Capital in the Twenty-First Century (79 page)

It is interesting to note that the year-to-year volatility of these returns does not
seem to be any greater for the largest endowments than for the smaller ones: the returns
obtained by Harvard and Yale vary around their mean but not much more so than the
returns of smaller institutions, and if one averages over several years, the mean
returns of the largest institutions are systematically higher than those of the smaller
ones, with a gap that remains fairly constant over time. In other words, the higher
returns of the largest endowments are not due primarily to greater risk taking but
to a more sophisticated investment strategy that consistently produces better results.
²⁹

How can these facts be explained? By economies of scale in portfolio management. Concretely,
Harvard currently spends nearly
$
100 million a year to manage its endowment. This munificent sum goes to pay a team
of top-notch portfolio managers capable of identifying the best investment opportunities
around the world. But given the size of Harvard’s endowment (around
$
30 billion),
$
100 million in management costs is just over 0.3 percent a year. If paying that amount
makes it possible to obtain an annual return of 10 percent rather than 5, it is obviously
a very good deal. On the other hand, a university with an endowment of only
$
1 billion (which is nevertheless substantial) could not afford to pay
$
100 million a year—10 percent of its portfolio—in management costs. In practice, no
university pays more than 1 percent for portfolio management, and most pay less than
0.5 percent, so to manage assets worth
$
1 billion, one would pay
$
5 million, which is not enough to pay the kind of specialists in alternative investments
that one can hire with
$
100 million. As for North Iowa Community College, with an endowment of
$
11.5 million, even 1 percent a year would amount to only
$
115,000, which is just enough to pay a half-time or even quarter-time financial advisor
at going market rates. Of course a US citizen at the median of the wealth distribution
has only
$
100,000 to invest, so he must be his own money manager and probably has to rely on
the advice of his brother-in-law. To be sure, financial advisors and money managers
are not infallible (to say the least), but their ability to identify more profitable
investments is the main reason why the largest endowments obtain the highest returns.

These results are striking, because they illustrate in a particularly clear and concrete
way how large initial endowments can give rise to better returns and thus to substantial
inequalities in returns on capital. These high returns largely account for the prosperity
of the most prestigious US universities. It is not alumni gifts, which constitute
a much smaller flow: just one-tenth to one-fifth of the annual return on endowment.
³⁰

These findings should be interpreted cautiously, however. In particular, it would
be too much to try to use them to predict how global wealth inequality will evolve
over the next few decades. For one thing, the very high returns that we see in the
period 1980–2010 in part reflect the long-term rebound of global asset prices (stocks
and real estate), which may not continue (in which case the long-term returns discussed
above would have to be reduced somewhat in the future).
³¹
For another, it is possible that economies of scale affect mainly the largest portfolios
and are greatly reduced for more “modest” fortunes of 10–50 million euros, which,
as noted, account for a much larger share of total global wealth than do the
Forbes
billionaires. Finally, leaving management fees aside, these returns still depend
on the institution’s ability to choose the right managers. But a family is not an
institution: there always comes a time when a prodigal child squanders the family
fortune, which the Harvard Corporation is unlikely to do, simply because any number
of people would come forward to stand in the way. Because family fortunes are subject
to this kind of random “shock,” it is unlikely that inequality of wealth will grow
indefinitely at the individual level; rather, the wealth distribution will converge
toward a certain equilibrium.

These arguments are not altogether reassuring, however. It would in any case be rather
imprudent to rely solely on the eternal but arbitrary force of family degeneration
to limit the future proliferation of billionaires. As noted, a gap
r
−
g
of fairly modest size is all that it takes to arrive at an extremely inegalitarian
distribution of wealth. The return on capital does not need to rise as high as 10
percent for all large fortunes: a smaller gap would be enough to deliver a major inegalitarian
shock.

Another important point is that wealthy people are constantly coming up with new and
ever more sophisticated legal structures to house their fortunes. Trust funds, foundations,
and the like often serve to avoid taxes, but they also constrain the freedom of future
generations to do as they please with the associated assets. In other words, the boundary
between fallible individuals and eternal foundations is not as clear-cut as is sometimes
thought. Restrictions on the rights of future generations were in theory drastically
reduced when entails were abolished more than two centuries ago (see
Chapter 10
). In practice, however, the rules can be circumvented when the stakes require. In
particular, it is often difficult to distinguish purely private family foundations
from true charitable foundations. In fact, families often use foundations for both
private and charitable purposes and are generally careful to maintain control of their
assets even when housed in a primarily charitable foundation.
³²
It is often not easy to know what exact rights children and relatives have in these
complex structures, because important details are often hidden in legal documents
that are not public. In some cases, a family trust whose purpose is primarily to serve
as an inheritance vehicle exists alongside a foundation with a more charitable purpose.
³³
It is also interesting to note that the amount of gifts declared to the tax authorities
always falls drastically when oversight is tightened (for example, when donors are
required to submit accurate receipts, or when foundations are required to submit more
detailed financial statements to certify that their official purpose is in fact respected
and private use of foundation funds does not exceed certain limits), confirming the
idea that there is a certain porosity between public and private uses of these legal
entities.
³⁴
Ultimately, it is very difficult to say precisely what proportion of foundations
fulfill purposes that can truly be characterized as being in the public interest.
³⁵

The results concerning the returns on university endowments suggest that it may also
be useful to say a few words about the pure return on capital and the inegalitarian
effects of inflation. As I showed in
Chapter 1
, the rate of inflation in the wealthy countries has been stable at around 2 percent
since the 1980s: this new norm is both much lower than the peak inflation rates seen
in the twentieth century and much higher than the zero or virtually zero inflation
that prevailed in the nineteenth century and up to World War I. In the emerging countries,
inflation is currently higher than in the rich countries (often above 5 percent).
The question, then, is the following: What is the effect on returns to capital of
inflation at 2 percent or even 5 percent rather than 0 percent?

