OUR ESSAYS

December 3, 2008
Ivy-Covered Hedge Funds
By Joe Malchow

In the reporting on our present economic infelicity we learn, astonishingly, that among the most extravagantly
foolish investors have been America’s oldest and (so we are given to believe) wisest institutions of higher learning,
including Harvard, Princeton, and Dartmouth. A twenty-something taking his first dip in the stock market might
be expected to display irrational exuberance. Centuries-old colleges? Stewards of billions and receivers of estates?
Call them hedge funds with libraries.

The endowments of institutions have generally been thought to enjoy an infinite time horizon. That is, they are
built primarily that they may grow; they fear no expiry; they will never be drawn down; their owners never retire
or die. This freedom, unknown to most of Wall Street and certainly to individuals, makes risk unnecessary. Given
twenty years, economist Burton Malkiel famously showed, investing in the broad market inevitably beats the
frenetic schemes of the best Wall Street analysts. There was a time when the portfolio managers who oversaw
endowments were bound by a gentleman’s code to keep conservative; and statute, too, once reined endowments in.
In The Intelligent Investor, Benjamin Graham yearned for “earlier days, when trust investments were restricted by
law to high-grade bonds and a few choice preferred stocks.”

Today a pinstripe suit and the telltale jangle of a Collateralized Debt Obligation are just about enough to get the
ivory tower on board. Or they were, last year.

An exploration of these schools’ finances over the past year does nothing at all to suggest that their tremendous
estates are deployed conservatively. Far from taking advantage of their infinite time horizons, each of them has
seen fit to make considerable speculations in whatever fresh hedge fund was lately concocted by its alumni. And
quite astoundingly none seems to have emerged from the pitch of 2000-2001 having learnt anything about the
fundamental distinction between investment and speculation.

BOOM, MEET BUST

To be sure, America’s leading schools have in recent years proved able to “beat the market,” gaining more than
the S&P 500 in up years and losing less in down years. In 1992 the top 10% of endowments had total assets 160
times greater than that of the bottom 10%. In 2005, the multiplier setting the elite schools apart from the rest was
400. Most of the difference is due to the Ivy League schools---which do not, by the evidence, find the spreading
of wealth to be an idea at all suited to their own selves.

But historical data show that clever stock-picking cannot outpace the market for long. As Harvard economist
Michael Jensen showed in 1968, and as Princeton economist Burton Malkiel confirmed in 1995 and again in
2005, it is virtually impossible for an actively managed portfolio to outperform the broader market for more than
twenty years. In fact, in the ten years ended December 31, 2005, the S&P 500 beat 79% of large-cap equity funds
run by the leading lights of Wall Street. This slim shot at outsized returns makes aggressive investing suitable for
very few.
The nation’s eldest colleges disagree; and the unhappy result has been that they are, like the foppish Gordon Geck-
os to whose brief glories their endowments are yoked, subject to periods of crapulous booms and horrifying busts.
In 2000, Dartmouth’s endowment was up 46%. The College drew down its usual 5%, an imprudent indulgence in a
fat year. Nine months later, after the dot-com bust, the budget was in paroxysm and the axe was put to such inno-
cents as Dartmouth’s century-old swim team and the Sanborn English Library. Six years later, in 2007, Dartmouth
earned a 22% return and founded the Leslie Center for the Humanities—a new initiative claiming to be a “space
for the development of fresh ideas” which this spring will sponsor a forum called “Race, Affirmative Action, and
the Study of the Other.” That some of this boom spending is unnecessary is far too gracious an evaluation.

And this month, not three quarters after the windfall, Dartmouth’s Executive Vice President announced a halt to
most building projects, dramatic near-term budget reductions of $40 million—a 10% cut—and a hiring freeze.
How will the shortfall be made up? Tuition, in part; those fabulously rich $200,000 households should prepare for
their wealth to be spread still more thinly. Will the Leslie Center disappear? Unlikely.

A cynic, Oscar Wilde wrote, is a man who knows the cost of everything and the value of nothing. By this measure
American higher education is—well, Oscar Wilde.

