Yale’s Class of 1954: Lucky and Good
In 1981, Yale’s Class of 1954 raised $75,000 to be invested in a fund separate from the Yale Endowment. A few weeks ago, the Class of ’54 was credited with a gift of $114,315,000 as proceeds from this fund. How was such a return achieved over a period of 24 years? How much better was this return than a random portfolio? How did the people at the Yale Endowment feel about this separate fund? Finally, what lessons can be learned from this story?
First, the details of how the fund developed and its returns. According to Mark Branch, editor of the Yale Alumni Magazine, the idea for the “54/50” fund was first proposed by Richard Gilder at the 25-year class reunion in 1979.
Gilder proposed to his classmates that they create a kind of mutual fund to be invested privately in anticipation of their 50th reunion. "I was thinking about the next 25 class council meetings and how boring they were going to be," recalls Gilder. "And Yale's investments weren't doing so well. So I came to believe that it might be more interesting if each class had some action of its own."
By 1981, the fund had raised $75,000 from between 20 and 40 class members. The money was put in the hands of Joe McNay '56, who founded Essex Capital Management in Boston. Between 1981 and 1984, an additional $305,000 was donated by 31 class members to the fund. In 2000, just before the market downslide, Yale convinced the class to hand over the funds, which then totaled $65 million. The class agreed to do so, with two caveats: a) Yale would continue to credit the fund with a 10% annual return until the 50-year class reunion in 2004, b) any donations of class of 1954 alums to Yale between 2000 and 2004 would be “matched” by the fund, thus doubling the “book value” of these donations. So if a member of 1954 had a spare $1.25 million lying around, he would be able to give an endowed professorship worth $2.5 million. This second stipulation encouraged additional donations to the fund. Because of these two accounting provisions, the book value of the class gift by 2004 was $114 million.
A quick calculation shows that the average compounded annual return of the fund (geometric mean) from 1981-2000 was between 31.8% and 34.5%. The actual number depends on exactly when the initial $75,000 and subsequent $305,000 were invested. The Associated Press has the number at 37%.
In any case, these seem to be spectacular returns. How were they achieved? McNay invested the funds in U.S. stocks, and said he was an early believer in investments in Internet companies, Wal-Mart, Home Depot and other companies that made it big.  We do not have more information, although I am currently trying to contact McNay.
Equally important, how did the class manage to get out just before the 2000 crash? It appears to be blind luck. As the fund’s coffers swelled, the Class set up a research committee to think about how their gift might best be directed. The nine-member committee, headed by Bob Quinlan, interviewed leaders in higher education both inside and outside Yale and spent hours with University officers learning about Yale's priorities. By the beginning of 2000, when the surging stock market had sent the total above $70 million, the Class decided to cash in its chips. Responding to President Levin's urging, the Class announced its gift three years ahead of schedule, earmarking $50 million for new science facilities. The timing of the gift, Levin argued, would be appropriate to celebrate the Tercentennial and would help launch the fundraising effort for the $500-million Science Hill plan. For $50 million, the Class would have two of the five new Science Hill buildings named for it.
How much better was the annualized 54/50 return than a random equity portfolio? For this study, I simulated the random performance of three different U.S. equity funds: high risk, medium risk, and low risk. The high risk portfolio is 100% NASDAQ index, medium risk is a random mix of NASDAQ and S&P500 indices, low risk is 100% S&P500 index (this is not actual risk, but relative equity risk). I used a Monte Carlo simulation of the bootstrapped monthly returns of each index (11/84-3/00 for NASDAQ, and 12/82-3/00 for S&P500, dates chosen due to availability of data).
In my bootstrap method, I recreated a 20-year history of returns (54/50 invested for 20 years) by randomly picking 240 monthly returns from the actually historical monthly returns for which I had data. I then ran between 1000 and 10,000 simulations repeating the same bootstrap method. In order to beat the 54/50 fund, the simulated portfolio results had to exceed 31.8% annual return, the lowest possible return the 54/50 could have achieved. My results reveal that the high risk portfolio randomly outperformed 2.7% of the time (27 of 1,000 simulations), the medium risk only 0.3% (3 out of 1,000), and the low risk never (0 out of 10,000). Here are the resulting histograms:
The period during which the 54/50 fund was invested coincided with a general bull market. Even so, this study shows with 97% certainty that the fund’s results were not random as relates to NASDAQ and/or S&P index funds. However, the study does not touch on results such as holding a particular number of random stocks, private equity investing, etc.
What were the Yale endowment leaders’ thoughts on this separate fund? According to Branch, the Yale development office was supportive initially. Gilder and others chatted up the new fund in alumni circles, and soon other classes tried to begin similar funds. However, when new leadership took over a few years after the funds creation, the attitude shifted.
As Gilder remembers it, "a number of classes of our vintage were thinking about setting up similar funds. But the new people at the Alumni Fund were concerned that the classes could run amok. So they not only killed the other class initiatives, but tried to kill ours over the years. But we had already gotten started, and we said no." Class secretary Joel Smilow says the University was concerned about two things: that the money was not under its control, and that the outside initiative might cut into the Class's annual giving.
By the 1990s, though, it became apparent that the Class was on to something. McNay, says Pagnam, "was managing in a very aggressive way. Unlike our investment office, he didn't have to worry about annual income. The class was just saying 'let's see how big we can get it.'"
How big could the fund get? This question makes one wonder: what were the forces that made this separate fund increase 18,000% while the S&P rose 1,200% and the Yale Endowment lagged the S&P during this time? What lessons can be learned?
It is interesting to think about the risk tolerance of the 54/50 fund vs. that of the Yale endowment. The former had no real obligations to look after as an impetus to protect principle, while the latter had income generation obligations and concrete liabilities to fund. The 54/50 invested in high-risk equities and got rich, while the Yale endowment plugged much of its money into fixed income and did poorly.
As a poker player, I know that I generally do better when the risk of losing is less of a concern. If I have a $25,000 bankroll and play at a game where I am bringing $400 to the table, I’m more likely to have a better relative return than if I play at a game with a $10,000 buy-in. The main reason is that I’m willing to take short-term risks that I strongly believe will optimize my long-term return. Also, “playing with the rent money” often leads to disastrous results as one micromanages each move for fear of loss.
It is also germane to think about career risk. What is McNay’s career risk if he loses money for the 54/50 fund, compared to the Yale managers if less money is available from donations and the Endowment? Undoubtedly much less. Career risk is often a major factor in the investment decisions of fund managers.
Also, how does beaurocracy affect investment decisions? Meeting the needs of the many can often result in least common denominator issues and risk aversion. In the long run, this may lead to an inability to exercise the full range of intelligent choices. Keeping one’s eye on the prize is often harder in a beaurocratic world.
One often hears poker players proclaiming, “I’d rather be lucky than good.” Joe McNay and the Yale Class of 1954 were both. And, of course, a little accounting magic always makes the final numbers look more sparkly.
June 17, 2004