How Smart People at Yale and Harvard Invested Stupidly

On June 30, 2008, the Yale endowment had a jaw dropping $22.9 billion in assets. Previously, it had a stellar record of outstanding returns. It earned 28% in fiscal 2007 and an astounding 41% in fiscal 2000. From 1998-2008, it trounced its benchmarks in every asset class.

Many believed the success of Yale's investment strategy was its access to "alternative assets". These include private equity holdings in leveraged buyouts, venture capital and energy investments. Yale's endowment managers had extolled the virtues of alternative investments as evidence of the value of active management. In its 2001 annual report, they stated:

"Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management."

Really? These investments also have high fees, are generally illiquid and have risks that are difficult to measure. The fact that Yale had enjoyed such extraordinary returns should have caused it to question the amount of risk it was taking.

So what happened in fiscal 2008, which ended on June 30, 2009?

The endowment had a loss of 24.6%. That's $5.6 billion!

What happened?

Well, the endowment's investments in alternative assets let it down. Private equity holdings in leveraged buyouts and venture capital lost 24.3%. Energy investments were a disaster, losing 47.4%.

So much for "exploit[ing] market inefficiencies through active management."

What if the entire endowment had been invested in a globally diversified portfolio of low cost stock and bond index funds, with an asset allocation of 60% stocks and 40% bonds? This allocation is used by most endowments.

For the one year period ending June 30, 2009, this portfolio would have lost approximately 14% of its value.

Yale can take cold comfort from the fact that it fared better than its rivals at Harvard. Harvard's endowment, which followed a similar investment strategy, lost 27.3% of its value, representing $11 billion. If it had followed a 60/40 asset allocation, its losses would have been 50% less.

Maybe the Yale and Harvard endowments will outperform a passively managed, globally diversified portfolio over the next decade and maybe they won't. It is statistically likely they won't.

The trustees of the Yale and Harvard endowments lost sight of a basic rule of finance: When you take more risk, you increase the potential for both higher returns and higher losses. There is no free lunch in investing.

Individual investors make this mistake every day. The smart people at Yale and Harvard should have known better.

Dan Solin is the author of The Smartest Retirement Book You'll Ever Read.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

 

 

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Comments

[dadw5boys]

Dan, How ling before the crash the whole system ? We know it has to come to this to have the full reset. AIG should never have been allowed to survive just to save Barclays.

[FarawaySouth]

This topic is a little more complex than the article suggests. These endowments differ from most portfolios in that they have a infinite investment horizon with limited short term obligations. Most individuals are saving for retirement have a fixed investment horizon. Therefore the endowments could exploit situations were a long term view was required. They also looked for uncorrelated investments in the alternative space, which is also a good idea. No problems there.
The issue with many of the truly alternative investments is that there is no mark to market. So a type of smoothing of returns takes place in the period before an investment get realised. Again not really a problem if you are truly taking a long term view.
Unfortunately they allocated ever larger portions of their portfolio to these investments.
What the article doesn't point out is that these funds earned good returns in the years when the S&P was doing badly. The performance stats are quoted very selectively. I would be suprised if they gave back all of their returns in 2008. I suspect that they are still better off than in they'd been invested only in T-bills and index funds since 1984, which is when they began to increase their allocations to alternatives.

[Billicart]

DID YOU SAY SMART??? How Sad, Too Bad.. Academics, especially pitiful “aligning corporate board compensation with shareholder value”, champion, Michael Jensen, as well as , the Long Term Capital Management jesters, Myron Scholes and Robert C. Merton, (they shared the 1997 Nobel Memorial Prize in Economic Sciences), are largely responsible for the mess. Ably assisted by Chicago School fan, Greenspan

[alibeamish]

They probably made alot of money. And they don't have to pay it back.

[johnsopinion]

Just a hunch but I have a feeling it might be (ah, the teaser
most oft used ('might') and most skipped over) that these
same endowment managers learned their economics from
the same professed saviors that crucified A.Rand back in the
50-60's for her "selfishness!" hahahahaha.

Robert Bass - Yale University
Bryan Caplan - Princeton University
Julian Edney - Yale University
David Friedman - Harvard University

Sorry but its just nigh impossible to feel sorry for pie-in-the-
sky-gone-awry.

[TheBeardedDragon]

So basically the old saying "Stupid is as stupid does" should actually read "Smart is as stupid does".

Wouldn't it be fair to say these "Smart People" as you label them (a very relative and subjective evaluation of individuals who you probably have no personal exposure to yet put in such high regard) clearly acted recklessly and carelessly (also know as "Stupidly").

[HamletsMill]

Many graduates of Harvard and Yale were personally responsible for creating the bogus derivatives based casino economy of Wall Street.

http://www.youtube.com/watch?v=wx3KMX6T8bo

Karma is a b****. At least two Wharton grads have seen the light - myself and Catherine Austin Fitts. After my military service during the Vietnam War era I fully realized the bitter truth that the Eastern Establishment that runs the United States minted out of Ivy League Universities with each generation are morally impaired madmen indoctrinated into a sense of life long entitlement they do not merit.

GWB was our "First MBA President". I rest my case.

Catherine Austin Fitts: Her personal story
http://dunwalke.com/

Catherine Austin Fitts on Goldman Sachs (06/09)
http://www.youtube.com/watch?v=PbjPHwBVCSU

Catherine Austin Fitts IRTA Barter Convention (09/08)
http://video.google.com/videoplay?docid=-5455605137215634518#

[sabredance]

Did they fail in defensive moves in 2007-8 or did they fail to make any defensive moves at all?

[StJames]

And do these managers still have their jobs?

[Dan Solin - Huffpost Blogger]

You are correct. They did better. But issues are these:

1. Can the risk be reliably measured?
2. If so, is the risk acceptable for an endowment?
3. How likely are they to repeat the stellar performance of the past decade in the future?

[beebletree]

1. Can the risk be reliably measured?

It cannot be reliably measured, otherwise we would see it against each stock and make our investments accordingly.

2. If so, is the risk acceptable for an endowment?

That is an easy one, you can find out by looking at future flow of money to these institutions :)

3. How likely are they to repeat the stellar performance of the past decade in the future?

Not likely at all, given where the economy is heading.

My question is - Why do you consider an active management strategy always high risk. Active management just means getting to know the individual ventures at a management level while investing, it can still be cautious.

[Dan Solin - Huffpost Blogger]

I don't consider active management to be always high risk. I consider it to be a strategy that has little academic support. .

[robinhood1]

So how did Yale do since 1998 if you include its bad year in 2009? I suspect that it still did better over the 11 year period than did its peers, or most investors for that matter.

[Aaror]

You have a good point, but here is a counterpoint.
An endowment, by nature, has an effect on fundraising for a college. If an endowment earns more than usual, it may paradoxically have a negative effect on alumni donations (the college doesn't need my money, they are doing well).
But a big loss would lead to more donations, right? Nope. Now the alumni are thinking "5.6 billion dollars? How much of that was from my donations? I'm not donating to them again, I will donate somewhere that my money will do some good, not be wasted on foolish speculatio­n."
So these two colleges hurt themselves coming and going...

[petef59]

Intelligence does not inherently preclude greed and amoral factors in decsion-maling.