When I decided to start a website, blog, journal, whatever you want to call it I envisioned writing about anything and everything that interested me. Lately, since I’ve been spending all my time traveling alone (often anxious) that has been the bulk of my writing, but eventually I will re-enter the workforce and hope to work for the investment team for a large university endowment, foundation, or a similarly-looking family office.
As always, these statements like all others are “directionally accurate.”
I find endowment investing fascinating and one of the most pure and broadest forms of investing. Perhaps, if I was more qualified on direct investing and stock picking I’d think differently, but I also think it’s the most interesting way to be involved in the investing world. The liberal arts of the investing world.
Endowments are wildly misunderstood by those outside of the institutional investing world. They certainly were to me before I sought gainful employment a decade ago. Hopefully this “Endowment 101,” helps demystify some of the misconceptions and tests whether my investing brain still works after months of hiking and sleeping in a tent.
First and foremost, endowments are not a piggy bank.
While large endowments certainly offer a school flexibility and allow for significant resources for a school’s operating budget they are not a pile of cash to be spent down on a whim. That’s true for normal expenditures and even during a devastating global pandemic. It’s not a war chest. It’s a perpetual pool of capital intentioned to support a school for its entire life, which most schools want to be as long as possible. Long after every current student, professor, staff and administration member, and trustee has passed away.
In this way, endowments are about generational equity and support. Imagine if you were able to harness the powers of the elves at Rivendell and became immortal. If Rivendell isn’t the place wherever they’re able to live forever and look like Evangeline Lilly and Legolas across generations…
Even with a substantial sum of money to support yourself (an endowment) the implications of living forever while balancing the uncertainty of future spending needs, inflation, and investment returns would necessitate prudent use of the money today to preserve it in perpetuity. I’ve heard the stock market in Middle Earth is highly volatile. Orcs, Smaug, Nazgul, Sauron. Try trading around that…
Many lottery winners are unable to maintain their windfall in their own lives let alone the lives of all their descendants, forever, which is essentially the goal of an endowment.
For this reason, most endowments target a 5% annual spend. 5% of the endowment’s value, or an average of the endowment’s value over some time period (usually 3 to 5 years) is distributed out of the endowment to support the school’s operations. This has been deemed a “prudent” spending amount to increase the likelihood, but not guarantee, maintaining the purchasing power of the endowment. Spend well more than that and the fiduciaries of the school are not doing their job.
This 5% rule is more or less true for all endowments whether they are $100 million or $50 billion. It is also true whether that 5% payout makes up 40% of a school’s operating budget (tuition being the other major source of funds) or 4% of the budget.
Size and reliance on the endowment do not change what it means to have a “prudent” spending rule. This is why school’s cant simply tap the endowment for any and all spending needs.
While today’s students might benefit from going zero tuition or any other wonderful sounding initiative, overspending today simply ensures fewer resources in the future or in a drastic measure the inability to continue as an institution. It is a balance between today and every other day of a school’s future life. If a large endowment started spending it down we would see their demise in our lifetime without a massive life support from future donors.
This means that most endowments target investment returns equal to their 5% spend plus long term inflation of 2-3% in order to maintain their purchasing power. 7-8% annual returns. Simple math. I’m easing back into this thing…
That probably sounds like a low number, especially lately, but long term returns of 8% with as little volatility as possible is not as easy as it sounds. It’s very hard.
If a golden ticket presented itself that guaranteed a 10% annual return, every endowment Chief Investment Officer (CIO) would take that deal. You should too for personal finances. Those guarantees don’t exist.
The S&P does not go up 10% every year even if it’s averaged better than that over the last decade plus. There are decades of flat or negative returns historically. It will happen again.
I can say that with certainty because I don’t have to put a date on it. If you have a known spend rate you will destroy your endowment with years of flat returns. You can do the math, but it will eventually go to zero, especially with inflation (which even lately isn’t as high as it can go…)
Endowments are always listed as an aggregate value, some of which have grown to immense sizes in recent years (Harvard: $50+B, University of Texas $40+B, Yale $40B, Stanford $38B, Princeton $35B, MIT $25B). That 5% rule does mean that Harvard has the ability to draw $2.5 billion from its endowment to support itself while a (still respectable) $1 billion liberal arts school can only draw $50 million.
If you want to argue the massive Ivy endowments are unfair to the rest of US higher education that’s a different story. If you want to argue that US higher-ed in general is flawed, that too, is a different story. I’m just trying to say where we are today. I wouldn’t know who to blame for the fact that a few institutions have been able to create the resources they have, but it’s similar to the fact that a few companies have been able to create the resources they have.
Do other countries have better education systems? Probably. Almost definitely. This is where we are and I personally don’t fault these institutions (that I could never have attended) for what they’ve become. Maybe that makes me a pawn of capitalism, but I enjoy the fruits of capitalism every day in my consumption online and offline.
While the headline numbers are always listed, in reality each of these sums is made up of hundreds or thousands of underlying “endowments.” Each endowment has a percentage of its total allocated as “unrestricted” those are funds given without direction or as a result of a surplus of the business operations (tuition, royalties, financing, etc.) of the school, but invested alongside the endowment. The vast majority, however, is usually “restricted” funds or underlying individual “endowments.”