Some people think, wrongly, that inflation reduces the average return on capital.
This is false, because the average asset price (that is, the average price of real
estate and financial securities) tends to rise at the same pace as consumer prices.
Take a country with a capital stock equal to six years of national income (
β
=
6) and where capital’s share of national income equals 30 percent (
α
=
30%), so that the average return on capital is 5 percent (
r
=
5%). Imagine that inflation in this country increases from 0 to 2 percent a year.
Is it really true that the average return on capital will then decrease from 5 percent
to 3? Obviously not. To a first approximation, if consumer prices rise by 2 percent
a year, then it is probable that asset prices will also increase by 2 percent a year
on average. There will be no capital gains or losses, and the return on capital will
still be 5 percent. By contrast, it is likely that inflation changes the distribution
of this average return among individual citizens. The problem is that in practice
the redistributions induced by inflation are always complex, multidimensional, and
largely unpredictable and uncontrollable.

People sometimes believe that inflation is the enemy of the rentier and that this
may in part explain why modern societies like inflation. This is partly true, in the
sense that inflation forces people to pay some attention to their capital. When inflation
exists, anyone who is content to perch on a pile of banknotes will see that pile melt
away before his eyes, leaving him with nothing even if wealth is untaxed. In this
respect, inflation is indeed a tax on the idle rich, or, more precisely, on wealth
that is not invested. But as I have noted a number of times already, it is enough
to invest one’s wealth in real assets, such as real estate or shares of stock, in
order to escape the inflation tax entirely.
³⁶
Our results on university endowments confirm this in the clearest possible terms.
There can be no doubt that inflation of 2 percent rather than 0 percent in no way
prevents large fortunes from obtaining very high real returns.

One can even imagine that inflation tends to improve the relative position of the
wealthiest individuals compared to the least wealthy, in that it enhances the importance
of financial managers and intermediaries. A person with 10 or 50 million euros cannot
afford the money managers that Harvard has but can nevertheless pay financial advisors
and stockbrokers to mitigate the effects of inflation. By contrast, a person with
only 10 or 50 thousand euros to invest will not be offered the same choices by her
broker (if she has one): contacts with financial advisors are briefer, and many people
in this category keep most of their savings in checking accounts that pay little or
nothing and/or savings accounts that pay little more than the rate of inflation. Furthermore,
some assets exhibit size effects of their own, but these are generally unavailable
to small investors. It is important to realize that this inequality of access to the
most remunerative investments as a reality for everyone (and thus much broader than
the extreme case of “alternative investments” available only to the wealthiest individuals
and largest endowments). For example, some financial products require very large minimum
investments (on the order of hundreds of thousands of euros), so that small investors
must make do with less profitable opportunities (allowing intermediaries to charge
big investors more for their services).

These size effects are particularly important in regard to real estate. In practice,
this is the most important type of capital asset for the vast majority of the population.
For most people, the simplest way to invest is to buy a home. This provides protection
against inflation (since the price of housing generally rises at least as fast as
the price of consumption), and it also allows the owner to avoid paying rent, which
is equivalent to a real return on investment of 3–4 percent a year. But for a person
with 10 to 50 thousand euros, it is not enough to decide to buy a home: the possibility
may not exist. And even for a person with 100 or 200 thousand euros but who works
in a big city in a job whose pay is not in the top 2 or 3 centiles of the wage hierarchy,
it may be difficult to purchase a home or apartment even if one is willing to go into
debt for a long period of time and pay a high rate of interest. As a result, those
who start out with a small initial fortune will often remain tenants, who must therefore
pay a substantial rent (affording a high return on capital to the landlord) for a
long period of time, possibly for life, while their bank savings are just barely protected
from inflation.

Conversely, a person who starts out with more wealth thanks to an inheritance or gift,
or who earns a sufficiently high salary, or both, will more quickly be in a position
to buy a home or apartment and therefore earn a real return of 3–4 percent on their
investment while being able to save more thanks to not having to pay rent. This unequal
access to real estate as an effect of fortune size has of course always existed.
³⁷
One could conceivably circumvent the barrier by buying a smaller apartment than one
needs (in order to rent it) or by investing in other types of assets. But the problem
has to some extent been aggravated by modern inflation: in the nineteenth century,
when inflation was zero, it was relatively easy for a small saver to obtain a real
return of 3 or 4 percent, for example by buying government bonds. Today, many small
savers cannot enjoy such returns.

To sum up: the main effect of inflation is not to reduce the average return on capital
but to redistribute it. And even though the effects of inflation are complex and multidimensional,
the preponderance of the evidence suggests that the redistribution induced by inflation
is mainly to the detriment of the least wealthy and to the benefit of the wealthiest,
hence in the opposite direction from what is generally desired. To be sure, inflation
may slightly reduce the pure return on capital, in that it forces everyone to spend
more time doing asset management. One might compare this historic change to the very
long-run increase in the rate of depreciation of capital, which requires more frequent
investment decisions and replacement of old assets with new ones.
³⁸
In both cases, one has to work a little harder today to obtain a given return: capital
has become more “dynamic.” But these are relatively indirect and ineffective ways
of combating rent: the evidence suggests that the slight decrease in the pure return
on capital due to these causes is much smaller than the increase of inequality of
returns on capital; in particular, it poses little threat to the largest fortunes.