The Failed Investments of Ivy League Schools and the Future of Hedge Funds

If the elite universities had simply invested in index funds that matched the stock market average instead of hedge funds, there would be much more money to grant to disadvantaged youth and to valuable research initiatives. Those universities have all that prestige and influence, and they even have a tax exempt status — and pound for pound they still did worse than a good average investor would have.

The New York Times highlighted the findings of a remarkable study last week. The study, by Markov Processes International, examined the 10-year returns of the endowments of the 8 Ivy League schools. The study found that all 8 endowments had lower returns than a simple mix of 60 percent stock index funds and 40 percent bonds. In some cases, the gap was substantial. Harvard set the mark with its annual returns lagging a simple 60-40 portfolio by more than 3.0 percentage points.

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And, just to be clear, the Markov comparison was overly generous to the universities. Their benchmark comparison of a portfolio of 60 percent stock and 40 percent bonds is in fact far safer than the alternative investments they hold. If they actually equalized risk, the comparison portfolio might be 80 percent or even 90 stock, making the Ivy league endowment returns look even worse.

The Ivy League schools are not the only big institutional investors who are turning to alternative investments. State and local pension funds also play this game in a big way. The beneficiaries are more often private equity partners, but the basic story is the same: people who make themselves very rich by playing financial games. And, as with the hedge fund folks and the Ivies, they do not provide the promised returns.

And, there is considerably more money at stake with public pension funds. The cumulative size of the Ivy League endowments is just under $140 billion. While this is hardly chump change, state and local government pension funds have more than $8 trillion in assets. Most of this money is not in alternative investments, but if just 10 percent were placed with private equity funds and other alternatives, it would come to $800 billion.

There is much to dislike about the behavior of these financial actors. They routinely play games with the tax code and bankruptcy law to increase returns. It is standard practice for private equity funds to leverage their companies as much as possible to take advantage of the deduction for interest on corporate income taxes.[1]

They also strip valuable assets, such as the real estate on which stores and restaurants sit, so that they can book a quick profit while leaving the companies they control more vulnerable to a business downturn. Bankruptcy is a common tool, which they use to get out of not only interest payments on debt (presumably lenders knew the risks they were taking), but also pension and health care obligations to workers, and payments to suppliers.

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In terms of inertia, people can point back to a period where the hedge funds did produce outsized returns, as did the private equity funds. People can think that the last decade or so is just an aberration, and that the good times will return.

While I can’t predict the future, there is a simple story that would imply the opposite. Both hedge funds and private equity funds prospered by finding seriously under-valued assets and then leveraging heavily to maximize their return. When there were few actors in the field, it was possible for some number of funds to make large returns this way. But now that there are many actors, with trillions of dollars to invest, seriously under-valued assets are few and far between.

This means that most hedge funds and private equity funds won’t be able to make outsized returns going forward. The high fees to the fund managers are a direct drain on returns that would otherwise more or less match the market average.

And just to be clear, we are talking about a 10-year period in which hedge funds have failed to match the market average. (It’s a similar story with private equity.) This is a long period, it’s not just a case of these funds having a bad year or two.

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