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Risk pays off for endowments

Colleges that put more into 'alternative' assets reaped bigger profits

When it comes to investing, risk has paid off for the nation's elite colleges and universities.

Endowments at a dozen top-tier schools grew much faster than those at higher education institutions as a whole since the early '90s, mostly because larger portions of the elite schools' endowments were allocated to "alternative" assets such as buyout, venture capital, and hedge funds, according to a new research study.

The study, by Harvard Business School professor Josh Lerner and two coauthors, shows substantial increases in average university endowments across the board during that period, but dramatically greater expansion of the top-tier endowments.

"It's clear the elite universities have really figured out how to play the game, and they've been doing it really well," Lerner said.

Based on data provided by endowments on condition it be presented only in aggregate form, the research paper, titled "Secrets of the Academy: The Drivers of University Endowment Success," is one of the first efforts to systematically examine the investment strategies of university endowments through a period that included both a boom in private equity and in technology start-ups fueled by venture capital.

The study, which Lerner wrote with Antoinette Schoar, associate professor at MIT's Sloan School of Management, and Jialan Wang, a Sloan doctoral student, is set to be posted in the next few days on ssrn.com, a website for academic research.

It shows that $1 billion invested at the end of 1991 by the average US college or university endowment grew to $3.68 billion at the end of 2005, a gain of 268 percent over the 14-year period. That was slightly less than the 278 percent compounded growth of the benchmark Standard & Poor 500 stock index in the same period.

By contrast, a $1 billion investment by "Ivy Plus" school endowments turned into $5.88 billion, a gain of 488 percent. The Ivy Plus group was defined as Ivy League schools - Harvard, Yale, Brown, Columbia, Cornell, Dartmouth, Princeton, and Pennsylvania - plus the Massachusetts Institute of Technology, Duke University, Stanford University, and the California Institute of Technology.

Because the Ivy Plus schools started with larger average endowments than most other schools, their higher percentage gains widened the gap.

The elite schools have been among the best performers among all institutional investors in the past two decades, surpassing the returns of many pension and insurance funds and elevating money managers like former Harvard Management president Jack Meyer and Yale investment chief David Swenson to the status of rock stars in their field. Among the nation's universities, Harvard topped the chart with an endowment of more than $35 billion at the end of the 2007 fiscal year, followed by Yale with about $22.5 billion.

Endowment wealth continues to be concentrated in a relatively small number of well-established and prestigious private universities, said Patrick M. Callan, president of the National Center for Public Policy and Higher Education, a San Jose, Calif., think tank.

"The implications are pretty much what you see: The rich get richer," Callan said. "A handful of institutions that were already well-positioned before the market run-up are pulling away from the rest. It means they're going to be in the best position to recruit superstar faculty and invest in the cutting-edge disciplines of the 21st century."

Top-tier universities have not only been getting richer but getting richer at an accelerated rate, thanks in part to their access to private equity funds effectively closed to other investors.

According to the study, endowments at the Ivy Plus schools earned average annual returns of 13.8 percent over the 14 years, while all schools (including the Ivy Plus group) earned average annual returns of just over 10 percent. Ivy Plus endowments had an average of 26.6 percent of their investments allocated to buyout, venture, and hedge funds between 1993 and 2005, more than double the 12.4 percent allocated to those alternative assets by all schools.

Endowment fund managers at Ivy League schools, many of them Wall Street veterans with strong ties to the financial industry, began investing in early venture funds in the 1970s when even many insiders regarded risk capital as an "obscure and esoteric asset class," Lerner said in an interview. "I'm not sure the average Harvard Business School graduate was aware of these funds back then," he said. "But these endowment managers had greater comfort playing in that sandbox."

By the time corporate and public pension funds joined them as limited partners in alternative assets in the 1980s and early 1990s, elite university endowments already had secured a "seat at the table," Lerner said. That gave them entree to funds closed to latecomers in the 1990s and earlier this decade when venture capital backed technology giants like Netscape Communications Corp., Akamai Technologies Inc., and Google Inc. - and generated giant returns to early investors.

The research paper notes that elite university endowments stood out in other ways. They offered higher compensation to their endowment staffs, had more effective investment committees, and also outperformed average college and university endowments in traditional asset classes, such as stocks, bonds, and real estate, though not as significantly as in alternative asset classes.

"Viewed as a whole, the past 25 years have been a benign environment for many alternative funds," the report said. "Whether these conditions will continue in the decade to come remains to be seen."

Lerner warned that as other endowments seek to raise their returns by boosting investments in alternative funds, it's far from certain that strategy will work as well in the coming decade. In fact, he said, elite endowment managers have shifted shares of their investment portfolios in recent years into new categories like timber and natural resources such as water and alternative energy.

"You see a lot of people out there who are very attracted to the success the elite endowments have had and will try to mimic that success," Lerner said. "But it's not clear the investment philosophy these guys had will be as well-suited to the period going forward."

Robert Weisman can be reached at weisman@globe.com.

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