Rewarding failure at Harvard’s endowment

November 21, 2013, 12:44 PM UTC
Photo: Steve Dunwell/Getty

Each spring a familiar ritual plays out at Harvard University. The school reveals how much its endowment’s top investment managers were compensated, and a small group of alumni and faculty complain about it (sometimes privately, sometimes to local media). It’s usually a philosophical argument about how the money could be better spent on other things, or about the intrinsic offense of cutting larger checks to money managers than to educators.

For a bunch of folks affiliated with Harvard, you’d think they could identify the more legitimate cause of protest: Harvard is guilty of overpaying its endowment managers because they haven’t done a very good job. And it is hardly the only school deserving of such a scolding. In many cases the systems are rigged to reward just about any endowment manager who doesn’t burn down the dining hall.

I recently reported on that Harvard ranks dead last among the nation’s 25 largest U.S. college and university endowments in terms of five-year returns. It also was in the bottom third for three-year returns and in the bottom half for one-year returns (ending June 30, 2013). All this follows a fiscal 2012 in which the system placed 22nd out of the top 25. Rather than sheepishly beg forgiveness, however, here is what Harvard’s endowment chief, Jane Mendillo, wrote in last year’s investment report:

“The fiscal year 2012 endowment return was 98 basis points in excess of the -1.03% return on the benchmark Policy Portfolio … Adding value relative to the Policy Portfolio — beating the markets — is not easily done and is not expected every year … we are pleased that the endowment held steady and was able to provide substantial support to the University.”

For the layperson, “98 basis points in excess of the -1.03% return” means that Harvard’s investment return was slightly negative. Yet despite such a putrid performance — in a year that saw not only positive returns for the median university endowment but also for the S&P 500 and the Nasdaq — Harvard gave Mendillo a 67% bump in her annual bonus (up to a whopping $4.18 million, on top of her $1 million annual salary).

To understand such largesse, go back to Mendillo’s mention of the “benchmark Policy Portfolio.” This is a threshold that an endowment’s board of directors, in consultation with its investment managers, sets at the beginning of a fiscal year based on what asset-allocation mix it feels will best serve Harvard’s operational needs. The board then develops what it deems to be appropriate “benchmarks” against which to judge each type of investment for the upcoming year, often via a mix of third-party indexes. Come June 30, everyone whips out his calculator to see if she beat the estimates.

The big problem with this model, of course, is that it completely ignores peer ranking. If you’ve underperformed most (or all) other endowments, it would seem to mean that there have been some serious missteps along the way. Maybe that’s asset allocation, or perhaps the specific benchmarks were chosen too liberally. Yes, each school has a different risk profile, but none would prefer lower returns to higher ones.

Again, Harvard is not alone. Cornell University, for example, had a one-year return for fiscal 2013 that ranked 15 out of the top 25 and significantly underperformed a Bank of New York Mellon benchmark that Cornell cites on its own investment reports. But it still beat its own benchmark handily. Harvard stands out because its $32.7 billion endowment is the nation’s largest — and its investment managers make the most — but this is a systemic issue.

Colleges and universities talk a lot about merit — getting the best grades, playing the best game, publishing the most research. Those triumphs are judged in large part against the accomplishments of others. But when it comes to investment managers, just showing up is often good enough.

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This story is from the December 09, 2013 issue of Fortune.