How to Short the Higher Education Bubble

You know the return on investing in college is low and declining. You know there are better alternatives to college. You know that “college for all” harms students—Harvard says so!

Some day, the education bubble will burst. How can you trade this?

(If you happen to think that degrees are undervalued, either as an investment or as collateral, feel free to use this as a cheat sheet for making that bet, too. It takes two to make a market.)

Short For-Profit Schools and Student Loan Companies

If you had to sum up the education bubble in one misconception, it might be: “The average 22-year-old is a good credit risk for $150,000 in debt, collateralized by something completely intangible.”

Tragically, there aren’t very many companies built on this premise. The money-good nature of student borrowers was enforced by government insurance, and few companies made it a specialty to lend to students without these inducements. The “College Cost Reduction and Access Act” and the “Health Care and Education Reconciliation Act” got rid of these subsidies, and the credit crisis led to a general shakeout, so it’s tough to find a company with lots of non-insured loans on the books. Nelnet, for example, lists uninsured loans as <1% of assets.

About 20% of SLM’s assets are in private loans. That’s better, especially since that’s where they expect most of their growth to come from. It would take a serious wave of defaults to actually cause SLM distress, and those defaults won’t come all at once even if college degrees do become worse collateral.

A more direct short is the for-profit education industry. They’ve already been shorted heavily, and some of these schools could benefit from the bubble popping if more people chose vocational schools. Regardless of which one you short, you’re getting in behind lots of savvy investors who will want to cover at some point.

Invest in Countries With Saner Higher Ed Systems

Australia has the low-hanging fruit we had 200 years ago: land and natural resources. So their economy looks a lot more like that of a country on the way up, rather than a status-seeking/rent-seeking culture like ours.

This LessWrong piece talks up the benefits of working in Australia, including low taxes, a growing economy, some guest worker-friendly retirement policies, and a laid-back attitude towards college degrees and other such credentials. They also pay truck drivers $145K/year.

Japan is another possibility. As In Praise of Hard Industries argues, their industrial policy was deliberately designed to create jobs for high school-educated workers, not just smart engineers. A country with that kind of policy will have a saner labor market, even if their superficial problems still drag down current performance.

Tilt Your Portfolio Towards Natural Resources

Dylan Grice at Societe Generale says When you buy commodities, you’re shorting human ingenuity. Fair enough.

A world in which college is a good investment, on the margin, is a world in which human capital is under-exploited and natural resources are over-exploited. In that world, continuous innovation will reduce our costs in terms of physical resources, leading to lower commodity prices.

If we’re over-investing in human capital when we need resources instead, that will lead to supply shocks eventually. A resource-heavy portfolio can be a great defense.

Short Second-Tier Companies in “Prestige” Industries

Goldman Sachs, McKinsey, and Google all prize well-educated employees. But they don’t have to chase them. But their competitors do need to chase them. These are the companies that are most likely to overvalue credentials. Goldman Sachs can attract the very best Harvard grads, but a smaller bank without the budget or the brand name will still try to find people who appear prestigious. If the best people are hired by top companies, the ones who are left are worse than their credentials make them appear.

The thesis of this short sale isn’t that these companies will collapse, but that as long as society overvalues college, they will bear the brunt of that problem. Even worse, many of these companies are in the labor arbitrage business: they sell employee time by the hour. That makes them especially vulnerable to anything that causes them to persistently overpay for workers.

The easy way to construct this portfolio: take a list of software companies, consulting companies, and investment banks. Order them by revenue per employee. And short the bottom half.

Invest in Test Prep Companies

What’s the easiest replacement for a college degree? Steve Hsu has a hint:

When I was on the faculty at Yale I knew people in admissions and it’s not clear to me that they were the best able to spot potential in 18 year olds. In studies of expert performance admissions people are less good at predicting UG GPA than a simple algorithm. (The “algorithm” is simply a weighted sum of SAT and HS GPA!)

If test scores and GPA give employers most of the information that four years of college would, that means that great test scores are the best short-term substitute for a college degree. And that means lots of people prepping for their SATs.

