Alison Wolf

August 31, 2007

Suppose British universities really managed to emulate the Americans and our alumni got used to giving generously, and often. Would large endowments really transform our lives? Or do governments need to regulate and oversee how we spend them, because ivory-tower academics may blow the lot and have to be bailed out by the taxpayer?

The evidence from the US is wonderfully encouraging. Of course some institutions may get into trouble, as some cities do - though I do not know of any universities that have, like the city of Cleveland, gone bankrupt. When it comes to investing, universities rule the roost. Their record is better than pension funds (in the private and public sectors), as well as insurance companies, banks and finance companies.

The evidence is reported in a paper for the National Bureau of Economic Research. In "Smart institutions, foolish choices?" Josh Lerner, Antoinette Schoar and Wan Wong compared the performance of different types of American institutional investors, including those investing for endowments and foundations. They found that endowments' annual returns were substantially and significantly larger than for any other large group - and for reasons that could not be explained away by luck or quirks of history.

The data were from investments in private equity funds over a 20-year period. When you invest in such a fund, you have to sit back and let the private equity people get on with it (which they do by buying, managing and selling companies - some start-ups, some established.) At the end of an initial investment period, you can withdraw your funds (and gains, if any) or reinvest.

The average annual returns from funds selected by managers of American university endowments were nearly 14 per cent higher than the overall average, and they did even better when compared with funds selected by investment advisers and banks.

Universities also began investing in private equity sooner than most other institutional investors, but while this accounts for some of the difference it is far from the only reason for their success. They also invest differently and seemingly more intelligently.

One obvious strategy for an investor is to look at current performance when an investment period ends and then reinvest in the same fund (or not) accordingly. Many institutional investors seem to do that in a fairly automatic way. In contrast, when endowments' strategies are examined, you find that the "current" performance of the funds that attract their reinvestment, and those that do not, is pretty much identical. The difference comes in their future, or later, earnings.

University endowment managers seem to be much better at spotting funds that are going to do well in the next period than managers of private pension funds or those working for banks and insurance companies. They are generally more active in their strategies: they reinvest less and tend to invest while funds are smaller.

Of course, not all of them do well. As usual, there is more variability within a category of investors than there is between categories. But the differences are major and impressive. Examining who does best within the university category also helps to explain why these differences are more than luck and why they are sustainable over time. None of the universities in the sample is exactly an academic non-performer; but the top 50 per cent of the group (using accepted US rankings) significantly outperform the bottom 50 per cent, and performance is significantly correlated with the rate of alumni-giving.

Universities seem to be better at choosing investment managers and better at using the information they gain as investors in deciding whether to stay with a fund or to shift. And it seems likely, from their generally superior performance, and from the fact that alumni involvement "helps", that they are using close ties with distinguished, prosperous and committed graduates to develop good investment strategies.

The conventional wisdom is that, in the long term, you cannot buck the market. But the NBER research underlines that, while much of what we see as success is really luck, not all success is random. Investors who are better informed and smarter may indeed make better choices - not always but often enough to make a very big difference.

The idea of large university endowments entrances vice-chancellors and politicians alike: vice-chancellors as a way of increasing their budgets without political interference, politicians as a way of increasing university spending without having to find the money. Obviously, there is no way of knowing if American patterns would translate to UK markets - but is there any reason to suppose they wouldn't?

Alison Wolf is Sir Roy Griffiths professor of public sector management at King's College London.

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