THE PUBLIC PORTFOLIO, THE IVY PORTFOLIO

An MIT Sloan School of Management study led by Josh Lerner reports that in 2005 the median public university
had 60.5% of its endowment in equities and 22.1% in staid fixed-income vehicles like bonds. Like an ordinary in-
telligent investor the median public university used about 5% of its wealth to speculate in alternative asset classes.
And it used 4.6% of the endowment to help fund its annual budget; this, called the “draw,” is a rather common
share.

The median Ivy League endowment took another form. It had 38.1% in equities, just 13% in fixed-income, and
a stunning 37.1% in exotic larks like real estate, hedge funds, and private equity of other sorts. And even the
Ivies’ publicly traded securities reflected greater exposure to more volatile small-cap stocks. One does not want to
suggest that these investments are absolutely unwholesome—increased risk can, and in recent years has, spelled
abnormal returns—but the preponderance in the endowments of grand old institutions of high-risk investments
must strike us as rather hard-headed.

To cite just one example of a reformed trust, the General Motors Pension Fund finds itself, at the present mo-
ment, hale and hearty: after suffering disproportionately in the dot-com bust, it reallocated into more conservative
vehicles, and now has only 26% of its wealth in equities. As a result, The New York Times recently reported, it has
borne through this year’s bear market more than ten percentage points better than its pension peers, and estimates
that it will have no foreseeable trouble making pension payments. Need Harvard adopt as retiring a stance as
General Motors? Hardly. But it would do well to learn from its past mistakes.

Much of the academy’s move to more arcane modes of investment stem from a man called David Swenson, who
since 1985 has managed Yale’s endowment in a style now called “The Yale Model,” which among other things calls
for a virtual abandonment of bonds and commodities. Swenson’s method has become the model for every institu-
tion that sees itself as in competition with Yale. Each has its own spin, usually involving proprietary investments
made possible by alumni connections.

Dartmouth invests in the hedge funds of Stephen Mandel, an alumnus who sits on its board; Mandel runs his
funds through his company, Lone Pine Capital; the College also has large sums of money in funds connected to
trustees Leon Black and Russell Carson. Before taking impressive losses, Harvard invested in Sowood Capital,
which was founded by Jeff Larson, a former money manager for Harvard. Larson left Harvard in 2004 and took
14 staffers with him to create what amounts to a Harvard hedge fund spin-out. Sowood lost $1.5 billion last year
and no longer exists. According to Private Equity Week Harvard is now struggling to unload more than a billion
in alternative assets. After Internet stocks tanked, Princeton was looking rather crimson when it lost $3.4 billion
in a New York-based hedge fund called Tiger Management.

Are these conflicts of interest? Not precisely, no: the professionals involved disqualify themselves so that they
cannot influence investment decisions directly. Indeed one hears reports of boards which can scarcely wrangle to-
gether a quorum; when investment questions arise the room is left nearly bare after a scampering of recusals from
trustees whose own funds receive sluices of the endowment.

The quest for fast money is hardly novel. Long before Swenson set foot in New Haven, Benjamin Graham
wrote:

Yale University... a number of years after 1937 [was] geared around a 35% “normal holding” in common
stocks. In the early 1950s, however, Yale seems to have given up on its once famous formula, and in 1969 held
61% of its portfolio in equities (including some convertibles). At that time, the endowment funds of 71 such
institutions, totaling $7.6B, held 60.3% in common stocks.) The Yale example illustrates the almost lethal
effect of the great market advance upon the once popular formula approach to investment.

A move from a healthy mix of assets, to an unhealthy reliance on securities, to an aggressive pursuit of outsized
returns—Yale, and, after it, Harvard, Dartmouth, Princeton, and the rest of the fast set, have chased ever better
“performance.” Yet the temporarily higher performance was largely compensation for the higher—and in the case
of mortage-related vehicles, unknown—risk involved in chasing, rather than fearing, trends.

