Why Are University Endowments Large And Risky?

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Why Are University Endowments Large And Risky?

Thomas Gilbert

University of Washington – Department of Finance and Business Economics

Christopher M. Hrdlicka

University of Washington – Michael G. Foster School of Business

May 11, 2015

Review of Financial Studies, Forthcoming


We build a model of universities combining their real production decisions with their choice of endowment size and asset allocation. Variation in opportunity cost, that is, the productivity of internal projects, has a first-order effect on these choices. Adding the UPMIFA-mandated 7% payout constraint, the endowment size and asset allocations match those empirically observed. This constraint has little effect on universities that do not value the output of their internal projects but harms those that do: it prevents the endowment’s use as an effective buffer stock, thereby increasing the volatility of production, and it slows the growth of the most productive universities.

Why Are University Endowments Large And Risky? – Introduction

Universities organize and implement investment projects, such as knowledge creation and its dissemination through teaching. These projects increase productivity throughout the economy, and the social dividends of these projects are therefore public goods with large positive value for society. Because the social dividends are incompletely monetizable, universities support their production with donations and the stockpile of past donations embodied in their endowments.

As producers, the opportunity cost of a larger endowment is forgone internal investment that would increase the output of social dividends. In choosing the asset allocation within that endowment, universities further face the trade-off that taking risk externally in the financial markets limits the risk they can take in new internal projects. Indeed, a university would only choose to forgo internal investment if the total return on its internal capital is lower than the return offered by financial markets. Following this intuition, we seek to explain why universities (and non-profits more generally) that have productive internal projects sufficient to motivate their high donation rates tolerate the opportunity cost of building large and risky endowments.

The donation flow to U.S. research universities and baccalaureate colleges is large, making up almost 20% of their annual budget.1 With these large donations, universities have accumulated substantial endowments, leading to an aggregate endowment value of nearly half a trillion dollars. Figure 1 shows that endowments are also large at the university level, averaging two to three times the university’s annual budget with a maximum of about fifteen times the annual budget (panel A). These endowments are heavily invested in risky assets, averaging about 75% of their assets in securities such as equities, hedge funds, real estate, private equity, and other alternative assets (panel B). Across universities, as the endowment size increases, the allocation to risky assets also tends to increase, although not monotonically (panel C).

To understand the observed endowments, we model the university as having a stock of capital that produces social dividends. The university has revenue sources, such as tuition, fees, grants, and state support if public. The university cannot cover all of its costs from these sources and must use donations and its endowment to support and expand its capital stock. We model a feedback loop between social dividend production and donations. As the university capital changes so too does the number of potential donors, for example, alumni, and hence expected donations are proportional to university capital. Donations are stochastic and covary positively with the risky asset return, consistent with the data seen in panel D of Figure 1. Panel D shows that donations (growth) and the market have a strong correlation of 0.56 at the aggregate level, consistent with Brown, Dimmock, and Weisbenner (2015). The volatility in donations makes internal projects risky, because if in any period the university has insufficient resources to maintain its capital, then the university must shrink, leading to a decrease in the production of social dividends. This risk creates an incentive for the university to hold an endowment that it allocates between a risky asset and a risk-free asset.

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