Nearly all major colleges, including Ivy League schools like Harvard, Yale, Princeton, and MIT, run some of the largest and most successful endowments in the world. In fact, the top 20 university endowments grew by more than 9% annually, on a real basis, between 1992 and 2005. But after ushering in negative returns in the wake of the 2008 U.S. economic crisis, many university endowments have re-jiggered their investment strategies.

A Successful University Endowment

University endowments are traditionally funded by donations. The size of each endowment depends on how shrewdly a given university spends on its current student population. But rather than putting their entire principal to practical use, most the universities invest the lion's share of their endowments, in an effort to generate future income. In fact, universities on average annually withdraw only 4% to 5% of their endowment funds for current use. Interestingly, 2008 was a remarkable year, where endowment withdrawals averaged 15% to 20% of college revenues, according to a study by the National Association of College and University Business Officers (NACUBO).

Key Takeaways

  • Nearly all major university rely on donor-funded endowments to pay for daily operations.
  • The majority of an endowment's portfolio is invested, to generate continuous income.
  • Asset allocation models are usually determined by an endowment's investment committee.
  • Endowments allocate the largest percentages of their portfolios to alternative asset classes like hedge funds, private equity, venture capital, and real assets like oil and other natural resources.

Endowments strive to meet two chief objectives. First and foremost, they attempt to generate high enough real returns to cover their yearly withdrawals, without dipping into their principals. Secondly, colleges aim to preserve the real value of their principals, which actually entails augmenting principal amounts, in an effort to combat inflation. In fact, endowments heavily rely on their own inflation measurement metric known as the Higher Education Price Index (HEPI), which factors the prices of goods and services specific to higher education expenses. It is generally believed that the HEPI exceeds the consumer price index for all urban consumers, by 1%.

Eating Your Cake With One Hand and Baking With the Other

Between 1985 and 2008, Harvard University's endowment generated 15.23% returns, while Yale pulled in 16.62%. Both endowments handily outperformed the S&P 500, which only grew 12% during that same time period. But there is no magic formula behind any one school's success. In fact, each university describes its unique investment story in its annual report, which details overall asset allocation models, although they seldom divulge individual investments within a given asset class.

An Eye Towards Alternatives

In the decades leading up to the economic crisis, from 1985 to 2008, endowments with assets of US$1 billion and above generally invested a small portion of funds in traditional stocks and bonds and a larger portion in alternative assets such as hedge funds, private equity, venture capital, and real assets like oil and natural resources. Many of these alternative investments outperform traditional stocks and bonds, but typically have longer gestation periods and impose higher minimum investments--especially in highly illiquid markets. Such investments suit bigger endowments, capable of locking in billions of dollars for long periods of time. This gives the bigger players an edge over smaller endowments, who are unable to exploit such non-traditional asset classes.

Put Everything in Writing and Leave it to Others

Endowments strictly follow well-documented investment policies mandated by investment committees, which traditionally comprise university alumni. Endowments have their own staffs that are led by chief investment officers, and have in-house investment managers on the payroll, to handle day-to-day portfolio management tasks. Endowments must also follow the written donor guidelines, regarding the allocation of endowment earnings for current use.

Invest Like Endowments

Those seeking to mimic a university endowment's investment strategy should bear the following points in mind:

  1. Endowments earn vastly different returns from one another, although funds with asset north of US$1 billion generally outperform smaller endowments, mainly because their chosen investment strategies require economies of scale.
  2. University endowments benefit from the expertise provided by investment committees, which is typically unavailable to individual investors.
  3. Universities boast vast social networks which give them greater access to many crucial investment opportunities.
  4. Endowments are exempt from government taxes.
  5. The best performing endowments access alternative investments, which require longer gestation periods and higher minimum investments than most individual investors can afford.

The Bottom Line

A successful endowment can helps reduce the financial burden of a university by generating a consistent flow of income. Although endowments broadly disclose their asset allocation breakdowns, investors may not be able to duplicate the success endowments have historically achieved.

[Important: Many economists believe the 23% drop endowments collectively suffered in 2008 was the worst decline since the 1970s.]