Friday, September 11, 2009

Fancy Universities Are Bad At Financial-Market Math

Two posts ago, in one entitled "Do Economists See The Light About Their Crappy Math. I explained that Benoit Mandelbrot's (image above) work with fractals would suit them better.

Today in the WSJ there is a pretty extensive article (reprinted in its entirety below) about Harvard's loses in particular last year...nearly $10B. But Yale too lost big bucks from their endowment along with Harvard because of (1) market turmoil, (2) asset classes became (and remain) correlated with one another (3) some asset classes evaporated all together (4) both institutions (especially Harvard used too much leverage, sometimes even borrowing so as to remain 105% invested in often illiquid elements and (4)they both failed to protect against their catastrophic risks. Columbia which has a much smaller endowment (~=$5.5B) than either giants mentioned above lost about 16% which they claim was all about earlier, more active and more conservative risk management. Incredibly enough, Cooper Union, the tuition-free (if you can get in!) college down here in Greenwich Village says it actually managed to break even.

Now here comes the part that is filled with delicious irony. I believe that Benoit Manelbrot will eventually win a Nobel Prize either for Physics or for Economics and maybe for both; his work in these two fields has been more than seminal it has been a breakthrough.

Now these two schools might claim that they aren't familiar with Mandelbrot's work and advice which, if followed might have avoided $$$billions in losses. Yale shed only half as much as Harvard, but their endowment is only half the size so what's the big surprise in that?

Or they may say that they didn't read his book because it wasn't available soon enough. "The (Mis) Behavior of Markets--A Fractal View of Risk, Ruin and Reward" was published, for God's sake, in 2004. Their academics, students and administration must at least be partly interested in this stuff.

Maybe they couldn't locate him? That's hard to believe because he once taught at Harvard and until he retired in 2005, he was a tenured, endowed-chair mathematics professor at Yale.

So why did these schools put their constituents (thousands, including whole towns) at risk? Why didn't they phone up Benoit and ask him for his opinion about their portfolios? He might have taken up a deep-digging project bro bono for them and analyzed their market situations from a fractal-math perspective. Why didn't they ask Benoit? This is inexplicable to me, except for one obvious reason...hubris.

Money managers often get so confident that they don't listen to any others...not even Benoit Mandelbrot. The shame here as I see it is that innocent folks and even whole towns can get crushed by this behavior. If you don't believe me, just swim across the river from Cambridge and you won't see a pretty site at all.

Here's the article:

