Yale spends $480 million a year on private equity fees. That might not be as dumb as it sounds.

In 2014, Yale spent $170 million on financial aid, fellowships, and prizes. It spent $480 million — nearly triple its tuition assistance budget — on private equity fund managers. People are upset:

I was going to donate money to Yale. But maybe it makes more sense to mail a check directly to the hedge fund of my choice.

— Gladwell (@Gladwell) August 19, 2015

It looks very bad on paper, and sure enough, University of San Diego law professor Victor Fleischer thinks it's a good reason to force universities to spend at least 8 percent of their endowments every year. That's definitely a smart policy. Yale's endowment has grown, on average, by 13.9 percent per year over the past two decades, but the university spends only 4.5 to 6 percent of its endowment annually; Harvard, Stanford, and other wealthy colleges have similar practices. It's perverse for an allegedly charitable institution to be socking away billions in real terms every year, tax-free, when that money could be spent funding socially valuable research or expanding access to education.

But that's a separate issue from the question of whether it's reasonable for Yale to spend $480 million on investment management. It seems very possible that Yale is making a rational decision — and one that could leave more money for research and financial aid, not less.

The case for spending $480 million in investment fees

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The reason rich universities hire private equity fund managers — and operate investment companies that offer very lucrative compensation — is that they're betting that actively managing their endowments will yield higher annual returns than putting money into a "passive" index fund that tracks a market average such as the S&P 500. The bet, specifically, is that those returns will be high enough to beat the market even after taking fees into account.

Are they right? Well, the bet seems to be paying off for Yale. If you examine the university's returns, you'll see that Yale has a modest edge on the market, at least in the medium term. According to its latest endowment report, from 2004 to 2014 Yale had an average annual return of 11 percent, compared with 8.4 percent for domestic stocks and 4.9 percent for domestic bonds.

A recent paper by the Commonfund, a firm that provides services to endowments, found that active management leads to higher returns for university endowments on average (though the authors might be overstating that conclusion a bit; Commonfund is not exactly disinterested). A 2013 article in the Journal of Financial and Economic Practice found that endowments greater than $100 million — like Yale's — beat the market, on average, and endowments larger than $1 billion beat it by a significant margin.

That makes some sense: Schools with big endowments have a lot of leverage in negotiating down fees, can afford top-tier investment managers, and have the capital to make big direct investments that smaller investors couldn't manage (Harvard bought 10,000 acres' worth of vineyards, for example, which usually isn't an option in an IRA). Schools like Yale also have access to large alumni networks that might provide access to market information and investing talent that most investors don't get. Insider trading definitely lets you beat the market.

The case against spending $480 million in investment fees

AEI / Mark Perry

But the argument for spending millions on actively managing endowments isn't ironclad. Maybe Yale just got lucky, and its returns over the next decade will underperform the market.

Harvard, for instance, brags that it averaged 8.9 percent returns from 2004 to 2014, versus 7 percent for the passively managed basket of assets against which the Harvard Management Company compares its performance. But in recent years they've far, far underperformed the S&P 500, and would've been much better off just throwing money into index funds.

This jibes with a lot of what we know about investment in general: It's just very, very hard to beat the market. We know that hedge funds, for instance, typically underperform relative to the index funds. Many of those hedge funds pay huge salaries for top talent, and have the scale to make large direct investments in exotic areas closed off to individuals. They're staffed by people who usually have plenty of social contacts in companies targeted for investment. In other words, they have many of the same advantages as big endowments, and they still fall short. Worse, big endowments typically invest heavily in hedge funds. So far, Yale has mostly been able to pick above-average hedge funds and so avoid getting scammed. But it's playing in an area we know is treacherous.

The scale advantages of large endowments also come with disadvantages. As Matthew Klein notes, one consequence of being able to own stuff like huge vineyards is that you have to be able to sell stuff like huge vineyards. Schools like Yale can invest in illiquid markets that are off-limits to other investors, but they still have to deal with the fact that those markets are illiquid. Yale is effectively earning a premium for the fact that it's willing to own assets that are hard to unload. But that premium isn't free; it comes at the cost of increased risk. Schools with large endowments also have to find more investments than schools or institutions with fewer assets under management if they are to beat the market, which can prove challenging.

Why this matters

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The upshot is that there's a pretty good argument that Yale has more overall assets as a result of forking over hundreds of millions of dollars in financial fees every year than it would've if it had just tracked the S&P, even though tracking the S&P is a better strategy for most schools. So the counterfactual that Fleischer is supposing — where Yale doesn't spend so much investing and instead is just passive — would quite possibly leave the school with less money overall: less money to invest, but also less money to spend on financial aid, research, and other worthwhile activities.

Indeed, it's quite possible that forcing schools to spend 8 percent of their endowments every year would lead them to spend more in fees. It would require the endowment to earn 8 percent plus the inflation rate (which is basically zero at the moment) every year to avoid losing value over time. That's possible with index funds — Vanguard's S&P 500 fund has averaged 11 percent returns before inflation since its inception in 1976 — but beating the market becomes more attractive when a greater chunk of your returns are being pulled out every year rather than being reinvested.

Investment fees aren't an extravagance — they're a tool. If fund managers boost returns by more than the fees they charge, then the fees are a useful tool; otherwise they're not.

The issue isn't that Yale is spending hundreds of millions in apparently worthwhile fees every year. The issue is that Yale is spending too little of the returns it gets on its students and on research, and too much on growing the endowment for its own sake. That's a real problem, but it doesn't have much to do with how much Yale is paying private equity managers.

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