As the simmering market of 2005 overheated through 2007 and the threat of gravity weighed more and more, the
top schools increased their holdings in private equity, hedge funds, and derivatives. Princeton and Yale were lately
reported as having 70% of their endowments in alternative asset classes; Harvard, 57%. Harvard, like Dartmouth,
has frozen hiring and is planning on eliminating some open positions. The University’s Dean of Faculty of Arts
and Sciences recently said that endowment losses would have “a major and long-lasting impact” that would “re-
quire significant reductions in...annual expenses.”

In 2005 the Ivy League had an endowment draw roughly equal to that of the public schools—around 4%. Now,
faced with tremendous losses, they are forced to draw even more deeply from their endowments. Dartmouth,
for one, now intends to draw about 7% to cover operating costs—surely greater than any return to which it can
reasonably aspire over the 2008 fiscal year. The price of marquee returns in boom years is eating, in bust years,
into principal. So if an endowment is meant to insulate institutions from short-term undulations in the economy,
why is Harvard declaring that the present market downturn—no deeper, as yet, than 2001’s swoon—will require
deep and lasting cuts? Why is Dartmouth actively decreasing the size of its endowment in order to cover ordinary
operating expenses?

CUTTING THE WHEAT, KEEPING THE CHAFF

Harvard, Dartmouth, Princeton, and their billion-bosomed coevals have lost the primal instinct that any keeper
of a profit-and-loss ledger possess; they have become acquisitive: accustomed, like a bad government outfit, to a
certain level of spending. With a relentless 4% endowment draw, a year of spectacular returns yields a glut of cash.
College administrators are convinced that their expenditures have every right to increase commensurately with
their abnormal investment returns. Thus fat years bring unnecessary new initiatives, while subsequent lean years
offer a ready excuse to cut into programs that are frequently the most popular among students—but the least
academically fashionable.
Even when diversely and conservatively deployed, investment trusts cannot save an organization from poor ad-
ministration. The Daily Princetonian recently issued a marvel of an editorial calling for “easy money for hard
times.” Given the difficult situation faced by the University, the Prince argued, it would be best helped if alumni
abandoned their directed giving and instead wrote unshackled checks that could be used to fund whatever the
administration thought most important. Easy money? Trusting too much in the libertines of the college was what
took Princeton in for these hard times to begin with.

Unsound administration and risky investments may not themselves threaten the sixty-two American universities
and colleges with billion-dollar endowments. In fact it may be these very endowments that permit the excess. Col-
lege administrators act very like government bureaucrats on a jeroboam dole. Like a ratchet, spending increases
until disaster strikes; and disaster causes the ratchet to be merely reset, not unhinged.

I have frequently thought that the redemption of our universities was to be found in their economics faculties;
these, at least in recent years, have learned to live as isles of their own; they operate, budget, hire, and think inde-
pendently of the moribund intellectual-administrative alloy that girds the rest of a university against intellectual
impiety. Somehow the English, Women’s, Native’s, Social, Geographic, and Religion departments persistently find
common cause with their administrators, the aegis of the latter protecting the barren quarry of the former. As a
longsighted professor recently observed to me, it isn’t the economics faculty who dominate the decision-making
processes; it is those who need the charity; and it is not the economists who are moved into executive positions;
it is quite purposefully those who are not adept at making decisions that would upset the school’s comfortable
stasis.

For all of this we might repine, and say that it has ever been thus: the down of old wealth comforts its present
beneficiary against the principles by which his forebears achieved it—if, acting more vilely, it does not make him
downright hostile to those principles. But colleges are not like the dynastic bluebloods waning in Westchester;
they live and breathe, and each is home to at least a small minority with the right ideas. The cycle of adding bad
in good times and cutting good in bad times, and of chasing after short-haul “performance” to satisfy hedge fund-
touting trustees—these are disastrous trends. Still, although its eldest members sometimes forget it, higher educa-
tion is a marketplace. And in a free market failure is known by the happier name of opportunity.

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JOE MALCHOW is a 2008 graduate of Dartmouth College and a writer based in Northern California. He has written for The Wall
Street Journal, The Far Eastern Economic Review, and National Review Online. In 2004 he founded Dartblog.com, a widely read run-
ning commentary on culture, politics, and American higher education.