The Evolution of Investing at the University of Michigan

Chapter Two: From 1817 Through the 1970s: The Early Years

The University of Michigan obviously had assets and funds, and thus some form of investments, since the establishment of its predecessor, the “Catholepistemiad of Michigania,” in 1817. However, it is not until 1928 that we find a record of what is now called the “Report of Investments” (ROI), and that is where we will begin a more detailed treatment of the evolution of investing. But nonetheless, a few interesting words can first be said about the University’s financial governance and history prior to 1928.

From 1817 until 1837, the “Catholepistemiad of Michigania” had a fragmented history. In fact, it seemed to essentially cease operating around 1827. During this period of limited operations, the institution appears to have been funded primarily via land grants (including a foundational land grant from the federal government under the Treaty of Fort Meigs) and donations (including for example an early $250 gift from the Freemason Zion Lodge No. 1 of Detroit). Land was periodically sold off to fund the institution.

In 1825, the Erie Canal was completed, opening up trade between the East coast and the Great Lakes regions. At the beginning of 1837, the State of Michigan was admitted to the Union. This same year the University of Michigan was established, or reestablished, pursuant to the Organic Act of March 18, 1837, in Ann Arbor, where the first meeting of the Board of Regents was held on June 5, 1837.

The first real “endowment” of the University of Michigan may have been a significant land grant gifted to it, again by the federal government of the United States on May 20, 1826 in “an Act concerning a seminary of learning in the territory of Michigan” (Exhibit 2). It was not long after the University was truly launched in 1837 that the first questions regarding the proper use of this “endowment” arose. In a January 1839 meeting of the Board of Regents, a report was presented regarding “the legality of appropriations made out of the fund derived from the sale of University Lands for the support of University Branches” (Exhibit 3). “University Branches” are a fascinating, and critical, early initiative of the University of Michigan whereby the University established and controlled what were essentially preparatory high schools throughout Michigan, to act as feeders for the new University. Otherwise, at this time, as one might imagine, secondary education, to the extent it existed in Michigan, was not designed to prepare students for higher education. Thus the University of Michigan played a critical role not only in the development of higher education but also in the development of secondary education in the State of Michigan.[1]

In 1850, the State of Michigan adopted a new state constitution. Article 13, entitled “Education,” made two important changes. The Board of Regents would now be separately and democratically elected, and the office of President of the University was created. Although governance had already gone through various iterations, immediately prior to 1850 the Board of Regents had been appointed by the Governor and had included the Governor himself and other members of state government, including Justices of the Michigan Supreme Court. Thus management of the University, including financial management, was entangled with other branches of state government—a reality that was bemoaned in the minutes of more than one Regental meeting. Now the University was constituted as a kind of independent fourth branch of government—and its financial management fell squarely and exclusively within the purview of the Board of Regents. This structure, as we will see, would years later in 1988 be litigated in connection with the divest South Africa movement.

In 1851, the Michigan legislature passed a new statute reestablishing the University of Michigan—this is the Act that governs the University of Michigan to this day (Exhibit 4). Three of the 23 sections of the Act contain the term “university fund” in the title and, in addition, various other sections refer to the use of interest on the university fund. The “university fund” may thus be regarded as the predecessor to what is now referred to as the “University Endowment Fund,” or UEF, the main endowment fund of the University, which is discussed in greater detail below. In 1852, Henry Philip Tappan was appointed the first University President.

In 1867, the first mill tax was established, and the University of Michigan has received some form of appropriation or other financial support from the State of Michigan ever since.

From early on, the University of Michigan also had the good fortune of attracting more private gifts than perhaps the typical public institution of the time:

Toward the end of the 19th century and the beginning of the 20th, “the era of spectacular contributions to the University was inaugurated.” The first true endowments were established, a long list of loan and scholarship funds was created, the Michigan Union and the Michigan League were constructed, and other gifts were used to build additional facilities, collections, and libraries.[3]

By 1928—the year in which the “Consolidated Endowment Fund” was first established and the first year for which we have a ROI—the financial assets accumulated such that the University had some $4 million in financial assets. The 1928 ROI was more a list of investments than a report, and it was called “Investments of all Deposit Accounts & Trust Funds.” There were four groupings of fund types:

1. Deposit Accounts in Custody of the Treasurer
2. Endowment Funds
3. Expendable Funds
4. Student Loan Funds

Investments had the following classifications:

1. Cash
2. Certificate of Deposit
3. Bonds
4. Contracts
5. Mortgages
6. Real Estate
7. Stocks
8. Student Loans
9. Tuition Notes

Of the $4,093,293.52 listed of total funds, 10.7% was invested in Cash or Certificates of Deposit, and 80.5% was invested in Bonds, Mortgages, and Real Estate. Stocks were 3.1% and Student Loans 2.9%. Other categories (mainly Contracts; see below) were 2.8%. The stocks were likely not acquired by purchase by the University but presumably acquired as gifts. Endowment Funds were about $2.7 million of the total.

Every investment of every internal unit was separately listed. “Mortgages” were single mortgages, not pools, many of them loans to the University’s own faculty and staff under a special program that no longer exists. A number of “bonds” were issued by banks and, interestingly, also appear to be backed by specific mortgages, which are listed. Other bonds were secured corporate loans. Generally speaking, investments were local to Southern Michigan, although there were many exceptions. The Lawyers’ Club held bonds issued by the Kingdom of Norway and the Martha Cook Dormitory held bonds issued by the United Kingdom of Great Britain and Ireland. Edison-affiliated companies appear in numerous places. There are bonds issued by the City of Toronto, the State of Queensland (Australia), Florida Power & Light Company, and various other utilities and railroad investments, for example. So, to an extent, the University was already investing nationally and even internationally.

The “Levi Barbour Oriental Girls Scholarship” held many of the “Contracts,” which also appear to be mortgages, but on undeveloped lots. And although the name may now sound anachronistic, it was a very progressive idea at the time:

Of the small allocation to equities, there were stock investments in, for example, various railroads, Detroit Chemical Works, White Star Line, and Grayling Lumber Company.

The end of the report contained listings “showing all bonds acquired during the year” and listings “showing all bonds sold, redeemed or otherwise disposed of during the year.”

Before continuing the history, we pause for an important observation. From inception through November 1986 (see below), there was a crucial practice that drove many aspects of endowment management, including spending policy. This was the practice of distributing income as actually generated by the portfolio, whether in the form of interest or dividends, to endowment beneficiaries. Of course, this practice was not undertaken arbitrarily but reflected the general practice of the times which, in turn, reflected the historical law of trusts. Under the old law of trusts, when a principal-protected (i.e., permanent) gift to an institution was made, the language was both written and interpreted so as to constrain the beneficiary in the institution to only receive and spend the income generated by the underlying assets in any given year. Thus even if the underlying assets had appreciated in market value, the principal could not, whether in part or in whole, be liquidated and spent. This policy could constrain an institution’s spending even if its investments had done very well. On the other hand, these gifts could also constrain an institution’s spending policy by in effect requiring income to be distributed to the gift beneficiaries—even if the principal had depreciated in value or if the income was more than required. These beneficiaries were of course always free to reinvest “excess” income back into the endowment or some other portfolio but, life being what it is, might have chosen to spend it instead.

The income approach was eventually replaced in law, gift instruments, and practice, both at the University of Michigan (as described below) and at other institutions, by the total return approach, whereby the focus would be on a portfolio’s total return (income taken together with appreciation/depreciation), which would then be divorced from short-term spending. Spending policy could then be set separately and reviewed periodically. Of course, over the long run, the two concepts of total return and spending must remain connected as one can only ultimately spend what one has made.

