Blog benefactor Felix Salmon points us to a speech by Harvard president Drew Faust, in which she warns that the financial crisis will likely lead to reduced endowment spending.
In their size, long time horizon, general reliance on outside money managers, and ultimate purpose (to invest capital in order to provide a more or less steady income stream for present and future generations) university endowments closely resemble family offices. So if you're a rich family it bears watching what endowments are up to.
In Faust's words, "endowment income has come to fund more than a third of the University's annual operating budget." That struck me as high, although my alma mater's is currently 37% and headed higher (although this number should not be confused with the "spending rule"--the percentage of an endowment's value that is spent in a given year, which is closer to 5%). For some family office clients it can be even higher, as high as 100%.
It raises the eternal question: What do you do when a high percentage of your yearly spending comes from income on an investment portfolio whose deliberate pursuit of high long-term returns almost always means it's subject to significant fluctuations in annual returns?
Answer one, unsexy though it may be, is to build in enough margin of safety in your annual consumption expenditures (including debt service from leverage!) that you can tolerate (downward) volatility in your annual income. The institutional imperative makes this almost impossible for a place like Harvard to do--in flush times it always manages to find more ways to add to overhead, and overheard is very painful to reduce at a university. Theoretically rich people should have it much easier--they can just live a little less richly for a few years. In practice it doesn't always work that way.
Answer two, also unsexy, is to reduce annual volatility of income by investing chiefly in low-volatility assets, like cash and fixed income. Unfortunately you almost always have to sacrifice long-term returns in order to do this, which means present consumption gains at the expense of future consumption.
Answer three is to smooth consumption, spending less in good times in order to spend more in bad times. This is what endowments are supposed to be doing, but it's hard to do unless you have liquidity. To spend more in bad times you likely have to eat into your principal--nothing wrong with that--but it's painful to eat into principal when that principal is shrinking and you have to sell illiquid assets at firesale prices. Not only is it painful but it penalizes future returns. Harvard's recent moves to sell some of its private equity LP interests, at steep discounts no doubt, may be an example of this.
Answer four is to try to do the (near) impossible: find an investment that delivers the long-term returns you want without the volatility you don't want. I used to work for a firm that has managed this feat for over a quarter-century, but that is extremely rare. Many hedge funds have promised to do this, but 2008 will end in tears for many who believed them.
I'm very curious to see which endowments and family fortunes have best managed to prepare for and navigate the current crisis in such a way that preserved both current and future consumption, which is what it's all about at the end of the day.
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