A peculiar thing happened in 2016. While the Dow Jones industrial average grew by almost 5 percent, college endowments saw nearly a negative 2 percent rate of return. The worst endowment performance took place at the nation’s wealthiest private institutions. Harvard’s endowment alone shrank by $2 billion, a 5-percent decline. Out of the 40 biggest endowments, 35 declined in value.
What’s going on here?
A key factor is poor performance by the hedge-fund gurus that institutions have increasingly paid to manage their investment portfolios. Colleges have reason to be angry because hedge funds charge high fees even when they lose money. Colleges and universities spent an estimated $2.5 billion on fees for hedge funds in 2015 alone. They paid an estimated 60 cents to hedge funds for every dollar in investment returns between 2009 and 2015, according to a report by the Strong Economy for All Coalition. These fees helped each of the top five U.S. hedge-fund managers earn more than $1 billion in 2015 despite mixed performance.
Unfortunately, the disastrous endowment performance of 2016 disproportionately affects public colleges and less-wealthy private colleges, while leaving the most-elite private institutions with their wealth intact. The wealthiest colleges felt relatively little impact from their losses in 2016 because they have benefited from major endowment growth since 1977.
To understand the current situation, it’s helpful to understand the backstory. Endowment wealth increased sevenfold, from $16 billion in 1977 to $112 billion in 2012, at the eight private research universities that had endowments larger than $1 billion in 1977 (all dollar amounts are in 2012 dollars) — Columbia, Harvard, Princeton, Stanford, and Yale Universities, the Universities of Chicago and Rochester, and MIT. Several colleagues and I document the last 10 years of this growth in detail in a recent article for the journal Socio-Economic Review.
Endowment growth at those eight wealthiest institutions benefited from two major shifts related to the increasing importance of financial markets and financial ideas throughout the economy. First, the colleges substantially ramped up donations to their endowments by adding members to their boards from the growing class of very wealthy Wall Street financiers.
Second, starting in the 1970s, the wealthiest universities shifted from a conservative investment strategy centered around bonds to more aggressive investment in stocks and other equities. In the process, they created what amounted to in-house hedge funds. These funds are staffed by top investment managers who are paid millions of dollars annually. Under their stewardship, the eight colleges went from average annual investment returns of just 5 percent in the 1960s and 1970s to average annual gains of 10 percent from 1980 to 2010.
Without sufficient resources to establish their own in-house hedge funds, the rest of America’s colleges and universities have followed the lead of those elite eight by turning over increasing shares of their endowment portfolios to actual hedge funds. Back in 1981, just 15 percent of colleges with endowments were invested in venture capital funds, the forerunner to today’s hedge funds, according to the Nacubo Endowment Survey. Even by 1987, less than 1 percent of all endowment assets were invested in venture capital funds, with only one college investing more than 12.5 percent of its assets with venture capital. In contrast, by 2015, most colleges and over 20 percent of all college-endowment assets — more than $100 billion — were invested in hedge funds.
But after promising higher returns, hedge funds have performed poorly for higher education and investors more broadly in the last two years. This is evident in the losses across nearly all endowments despite strong stock-market growth. Proponents of hedge funds would argue that this is because high-risk hedge-fund strategies can yield volatile returns but produce higher average growth in the long run. However, critics allege that hedge funds are performing worse now because Obama-era financial regulations are requiring them to play by new rules designed to prevent another financial crisis.
Hedge-fund performance may remain volatile even if President Trump succeeds in rolling back Dodd-Frank Wall Street Reform and Consumer Protection Act and other Obama-era regulations. Dodd-Frank required Securities and Exchange Commission registration of hedge funds and the separation of hedge funds and consumer banking to prevent this volatility from bringing down the broader banking system.
Whatever the reason for poor hedge-fund performance, hedge-fund managers are now failing to deliver. And some colleges are pulling their portfolios out of those funds, following the lead of the massive California Public Employees’ Retiree System.
Endowment donations and wealth have meanwhile remained concentrated at the elite eight colleges and a handful of other wealthy institutions. Endowment growth has provided substantial surpluses at these institutions in part because they have mostly held undergraduate enrollments flat for the last 30 years. As a result, the wealthiest eight institutions were able to increase spending on university operations just from their endowments from $9,574 per student in 1977 to over $60,000 per student in recent years. This helps to explain a new finding from the Stanford economist Raj Chetty that 38 top private colleges enroll more students from the top 1 percent of the U.S. income spectrum than from the bottom 60 percent combined.
The appeal of hedge funds is understandable for public institutions and less-selective private colleges. These institutions are thirsty for new revenue sources because they have boosted enrollments in recent decades. At the same time, they have struggled with unstable revenue from state appropriations and student loan-financed tuition.
The investment losses of 2016, however, underscore that endowments and hedge funds are not a scalable or reliable solution to their revenue woes. We need to imagine new models for resourcing higher education in the 21st century.
Charlie Eaton is a postdoctoral scholar in the Graduate School of Education at Stanford University. Follow him on Twitter @eatoncharlie.
Correction: An earlier version of this essay showed the Dow Jones rate of return for the 2016 calendar year instead of the 2016 fiscal year. That number has been corrected.
