its individual deal-negotiating skills from natural-resources investments (such as buying and holding timberlands) to determining what arrangements to reach with private-equity and hedge-fund investment managers. That has obvious implications for the fees HMC will pay to outside managers in the future, too.

The ultimate payoff of these changes—in investment performance and smoother correlation of endowment management and University priorities—is a long-term proposition. In the meantime, returns on endowment investments in the next few years have very significant implications for Harvard’s operations and opportunities, as well as for those of peer institutions.

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