Wednesday, January 7, 2009

Ivy league endowments

The Economist has an interesting article on problems at some Ivy League school's endowments. Many schools adopted the so called "Yale Model" which basically advocated buying long term illiquid assets because universities presumably have long term holding periods. In recent years these endowments posted fantastic returns.

But there are a couple of problems with this model...First, the past returns are frequently based on estimations of asset value. This is because these illiquid assets don't trade very much (because they are illiquid) and therefore timely market data is unavailable on them. When an endowment spends part of its "returns" it is converting a paper return to an actual cash outflow. Second, when the universities saw other sources of income decline, they decided to try and liquidate some of the illiquid assets of the endowment to make up the short fall. Of course it's very hard to sell illiquid assets in a down market.

This is a clear reminder of the basic rule in finance: higher returns imply higher risk. In this case these endowments enjoyed higher returns due to higher liquidity risk. If you are going to buy illiquid assets, you should have enough money invested in very liquid assets to cover cash short falls. Of course, these very liquid assets will drag down your portfolio return. That brings us to the second rule of finance: there is no free lunch.

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