Harvard, Yale Are Big Losers in 'The Game' of Investing Yahoo! Buzz By JOHN HECHINGER It's a tie in the Harvard-Yale investment game. Both schools were thrown for colossal losses. The universities on Thursday said their endowments, higher education's two largest, each lost 30% of their value in the year ended June 30. Combined, the pair of investment pools shrank by a staggering $17.8 billion. Declines in the endowments have forced the two schools to cut budgets and delay plans to expand facilities and hire staff, as even the country's top colleges are being forced by the financial crisis to retrench. The pain is being felt widely across higher education. While many private colleges are getting less help from their endowments, public universities are suffering because of state budget cuts. Harvard University and Yale University, such fierce rivals that their fall football contest is known to both sides simply as "The Game," badly trailed the results of the typical college in the latest year. The dismal returns have exposed weaknesses in their exotic approach to investing, which after turning in chart-topping performance for years has proved to be highly risky. The schools were hurt by investments in assets that can't readily be sold, such as private-equity partnerships, which were pummeled in the past year after stellar results over the previous decade. In the category Harvard calls "real assets," including timber, commodities and real estate, annual losses neared 40%. Harvard was already budgeting for a 30% decline, but hadn't released a final tally. On Thursday, it said its endowment shrank to $26 billion on June 30 from $36.9 billion a year before. The decline also reflects spending from the endowment and donations. The Cambridge, Mass., university's investment loss itself was 27%, dwarfing the 18% drop in the median return for large endowments calculated by Wilshire Associates, an investment consulting firm. Yale said its endowment fell to $16 billion on June 30 from $22.9 billion a year before. The New Haven, Conn., university didn't break out its investment results. Yale had projected a drop of only 25% and Thursday warned of further budget cuts. In a letter to Yale faculty and staff, Richard Levin, the school's president, and Peter Salovey, its provost, said it now projects an annual deficit of $150 million each year from 2010-11 through 2013-14. Last winter, Yale cut staff and nonsalary expenses by 7.5% for the 2009-10 academic year and signaled it would ask for further cuts in nonsalary expenses of 5% for 2010-11. On Thursday, the university said it would ask for the 5% cut this year instead. The administrators pledged to preserve financial aid, but said otherwise "no area of expenditure will be immune from close scrutiny." Messrs. Levin and Salovey said most major construction would be halted until donor support could be found or financial markets recovered. They said Yale would also slow the pace of faculty recruitment. Facing a cash crunch last fall, Harvard has laid off staff, suspended some faculty searches and delayed a major expansion of its campus. Other wealthy schools, including Stanford University, Princeton University and Massachusetts Institute of Technology, have predicted losses similar to Harvard and Yale's. They all follow an investment model that de-emphasizes traditional stocks and bonds and instead loads up on alternatives unavailable to the average investor. Yale and Harvard pioneered the approach, arguing they could afford to take big risks, because they were investing for decades, even centuries. Many copied the schools, saying they had found a high-return, low-risk strategy. But Eric Bailey, managing principal of CapTrust Financial Advisors LLC, a Tampa, Fla., firm that advises college endowments, says, "If it looks too good to be true, it probably is." Mr. Bailey says typical colleges outperformed Harvard last year, because they stuck to a plain-vanilla approach, typically allocating 60% of their holdings to stocks and 40% to bonds. That strategy would have generated a loss of roughly 13% in the year ended June 30. Harvard aims to have only 4% of its investments in U.S. bonds, which were one of the few safe havens over the last year. It has cut by more than half its target for investments in U.S. bonds since 2005. The University of Pennsylvania's endowment, by contrast, loaded up on Treasury securities in 2008 and reported a more moderate 15.7% decline. In New York City, Cooper Union for the Advancement of Science and Art, which charges no tuition, ratcheted down the risk of its investment portfolio three years ago and expects its endowment to hold steady for the year. Yale and Harvard say their long-term results justify the strategy. Harvard's endowment remains the largest in higher education. In fact, the $10.9 billion it lost last year is bigger than the 2008 value of the endowments of all but six colleges. In Thursday's report, Jane Mendillo, Harvard's endowment manager, noted that Harvard achieved an average annual return of 8.9% over 10 years, three times its peers' -- adding $18 billion in value over what would have been earned by a 60%-stock, 40%-bond portfolio. Ms. Mendillo said the school is better off than it would have been if it had "pursued a more conservative investment strategy over the longer term." In Thursday's report, Harvard said its private-equity funds, which generally represent about 13% of its endowment model, fell almost 32%. Its real-asset segment, representing nearly a quarter of the endowment, lost 38%. Investments in "absolute return" hedge funds, designed to generate positive results in good times and bad, instead posted a 19% loss. The report showed Harvard trimmed its endowment's risk profile by raising cash, cutting by $3 billion its future commitments to invest in private-equity and other investment funds, and reducing its real-asset category to 23% from 26% of its model portfolio. Harvard also said the school now aims to hold 2% of its assets in cash. Previously, it targeted a negative-5% cash position, reflecting its use of borrowed money to expand its investments. Ms. Mendillo said endowment managers had learned to better reflect "the risk tolerance of the university." Ms. Mendillo pledged to manage more of the school's money in-house, giving it readier access to securities to sell for cash. Currently, 70% is farmed out to outside managers. That move could focus more attention on its managers' multimillion-dollar paychecks, which have provoked controversy on campus. Ms. Mendillo said "a substantial number of portfolio managers" had portions of their bonuses, awarded for past years, "clawed back" into the endowment because of poor performance. Harvard and Yale, like other schools, also signed contracts that committed them to huge future investments in private-equity and other funds at exactly the time they could ill afford them. In Thursday's report, Ms. Mendillo said Harvard cut its "uncalled capital commitments" to $8 billion from $11 billion.


  1. Curiously, Yale's David Swensen's investment advice for normal people is quite sane: mix of asset types, emphasis on low-expense ratio mutuals, a moderate amount of real estate, 30% or so in govt and inflation-protected bonds, a bit of BRIC and Asia, etc. [] Sounds like maybe he didn't follow his own advice?

  2. You are absolutely...and a number of people that I know in the venture know the guy pretty and they say that he not so privately would admit the same thing and especially for an academic institution which must guarantee not only perpetuity for the institution but also an ability to maintain current expense levels.

    Bob H. As always, thanks for the comment.