Invest in Dropouts

The best technology companies seem to be founded by college dropouts and PhDs. By the time these companies go public, their founders’ credentials are basically meaningless. But at the earlier stages, lacking a college degree can be a serious impediment to getting a job or raising money for a business.

It’s a bad idea to blindly bet on college dropouts. Many people drop out because they simply can’t handle the work. In that case, they’re a symptom of the bubble (dropout rates have risen as it’s gotten easier to borrow money—and as degrees have gotten more common).

But dropouts with a few years of job experience are undervalued by the job market. Large companies’ HR departments will automatically reject them, but they don’t have the personal networks necessary to get their résumés in front of the right people any other way.

This isn’t an “investment” strategy per se; it’s not going to show up in a broker’s monthly statement. But it’s a way to use lifestyle decisions to hedge against risks, like buying a Prius instead of buying oil futures.

The Usual Caveats

The market can stay irrational longer than you can stay solvent.

That’s a feedback loop problem: people making bad decisions ought to lose money, but it’s entirely possible for someone to buy an overpriced house or an overpriced e-commerce play and still come out ahead in the short term.

The education bubble faces a different problem entirely: basically everybody in charge got their money’s worth from a college degree. Take a look at the board of directors at SLM or NelNet; you won’t find many University of Phoenix graduates. Most educated people have a disproportionate number of educated friends, so their personal experience will consist entirely of smart people for whom college was a good option.

So not only can the market stay rational, but that Ivy-educated market can rationalize like crazy.

The Short Higher Ed Portfolio

It’s not smart to build a portfolio around a single undiversified bet. When he wanted to short housing, John Paulson created a separate investment vehicle; Scion capital never invested more than a small percentage of its assets in CDS trades, even when Michael Burry was convinced that it was an obvious trade.

So a portfolio shorting higher education will look a lot like a typical portfolio. But it will be:

• Underweight finance, and possibly short SLM.

• Possibly short for-profit education companies, but long test prep companies.

• A bit more international than most, with a special emphasis on Australia and Japan.

• Long natural resources, especially energy.

• Long elites (Goldman, Google), short sub-elites (smaller banks, consulting companies).

It’s a slightly depressing portfolio, actually: if this works out, the rich will get richer, the poor will lose some hope for upward mobility, we’ll all pay more for gas, and the sheepskin industry will be devastated.

That’s just one more reason to short higher education. We’d all like to live in a world where human capital is worth investing in, and where we’ll have both material abundance and a smarter, happier populace. So think of this portfolio as a hedge against a sadder future.

Full Disclosure: The author currently has no position in any of the securities mentioned in this piece. That could change without notice. Consult a financial advisor before making any trades, do your due dilligence, etc. The author is a college dropout, and considers the decision prudent. The author does not speak for his employer.

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| February 15th, 2011 | Posted in economics |
  • ParkGrades

    So I’m thinking: Move to Australia to start a natural resources firm, staffed by college drop outs.

    Nice work!

  • Scott Locklin

    Only thing I’d argue with: I think smaller IB’s which don’t rely on pedigree will do better in the long run than Goldman. Example: Jefferies. But I’m an extreme education bubble (and oligarchy) pessimist.

  • byrneseyeview

    It’s not a direct relationship; if I were putting together a real portfolio
    based on this, I wouldn’t do the revenue per employee thing; I might use
    LinkedIn to find out which companies had lots of Ivy-League employees, but
    tended not to get people poached by better banks or by hedge funds.

    There are other signals, too:

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  • Joe101

    Clearly there is a tremendous miss-allocation of resources here. Large numbers of people acquiring very lager amounts debt for an essentially worthless degree that they have no hope of ever paying off. Worse they wind up with endless fees and penalties that grow the debt.

    One question I have Is who will take hit when it becomes clear they will never pay off the debt or is this a real issue?

    It seems to me very hard to short this outright. An anemic economy is one result but we are at this point already

    Here is a thought, this debt is a persistence drag that is very clearly getting worse. Politicians take the put out the fire by pouring more gasoline on it approach. They continue to make this situation worse buy pumping more money into this mess. It would not shock me if some kind of debt forgiveness is given out by some future politician. A second derivative bet on the consequences of this?