Every small donation I’ve given to my alma mater ends up in the unrestricted bucket. I don’t have enough zeroes on my check to give with stipulations on how the money is to be used. $13 doesn’t get the benefit of being tracked annually into perpetuity.
The large gifts that make up a minority of total donors, but a significant majority of total dollars given to an endowment almost always come with direction. In endowment accounting, that leads individual endowment “units.”
If I give $100 million to my alma mater increasing the total to $1 billion, 10% of the total endowment that is printed on college websites and The Princeton Review stats is my gift. My endowment. While it’s not the same thing as ownership in a company’s stock or a mutual fund since it’s a gift not an investment, it is a distinct unitized gift that has implications on how it can be used now and into the future. The mutual fund shares analogy is a helpful simplification.
That $100 million is accounted for every year and most likely every quarter or month to determine whether it’s included in the 5%. Usually, in addition to the prudent spending rule, each unitized endowment is determined whether it is above or below water. Whether the principal is above or below the original gift. Over time, you expect this gift to grow in value, even after the 5% spend rate and inflation. Timing matters though.
If I give this gift right before the dotcom bubble crash or ‘08 it’s immediately underwater. Since it’s unitized and its own endowment that usually means that the 5% rule does not apply for the goal of maintaining the principal value. There are many rules established for being “prudent.” They usually prohibit, or at least require those involved to explain, why spending an underwater endowment is prudent. It’s not just a simple “because we’re gonna spend it…”
This is another reason why an endowment can’t just dump it all into the S&P 500. While it may have great long term returns, any investor in the S&P is liable for 50% declines at any point in time. That can take a long way to get back to principal value of my generous gift. Side note: if I had $100M to throw around I have a few things on my list before a gift to my alma mater, namely me, saving animals, and tiny cabins with fishing and hiking access in multiple countries…
So, again, an endowment cannot tolerate the volatility of the S&P. Most individuals can. Most individuals don’t have to think about perpetuity for their nest egg and especially during their working years they should allocate the substantial majority of (maybe all) of their net worth to an investment like the US stock market that has incredible long term returns but also comes with a lot of volatility. Just don’t look at it every day.
So what is an endowment to do? If you need strong long term returns above 7%, but you can’t stomach the volatility of the stock market, what options do you have?
In my opinion there are three options. An indexed (low fee) approach that aims to maximize returns under a given level of volatility by investing in a simple combination of stocks and bonds taking the “market” return and nothing else. Bonds historically have a lower return than stocks so it’s much harder to mathematically reach that 7% especially with the low rates today (which generally correspond with inflation anyway), that is a lot of hope in returns “math.” Still, more endowments should go for this approach than currently do, my future career goals notwithstanding.
Or, pursue an actively managed approach which seeks to outperform the market. The fun, but incredibly difficult path.
This active approach ain’t easy, especially lately. You can conceivably achieve an active, positive return through timing the market and attempting to sell out of or buy into asset classes or investments that are undervalued, (i.e buying individual stocks, sectors, geographies, etc. at the right time) and avoiding those that are overvalued, but this is extremely difficult if not impossible.
There is a reason everyone knows who Warren Buffett is. He is unique. While I’m not calling him a market timer, if everyone could buy low and sell high he’d just be another guy from Omaha.
With a more or less static allocation across any number of factors and asset classes that would imply selecting (or investing with someone who can select) the investments that will outperform.
Simply stated and in the news these days, that selection would have implied buying Nvidia, Meta, Microsoft, Amazon and others and riding them to investing greatness. So obvious now. Not as obvious ten years ago. (I will make a bet with anyone reading this that they can’t pick the best performing stocks over the next decade…). Still, there’s a very large and lucrative business pursuing these lofty goals.
The active approach for an endowment can be pursued in two very different ways which I also plan to write about because they’re fascinating to me. Two of those big endowments, Harvard and Yale, pioneered two very different strategies in the 90s and early 2000s to achieve incredible returns above what you could achieve from a passive, indexed approach. What I could have achieved in my 401k or personal account basically. Don’t day-trade your retirement…
My plan is to write about the Yale model, an outsourced, manager selection approach which aimed (and did) partner with some of the best external investors across asset classes (i.e. let’s find the best stock pickers, hedge funds, venture capitalists, and real estate managers and invest with them) and the Harvard model which aimed to do most of their investing internally across asset classes and function more similarly to a multi-manager hedge fund than an allocator. Both models achieved incredible results for many years.
While the Yale model is now well ingrained in the endowment world, no one to my knowledge has ever recreated the “Harvard Model.” Today, not even Harvard pursues that approach, looking much more similar than different to Yale and the other large endowments.
I want to continue researching and write a coherent, digestible post on the Yale vs. Harvard models so putting this out there makes it more likely even if it happens in early 2025 with some travel ramblings in between. I’ve found that while not 100% successful, publicly voicing your goals is a great way to achieve them, so that’s what I’m doing. Both models also have incredible stories on apprenticeship that I find relevant to any line of business. So hopefully I can make them interesting for all to read…
If you read this far you probably worked with me or are my parents… if not, I love you even more for it.
Thanks
November 2024
Queenstown New Zealand
Leave a Reply