Summarizing important differences between the two approaches:

1. As mentioned, under the income approach, spending policy (often called “distribution policy,” which sounds less profligate) was linked lockstep to investment policy, with numerous consequences. Distributions might be higher or lower than optimal or desired and could fluctuate from year to year in unexpected fashion. In contrast, under the total return approach, spending policy can be divorced from income considerations, be made stable and predictable, and the portfolio can be managed for the long term on a total return basis, with the focus on targeting the appropriate overall risk/return profile to meet the spending policy in the long term.
2. Related to the prior point, the total return approach allows spending policy to target the long-term preservation of the real value of the endowment. Under this approach, which is common at many institutions, spending policy is conservatively targeted to be less than, or equal to, the expected long-term return on the endowment minus expected inflation.
3. Under the income approach, investments might be made on the basis of how much stable income they produced as opposed to what total return they might generate, or what risk/return characteristics they brought to the portfolio. There is thus a natural bias toward fixed income and more conservative investments under the income approach, and a bias toward equity and more aggressive investments under the total return approach.
4. The income approach involved less emphasis on market value and total return and, therefore, tended to focus on the traditional accounting concepts of book value and income return. Thus we see that even through 1992, the University’s investment reports contained book value information for its investments. And it was not until 1977 that the University started publishing total market value returns regularly for its main endowment fund. In current investment management practice, there is an almost singular focus on total return.
5. The total return approach invites a greater degree and precision of benchmarking and relative comparison of performance, both of investment managers and across institutions. Without digressing too much, we note that widespread adoption of benchmarking has contributed to deep changes in the investment management industry, including making it more competitive and professionalized and allowing for complex structuring of performance-linked incentive compensation for investment managers.[5]
6. Finally, of less direct importance but interesting nonetheless, the widespread adoption of total return investing has been found to have contributed to changing dividend policy at public corporations. When equity securities were bought primarily for income there was greater pressure on, and incentive for, the issuers of these securities to distribute free cash flow to their equity investors. The adoption of total return investing has changed investing, corporate policy, and management in other ways, a comprehensive analysis of which is beyond the scope of this book.

An internal Investment Office report from May 1952 (Exhibit 5) summarized the old income approach nicely:

Continuing now with the history, in November 1931, the Board of Regents adopted two new resolutions authorizing any two of the four listed University officers, with the prior approval of the Finance Committee or of the Board of Regents as a whole, to sell investment securities on behalf of the University. The listed University officers were (i) the President, (ii) the Vice President and Secretary, (iii) the Controller and Assistant Secretary, and (iv) the Investment Officer (Exhibit 6). We say “new” resolutions because they do not appear to replace any language that might have been in place previously. These resolutions were incorporated into the University’s Bylaws in 1940 and, despite numerous revisions and movements, much of the same—now highly antiquated—language remains in place today. A couple of months before the passage of these resolutions, in September 1931, the University had created the position of Investment Officer and named its first one, Julius E. Schmidt.

Note that the focus of these resolutions was on selling investments, not buying them. This might be because at this point in time the University was either keeping gifts of securities long-term for their income stream (which included, in the case of debt securities, eventual redemption) or occasionally liquidating them for cash. Making new investments with cash may have been less of a focus—although it certainly also happened.

Finally, note that the role of the Board of Regents (or its Finance Committee) was in relation to the investments themselves—not in relation to investment managers, as is the case now. In fact, it appears that at this time the University did not have any outside investment managers whatsoever—not surprising for this point in the history of investing.

Buying and selling efficiently and in volume requires developed and liquid capital markets. In 1933, the Securities Act (regulating securities registration) became law in the United States and, in 1934, Congress passed the Securities Exchange Act (regulating securities trading). In 1939, the Trust Indenture Act (regulating bond indentures) was passed and, in 1940, the Investment Advisers Act (regulating investment managers) and the Investment Company Act (regulating mutual funds) were passed. This suite of legislation formed the basis for the explosive development and growth of the securities markets in the United States and contributed to giving the U.S. economy—and investing—a modern structure. Over time, many other countries would emulate the U.S. capital markets model.

In April 1936, the Board of Regents approved the purchase of up to a 10% allocation to common stocks—supporting our prior inference that purchasing securities (particularly purchasing stocks) was historically a less common transaction than selling securities. Thus began a relentless, multidecade process of converting the University’s endowment portfolios from almost all fixed income to mostly equity today.

The common stocks were to be chosen from a list of “approved common stocks of high grade, regarded as proper investments for trust funds under the decisions of the Michigan Supreme Court. . . . All such investments are to be with the approval of the Finance Committee” (Exhibit 7). This reference to a so-called “legal list” of “high grade” common stocks reflects the then prevailing trust law in Michigan and throughout much of the country that deemed certain investments as improperly speculative and thus impermissible for trusts per se—that is, as a matter of law. Thus no common stock could be purchased unless it was included in the legal list and with the actual transaction also being approved by the Finance Committee of the Board of Regents.

