Editor’s Note: Today’s story — a look at the financial investments that make up the University’s endowment, the individuals that manage it and the kinds of strategies they employ — is the first in the Daily’s four-part “Anatomy of an Endowment” series. Subsequent stories in the series will try to answer other important questions about the endowment, like why more endowment funds can’t be used for financial aid, how the global financial crisis will impact the endowment and how the University’s investors take into account social responsibility and ethics when investing the endowment’s funds. By the end of the series, our goal is to have dissected, described and analyzed in simple terms a massive, intricate financial portfolio — one that is critical to the University’s success.

It’s often said that the University of Michigan, the state’s flagship institution of higher education, is about as close to a private school as a public university can get.

On the one hand, this can be attributed to the University’s impressive alumni base and the fundraising success that comes with such a vast alumni network — both characteristics of elite private universities.

But declining state funding has pushed the University further in the private direction. Since the 2002 fiscal year, annual appropriations funding from the state government has decreased almost $97 million when measured for inflation.

As a result, the University has been forced to rely more than ever on its multi-billion-dollar endowment to fund its academic departments, provide financial aid for students, pay for other University operations and essentially keep the University in business.

Yet despite the endowment’s increasingly vital importance to the University, very few people understand what the endowment is, what it’s comprised of, how it functions, who manages it and, most of all, how decisions are made concerning how much of those billions of dollars can be spent at any given time.

“Almost the entire public doesn’t understand what endowments are,” said University President Mary Sue Coleman in an interview last fall. “Very, very intelligent people, you know, some of our donors will say to me, ‘Well, why don’t you just spend more of the endowment?’ And I say, ‘Wait, wait, wait. Let me explain it to you.’ ”

Given the dire financial situation facing the state, many wonder how reliable a source of funding state appropriations will be for the University moving forward. And with the endowment compensating for dwindling state funding, it becomes increasingly important that students, faculty, administrators, alumni and everyone else connected to the University understand how the school’s multi-billion-dollar financial backbone actually works.

BILLION-DOLLAR ‘BUCKETS’

Though referred to in the singular, the University’s endowment — temporarily valued at $6.5 billion as of Dec. 31 — is actually made up of over 6,000 different investments.

These investments are organized into asset classes — groupings of similar kinds of investments — or “buckets,” as University Chief Investment Officer Erik Lundberg often calls them.

The first and most recognizable bucket is the endowment’s equities or stock holdings, which made up just over 20 percent of the endowment as of Dec. 31, according to a February investment filing.

The University invests in both domestic and international stocks — the kinds any investor could buy on, say, the New York Stock Exchange. The stocks include online shopping site Amazon.com, oil corporation Exxon Mobil, American automaker General Motors, British military contractor BAE Systems and telecommunications giant AT&T, according to the latest equities data dated June 30. (For a complete listing of the University's endowment equities information for the past five fiscal years, click here.)

So far this fiscal year between July 1 and Dec. 31, the endowment’s equities recorded staggering losses of nearly 37 percent while also posting losses of 6 percent last fiscal year. The University’s investment team has also sought to decrease the amount of stock holdings in the endowment, according to the June 30, 2008 Report of Investments created by the University Investment Office.

The next investment bucket in the endowment is “fixed income,” or otherwise known as bonds. These investments, which comprised almost 9 percent of the endowment as of Dec. 31, are essentially loans on which the University collects interest and, at the end of the loan term, is repaid the principal amount.

Bonds have posted minor losses this fiscal year of almost 1 percent as of Dec. 31. In the 2008 fiscal year, however, bonds recorded gains of 5.1 percent. Like stocks, endowment investments in bonds have also decreased due to the limited gains to be made compared to other types of investments in the endowment’s portfolio, according to the 2008 Report of Investments.

“Absolute return,” the next asset class, is a much more complex grouping of investments. Rather than focusing on a single type of investment, this bucket is grab bag of a number of different investments and strategies employed by University investors and the outside funds with which they work. This bucket includes investments in Treasury bills, high-yield bonds and debt securities of struggling companies as well as corporate events like mergers or company restructurings. The goal for this bucket is to try to post positive gains each quarter — not incredibly high, but always making gains — regardless of how the financial markets are performing.

One strategy used in “absolute return” is “long-short” investing, in which investors buy stocks (otherwise known as taking the long position) known to perform well and sell stocks (known as the short position) performing poorly. As long as the purchased stocks outperform the sold stocks going forward, the investor will gain from the strategy.

Having posted a 10-percent gain in the previous fiscal year, positive returns had almost always been the case for “absolute return” until the current fiscal year as of Dec. 31, in which it has recorded losses of nearly 21 percent.

The endowment also has a “cash” bucket containing cash holdings, which comprised over 3 percent of the endowment as of Dec. 31.

While stocks, bonds and “absolute return” investments are considered liquid assets — meaning they can be converted more quickly and easily into cash — the rest of the endowment consists of illiquid assets, which are often investments in longer term partnerships and agreements.

Venture capital and private equity investments — together making up almost 23 percent of the endowment as of Dec. 31, according to the February investment filing — are two types of illiquid investments.

In the case of venture capital and private equity, the University’s investment team meets with fund managers and investors, learns about their investment strategies and decides whether or not to work with that fund. If the University decides to work with these groups, its investors commit initial money to the fund. Unlike stocks or bonds, however, venture capital and private equity commitments usually span multiple years and sometimes more than a decade, meaning University investors can’t simply yank their money out of a fund if they so desired.