The Law of Gravity

What goes up indeed comes down. Following the breathtaking 32.2 percent return on investments for the fiscal year ended June 30, 2000, Harvard Management Company (HMC) reported this September that endowment performance for the succeeding 12 months, after all expenses, was -2.7 percent. Perhaps a second law, about history repeating itself, is at work as well: the only prior year in which investment return was negative was 1984--following HMC's record performance in 1983.

The change in direction could hardly surprise anyone who paid attention to an environment that HMC president Jack R. Meyer, M.B.A. '69, characterized as "harsh" during the fiscal year, with "sharply negative" returns for "all the major equity markets, including private equity." The latter category includes venture capital, which propelled the outsized gains in the prior year (see "Rocketing Returns," November-December 2000, page 78).

What may be surprising--and reassuring--is how well HMC's fund managers did under adverse conditions. The -2.7 percent endowment return exceeded the aggregate performance of HMC's "policy portfolio" (the weighted mix of different kinds of assets used to guide its investment decisions) by 7.1 percentage points, the second-largest margin in HMC's history. Had the endowment declined in line with the -9.8 percent return of its market benchmarks, Harvard would be $1.4 billion poorer.

In fact, the endowment's value declined to approximately $18.3 billion at the end of June from $19.1 billion a year earlier. The negative investment return accounted for about $500 million of the decline in value. A larger factor was the roughly $615 million in endowment income disbursed to support the University's operations in fiscal 2001, offset in part by $300 million of new endowment gifts. Fiscal year 2001 concludes a decade of HMC operations in their current form. During that time, annualized investment return has averaged 16.5 percent--3.5 percentage points better than benchmark returns, and 4.6 percentage points above the median return for comparable large institutional investment funds. That performance, Meyer observed, produced an endowment $7.4 billion larger than if HMC had earned only median returns.

Although he characterized the negative investment return as "disappointing," Meyer said he was "very pleased that we managed to outperform our benchmarks by a large margin--otherwise, this would have been a pretty serious down year."

As noted, benchmark returns were negative for all categories of equity investments, but HMC's large domestic and foreign equity portfolios--accounting, in total, for more than one-third of assets--avoided the worst damage, returning, respectively, -4.6 percent (versus a market return of -10.9 percent) and -16.9 percent (-23.3 percent for the market). Emerging-market assets actually had a positive return of 3 percent, 17.2 percentage points better than the market, as a strategy involving discounted closed-end funds proved highly successful.

Private equities, where Harvard's 155.2 percent return in fiscal 2000 exceeded the market by more than 100 percentage points, this year underperformed a sharply declining market by a small margin. Over the course of an astonishing three-year venture-capital cycle, Meyer said, HMC's private-equity investments paid off enormously; even with the recent losses, he noted, HMC's inability to invest as much as it wanted to in this asset class early in the cycle reduced returns by a significant amount.

As one would expect in a period of slowing economic activity, HMC's fixed-income investments (about one-fifth of assets) performed very positively; Meyer called 2001 "a bond year." Domestic bonds returned 19.1 percent, nearly double the benchmark. Foreign bonds returned 13.2 percent, sharply better than the benchmark losses for that asset class, and the best such relative performance in memory. And inflation-indexed bonds matched their positive benchmark.

If HMC had a single remarkable result in the past year, it was recorded in the "absolute return" asset class--hedge funds, whose managers can pursue diverse strategies such as buying stocks or selling them short, trading currencies, or engaging in arbitrage. HMC's leading absolute-return fund manager is Highfields Capital Management, run by Jonathon S. Jacobson, M.B.A. '87, a former star at HMC who set up shop on his own in 1998. During the past year, absolute-return funds earned 26.9 percent--the best return for any asset class, and more than 35 percentage points better than the benchmark result. Meyer called it an "extraordinary" performance. If there is a downside, he noted, it is that hedge funds remain an attractive option for HMC's professional fund managers, complicating efforts to retain Harvard's staff.

Rounding out the endowment results, high-yield investments narrowly exceeded benchmark returns, but were negative; commodities, including timber, returned 4.2 percent in a slightly down market; and the real-estate portfolio returned 10.2 percent, a percentage point less than estimated market returns, perhaps reflecting conservatism in Harvard's appraisals at the end of the fiscal year.

Overall, Meyer declared himself "delighted that we had a good value-added year." He might have added that sustaining such performance may well be even more important in the current environment. Without speculating on the effects of gravity on investing or on the relevance of history for future returns, Meyer, writing two weeks after the September 11 terrorist attacks threw the financial markets into disarray, cautioned about the possibility of "a considerable period of disappointing returns."

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