As a note, the University’s “Endowment Funds” had a book value at this time (1936) of $4.2 million, equivalent to about $73.9 million in 2016 U.S. dollars according to a CPI index adjustment.

Interestingly, just one year later in 1937, the State of Michigan became one of the earlier adopters via statute of the so-called Prudent Man Rule (now known as the Prudent Investor Rule), whereby legal lists for trustees were abolished and the “prudent man” standard (i.e., good fiduciary judgment) was required to be applied instead.[6] Nonetheless, the University practice of using a “Master List” (as it was called) for common stocks did not die so easily—it was probably around this time that the Master List became an internal construct, rather than one mandated by state law and regulation. In fact, as we shall see, the Master List lived on for almost another half century, until November 1986.

By July 1940, the above-described November 1931 resolutions had been recast and incorporated into the University’s Bylaws as Sections 3.16 and 3.17 (Exhibit 8). In July 1945, the Bylaws were again recast and renumbered, with technical changes (Exhibit 9).

It is interesting to note that during the years of World War II, 1939 to 1945, the Reports of Investments do not appear to contain a single reference to this great war. What a different time! Currently, even minor political crises (certainly relative to World War II) tend to give rise to profuse economic and market analyses. One can come up with various reasons why this might be the case: the ways in which the media has changed, the ways in which investing has changed, and the ways in which investments are viewed has changed. A full analysis would take us beyond the scope of this book.

In the minutes of the February 1952 meeting of the Board of Regents, there is a short but important reference. The Board

This defining event marks the University’s initial entry into the era of modern investment management. It occurs 15 years after the adoption by the State of Michigan of the Prudent Man Rule (now more commonly known as the Prudent Investor Rule), not quite 20 years after the passage of the Securities Act of 1933 and of the Securities Exchange Act of 1934, and in the very same year that Harry Markowitz published his seminal paper on Modern Portfolio Theory in the Journal of Finance. Also, this is the first reference we discovered to an outside investment adviser being formally engaged on an ongoing basis by the University.

One might infer that prior to 1952 it was the University’s Investment Office that was, with the approval of the Finance Committee, directly involved in selecting most of the University’s securities, perhaps with occasional outside consultations—with a reiteration that in any case there would have been a limited amount of purchases of equities. After 1952, with the appointment of NBD, there began a trend whereby the Investment Office became more focused on selecting advisors and vehicles, and setting strategy and asset allocation, rather than on selecting the securities themselves.

A few months later, in May 1952, and perhaps related to the new relationship with NBD, the Bylaws relating to investing (now renumbered) were again amended, removing the requirement for Finance Committee approval of all investment transactions. However, all transactions were still to be reported to the Board of Regents at the following meeting (Exhibit 11). Nonetheless, as we shall see, despite this revision of the Bylaws, it seems that the Board of Regents continued ratifying investment transactions after the fact, as well as changes to the Master List. But perhaps the processes were simplified at this time.

A May 1952 report (see Exhibit 5) disclosed that the University now held 13% of its endowment funds in common stock. It recommended an “Intermediate Objective” for the next 2 to 3 years that included a target of 35% to common stocks. A “Possible Long-Term Objective” targeted a 45% allocation to common stocks. Though not termed as such, these objectives could be thought of as a predecessor to the current concept of Model Portfolio. In this connection, it is interesting to note that the University reviewed “a study of twelve large endowment funds of educational institutions [that] was presented at a meeting of the Central Association of College and University Business Officers”—an early example of benchmarking to other institutions. At this point in time, the University of Michigan was significantly “behind” in its equity allocation as compared to other higher education institutions, which averaged 43% as of the end of 1951—in general, private institutions were earlier investors in equity securities than public ones.

In June 1953, the Board of Regents unitized the Consolidated Endowment Fund (CEF). Like with a mutual fund, University departments and other units with an interest in the CEF would now hold internal “shares” that could be acquired or redeemed. This change would serve to ease and make uniform the accounting, administration, and investment of endowment monies. To this day, all major University portfolios are unitized.

