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Carnegie Mellon’s hedge fund investments will not pay off

Over the past ten years, the S&P 500 has gained 65.24 percent while Carnegie Mellon’s carefully-chosen investment strategy has yielded returns of 56.3 percent. While the university’s investments in hedge funds do offer greater risk-adjusted rates of return, as shown by Carnegie Mellon’s outperforming the stock market during the Great Recesion, over the long run, the passively investing the stock market is likelier to do better or at least just as well with much less effort and thus cost. (credit: Shlok Goyal/) Over the past ten years, the S&P 500 has gained 65.24 percent while Carnegie Mellon’s carefully-chosen investment strategy has yielded returns of 56.3 percent. While the university’s investments in hedge funds do offer greater risk-adjusted rates of return, as shown by Carnegie Mellon’s outperforming the stock market during the Great Recesion, over the long run, the passively investing the stock market is likelier to do better or at least just as well with much less effort and thus cost. (credit: Shlok Goyal/)
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Academics like behavioral economists have been arguing for years that even professionals cannot consistently “beat” the stock market. This means that the average returns on investments provided by the largest public companies generally do as well as any elaborate attempt by investment professionals trying to find the perfect stocks to invest in.

Investing in these large public corporations can often be done easily by investing in “index funds” which track a widely-available conglomeration of hundreds of the best stocks. For example, one can indirectly invest in the S&P 500 (the most popular such fund), which would mean putting your money into an aggregation of the 500 largest American companies. This involves little effort and thus has low management fees.

Even though Carnegie Mellon is a university whose primary motive is to spread such financial knowledge to thousands of students, its own administration has not considered these teachings when making its investment decisions. Instead, Carnegie Mellon has consistently attempted to make greater returns than the market average and it has, like most other universities, failed to do so.

As of June 30, 2016, Carnegie Mellon was investing 41 percent of its endowment in hedge funds (aggressively-managed funds) and private equity investments, which tend to involve high risk but promise great reward. Only 16 percent was invested in U.S. public equities (stocks that are publicly traded). Worse, the university plans to move further to increase its investments in hedge funds, from 12 percent to 18 percent while decreasing investment in U.S. public equities from 16 percent to 14 percent.

The obvious question that arises, then is, how well has Carnegie Mellon performed with its current investment portfolio? The answer is that it has performed well, but not as well as it could have. Between the end of fiscal year 2009 and 2016, Carnegie Mellon gained 84.9 percent on its investments, but the S&P 500 index fund gained 134.1 percent.

If Carnegie Mellon had invested its entire endowment in the S&P 500 since 2009, it would have earned $414 million more by now. Since that covers seven years, that would be $59 million more per year. Even assuming current enrollment levels, including undergraduate and graduate students, for all seven years, that would mean $4,243 for each student each year, a substantial cost savings if that additional profit could have been put into financial aid.

But, that’s unfair. After all, hedge funds promote themselves as the safer option since they offer greater risk-adjusted returns. That is, they offer lower losses in a down market and lower returns in a booming one. We should thus account for the Great Recession in 2007 and 2008 when evaluating the two options.

Over the past ten years, then, the university has earned a total return of 56 percent through its investments. If the Administration had simply invested in the S&P 500 index fund, it would have earned returns of 65.24 percent. Even a mix of 60 percent of funds in the stock market and 40 percent in safe fixed-income securities (such as a bond, which is when you purchase a loan) would have resulted in returns of 61 percent.

Some may say, however, that the problem lies with the specific investments Carnegie Mellon made or its personnel. Rather than abandon the strategy of investing in hedge funds, these people argue that we should remain patient and merely evaluate our investing philosophy.

Carnegie Mellon’s investment team certainly holds that opinion. 2016 was the 11th year since Carnegie Mellon had shifted from investing in public equities to more global private equity investments. The Annual Report excuses currently low returns in the hope that they will eventually pan out, stating, “We believe that over the long-term talented fund managers will be able to exceed the return from investing in public securities.”

Translation: Sure, we are losing money now, but to make up for that we are going to double down on the strategy that isn’t working in the hope that eventually it will.

But, this is not how the investments Carnegie Mellon has made work. Fund managers are generally trying to maximize short-term profits. If they can’t do that this year, or over the past ten years, there is no guarantee they will ever be able to do so.

What is a guarantee is that they will never be able to do so consistently. Research by S&P Dow Jones Indices showed that 99 percent of actively managed U.S. equity funds under-performed compared to the S&P 500 over the last ten years, according to the Financial Times. In The Power of Passive Investing,Richard Ferri notes that the average active manager under-performed his benchmark by 2 percent.

Most hedge funds, too, fail with the average lifespan of one being five years, according to The New Yorker. More, most hedge funds have a 2 and 20 rule, where they charge two percent of all investments put into the fund and 20 percent of any profits made, negating the benefits of potentially outperforming investments.

Unless Carnegie Mellon is going to consistently pick the top one percent of private equity funds or one of the few hedge funds that will offer outstanding returns, if such funds exist, its investment strategy is not going to be very helpful, either in the short-term or the long-term.

But Carnegie Mellon is not alone in this. Peer institutions with high endowments have been consistently under-performing the market, but refusing to change their strategy. A report released two weeks ago by the National Association of College and University Business Officers showed that universities with smaller endowments (under $25 million) saw significantly higher returns than those with larger endowments (more than $500 million), according to The New York Times. For comparison, Carnegie Mellon’s endowment is worth $1.3 billion.

The reason for this discrepancy in investment success was simple: colleges with smaller endowments have moved their money from hedge funds and other alternative investments to low-cost index funds and bonds.

The universities with the smallest endowments have just 17 percent of their endowment in alternatives, hedge funds, and private equity firms. Their larger counterparts (those with endowments greater than $1 billion), which have fared much worse, have on average 90 percent of their endowments in these groups.

Carnegie Mellon is much better off than other institutions of its size, but that doesn’t mean it can’t work to improve in the future. An investment strategy that more closely follows financial experience would bring higher returns to the university. Perhaps it could even mean an end to tuition increases.