University Endowment Losses: Why Aren’t They News?
Over the past three months, America’s major private universities, which a year ago were under attack for the excessive size of their endowments and their low payout rates, have been reporting the impact of the economic collapse on their accumulated assets.
Of particular interest are the differences in amounts lost: Brown and Harvard lost the most (30%), followed by Yale (25%), Stanford (20-30%), Dartmouth (18%), and Columbia (15%).
One would think that the heavy losses suffered by the academic high-fliers — Yale and Harvard — contrasted with the relatively small losses suffered by Dartmouth and Columbia would pique the curiosity of investigative journalists (and, perhaps, charities regulators) in the nonprofit sector.
It is common knowledge that Yale and Harvard financial managers pursued high-risk investment strategies that, in boom times, brought spectacular returns. Did these same strategies contribute to the spectacular losses suffered by the endowments of these institutions? And, given the fact that these endowments and the contributions to them were subsidized by government, is there reason to inquire into their investment practices?
In the Depression of the 1930s, there were also major differences in the downturn’s impact on endowments: Harvard lost very little; Yale lost its shirt. Why? Because, as early as 1926, Harvard’s fund managers, believing that the stock market was spinning out of control, sold off most of the university’s equity holdings. As a result, the Great Crash found Harvard cash-rich. Yale, historically conservative in managing its funds, had held off on investing in equities until 1926. when its leading economist, Herbert Hoover confidante Irving Fisher, persuaded the university to take the plunge — with disastrous consequences.
What saved Yale was the fact that its great early twentieth century benefactor, Standard Oil mouthpiece John W. Sterling, had entrusted the management of his $15 million legacy to his own trustees, rather than to the university. Prudently invested, it weathered the Crash, leaving Yale — in spite of itself — prepared to enter its greatest period of physical expansion.
Since giving in this era was not tax-driven (only the wealthy paid income tax before the early 1940s), the public had no direct stake in the relative competence of endowment managers. The situation today is another story, when exemption and deductibility are significantly subsidize private giving.
The basic question is whether the high risk investment strategies that brought in such impressive returns were “prudent” from a fiduciary perspective. In weighing this, it is worth turning back to the origins of the “Prudent Man Rule” — a legal doctrine that originated, curiously enough, in a litigation involving Harvard College.
In 1823, John McLean, a wealthy Boston merchant died, leaving his widow as beneficiary of a trust estate, the remainder of which was, on her demise, to be divided between Harvard College and the Massachusetts General Hospital. McLean had been an early and highly successful investor in the stocks the infant textile industry.
McLean’s trustees, Jonathan and Francis Amory, continued his practice of investing in manufacturing stock which, like all such securities, were subject to fluctuations in value. The trust principal, which had amounted to $50,000 at the time of McLean’s death, had sunk to $30,000 in value by 1828, when the widow McLean passed away.
The college and hospital brought suit in the Supreme Judicial Cour Demanding that the trustees make good the loss, which they charged was due to risky investments.
The presiding justice, Samuel Putnam, a well-connected Bostonian with extensive interests in manufacturing, carefully reviewed both the legal and practical issues defining the duties of trustees as fiduciaries. Depending almost entirely on English precedents, he declared that to hold trustees accountable for diminutions of principal (in the absence of obvious mismanagement) would impose such a burden that no sensible person “would undertake such a hazardous responsibility” of serving as a trustee.
Putnam devoted most of his attention to the question of risk in investing. Again citing British precedents, he pointed out that neither government securities nor the “safe and productive stock” of banks were any less prone to fluctuations in value than stocks in trading and manufacturing companies. “It may well be doubted,” Putnam declared, “if more confidence should be reposed in the engagements of the public, than in the promises and conduct of private corporations which are managed by substantial and prudent directors.”
“Do what you will,” Putnam intoned, “the capital is at hazard”:
Investments on mortgages of real estate, after the most careful investigation, may be involved, and ultimately fail, and so the capital, which was originally supposed to be as firm as the earth itself, will be dissolved.
All that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.
Putnam’s decision helped to turn Boston into one of the nation’s early centers of investment banking. The endowments of its many charities, rather than languishing in unproductive “safe” investments shifted into the far more lucrative — albeit risky — stocks of railroads, factories, and financial institutions. The “Prudent Man Rule” was the basis for a revolution in American finance.
Easy as it is to charge today’s endowment managers with imprudence (it is open season on bankers, after all!), it is worth weighing what seems like unacceptable risk-taking against the necessity of innovative financial management in contexts of rapid economic change.
An article in Saturday’s (2-21-09) New York Times raises the question of whether the university’s risk-taking had been excessive. Its complex portfolio, “with many investments involving leveraged bets on equities and commodities that are difficult to unwind,” has left Harvard hard-pressed to meet its short-term obligations. To make payroll last month, the university had to float a $1.5 billion bond issue.
According to the Times, “Harvard has frozen salaries for faculty and nonunion staff members, and offered early retirement to 1,600 employees. The divinity school has warned it may not be able to cover tuition for all its students with need, the school of arts and sciences is cutting its billion-dollar budget roughly 10 percent, and the university president said this week than the unprecedented drop in the endowment was causing it to delay its planned expansion, starting with a $1 billion science center, into the Allston neighborhood of Boston.”
In a recent paper, New York University Law School Professor Harvey Dale argued against efforts to impose standards of prudence on trustees as “ossified” and “sclerotic,” embracing outmoded ideas about safe investments and ignoring modern portfolio management theories.
The situation of Harvard and other high-flying endowments suggests that we may need to revisit the question of prudence.
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Harvey Dale. “Prudence Perverted: Politics, Perceptions, and Pressures.”
Harvard College and Massachusetts General Hospital v. Amory. 26 Massachusetts Reports (9 Pick.) 446, 447 (1830).