In 1958, the U.S. Congress created the Small Business Investment Company (SBIC) program to facilitate the flow of long-term capital to America’s small businesses. The creation of the SBIC program was a seminal step in the development of the professional venture capital industry. As we shall see, decades later the University would participate as an investor in this new, as well as other new, asset classes, as the University diversified into alternative investments.

In February 1968, all of the University’s Bylaws were reorganized, but with no significant changes to the investment Bylaws. In July 1968, the Bylaws were tweaked to relax the resolution specifying which two officers could execute purchases and sales (Exhibit 12). Also in 1968, the Report of Investments finally stopped listing individual endowments. As a result, this 1968 report went down to 7 pages in length from 102 pages the prior year, though the length would again increase in the future.

In December 1969, the Board of Regents approved the creation of a new, separate investment pool within the endowment (Exhibit 13). The June 30, 1970 Report of Investments explained that this new pool, termed “Funds Functioning as Endowments” or, alternatively, “Total Return Fund,” would be “operated on the ‘Total Return’ concept.”[7] This development represents (i) the first point in time the University would explicitly start managing a portion of its investment funds on a total return, as opposed to income, basis and (ii) the birth of the concept of identifying funds that are not “true” endowment funds, but which will nonetheless be managed for the very long term in parallel with permanent endowment funds. This same concept would be extended in 1994 to an investment by the University’s operating funds, at that time called the “University Investment Pool,” or UIP. These investments of nonendowment funds into the endowment portfolio are now commonly termed “quasi-endowments.”

In 1970, still 6 years before the passage of the Uniform Management of Institutional Funds Act (UMIFA, see below), the University was still operating under the legal advice that it was not permissible to invest “true” endowment funds on a total return basis, so, wanting to adopt the total return approach to the extent permissible, it segregated funds that were not “true” endowments in order to do so. As we shall see, by the early 1980s, all of the University’s funds would be invested on a total return basis.

Now we turn to two areas of investment policy that the Board of Regents has retained to this day: proxy voting and divestment policy. Both of these areas lay dormant as a subject of active engagement until the turbulent era of the 1970s.

In April 1971, the Board of Regents addressed proxy voting in connection with “Campaign GM” initiated by Ralph Nader and driven by automotive safety concerns. This campaign has been called by some the inauguration of the consumer movement for corporate responsibility. One of the campaign’s initiatives involved proxy voting resolutions. At this time the Board of Regents reviewed, and reaffirmed, the University’s policy on voting proxies (Exhibit 14).

This policy, although refined over time, has not changed substantially and states, in summary, that the University votes on specific items with management, unless voting with management would be against the financial interest of the University, in which case the University would vote against management or consider selling its position. There has to date never been a general consideration of social or political issues in connection with proxy voting unless the Board of Regents has given specific direction. Thus the University did not support the Campaign GM resolutions, stating:

In 1978, the Board of Regents considered its first divestment proposal in connection with Apartheid in South Africa.[8] An extended examination of the complex history of this issue, which played out over years and appeared to be contentious, is beyond the scope of this book; however, we do summarize the deliberations because important policy, still in place to this day, was set at this time.

In March 1978, the Board of Regents stopped short of directing full divestiture from South Africa but adopted numerous related resolutions, as well as affirmed the so-called Sullivan Principles, as recommended in a report on “Investment Policies and Social Responsibility” presented by the Senate Assembly Advisory Committee on Financial Affairs (Exhibit 15). Importantly, these resolutions in effect set a general policy and process for consideration by the Board of Regents of social investing issues, to be applied going forward:

Six months later, in September 1978, the Board of Regents considered a motion to study whether the University should form a standing (permanent) “investment advisory committee on social responsibility and investment policy”—in contrast to the ad hoc approach they had approved 6 months earlier (Exhibit 16). The motion did not pass. One Regent felt that

In 1982, the Michigan legislature passed Act 512, which in effect required the University of Michigan to divest from companies operating in South Africa. At the April 1983 meeting, the Board of Regents in fact finally voted to divest—except, that is, from corporations headquartered in Michigan. Although one Regent stated that “the reason why the majority of the Board determined to divest from South Africa was because they truly felt it was the best thing to do. Not because the legislature told the University to do it,” it is clear that the legislative action had a critical impact in terms of the balance of power among Regents with respect to this issue. One Regent lamented “the tragic result of the . . . viral political infection from Lansing . . . politicizing . . . this University for international political goals” (Exhibit 17). Yet at the same time that the Board of Regents voted to divest, it also voted to mount a constitutional challenge to the legislative action, on the basis that the State of Michigan did not have constitutional authority to dictate investment policy to the University of Michigan. Five years later, the University won; see Regents of the University of Michigan v. State of Michigan, 166 Mich. App. 314 (1988) (Exhibit 18).

One Regent noted a perennial argument against divestment proposals (see Exhibit 17):

According to the notes from the November 1985 meeting (see Exhibit 32), as a result of the divestment directive, “the University was excluded [from] two-thirds of the Standard and Poor’s 500 stock index because of the limitations of the South African divestment policy.” If this is accurate, the impact on the University’s portfolio and investment choices must have been substantial. In fact, the South African divestment restrictions were in place until November 1993, a full 10 years of operating a South Africa–­constrained portfolio (Exhibit 19)! These restrictions had a notable impact on the University’s investment returns during this period. As the meeting notes of the Investment Advisory Committee[9] from February 1991 noted:

There is logic to the fact that an elected Board of Regents has retained authority over these two areas of potentially high public visibility—proxy voting and divestment. As can be seen from the described examples, they are two areas of investment policy with potential implications that extend beyond purely financial considerations of the portfolios (such as risk/return profile, asset allocation, and diversification), so it is logical that the Board of Regents, as the ultimate arbiter of University policies, retains its power of review in these areas.

In 1976, the State of Michigan became an early adopter of UMIFA, first promulgated in 1972 by the National Conference of Commissioners on Uniform State Laws (Exhibit 20).[10] The driving idea was to codify in a uniform way for the nonprofit sector the Prudent Investor Rule, which had already replaced the legal lists in many U.S. states. This rule had also been in effect codified under the Employee Retirement Income Security Act of 1974 (ERISA), the federal law regulating private pensions. Whereas previously nonprofit institutions in the management of their funds had generally been subject to the broader case law of trusts, now they would be governed by a statute customized to their particular circumstances and issues.

Among other things, UMIFA provisions made it clear that a “governing board” (in the case of the University of Michigan, the Board of Regents) could invest in pooled vehicles where “investment determinations are made by persons other than the governing board” and could “delegate to its committees, officers, or employees of the institution or the fund, or agents, including investment counsel, the authority to act in place of the board in investment and reinvestment of institutional funds.”

Again moving away from historical trust law, UMIFA also restated a governing board’s standard of care as being one of “ordinary business care and prudence under the facts and circumstances prevailing at the time of the action or decision.” The accompanying comment to the model code explained that this “standard is generally comparable to that of a director of a business corporation rather than that of a private trustee.” Historical trust law generally contained standards of care that were more onerous and less flexible for trustees.

These provisions in UMIFA explicitly allowed for the delegation of investment decision making and the ability to invest in pooled vehicles and corporatized the standard of care—both natural consequences of the reality of investment management becoming more complex, international, and professionalized, with more options, securities, alternative investments, specializations, asset classes, countries, and currencies from which to choose.

Finally, a provision of UMIFA authorized the governing board to

This was another key, and together with additional provisions in UMIFA permitting the broad interpretation of the language in gift instruments, it opened the door for the adoption by institutions of the total return approach to investment and distribution policy. Although, as previously described, the University of Michigan had already taken steps in that direction, it would go fully total return in November 1986.

Thus Michigan’s passage of UMIFA set the stage for and enabled the big changes that were to come in the following two decades in the management and oversight of the University’s investments.

As a first step, in November 1978, the Board of Regents appointed the Financial Control Systems Division of Michigan Corporation, later known as the Wellesley Group, “to evaluate the investment programs of the University’s endowment funds.” This is the first reference we found to the engagement of what we now term “investment consultants.”