Endowment Gains: Last Hurrah?

Very strong returns on investment boosted Harvard's endowment $3.3 billion last fiscal year, to a new record of $22.6 billion as of June 30. Harvard Management Company (HMC) reported on September 15 that total investment return for the year was 21.1 percent, up smartly from the 12.5 percent return achieved in the prior fiscal year (see "Rebounding Returns," November-December 2003, page 59). That capped more than a decade of unusually — and perhaps unsustainably — robust results (see "Harvard by the Numbers."

Chart by Stephen Anderson

"Obviously, it was a good year," said HMC president Jack R. Meyer, M.B.A. '69. He cited both the absolute return on invested assets ("It's hard to complain about 21 percent") and the value added by the investment professionals, whose aggregate return exceeded benchmark measures of market performance by 4.7 percentage points ("About a billion dollars — that's a big number and gratifying"). He also noted that HMC's results exceeded the median performance of a universe of large institutional funds by nearly 5 percentage points, and of the 25 largest university endowments by about 4 percentage points.

Meyer highlighted the consistent performance across HMC's investments: in 9 of 11 asset classes, Harvard's funds exceeded the market benchmark. (During the past decade, for all nine categories with 10-year histories, HMC managers have outperformed their market benchmarks.) In a strong market, all classes of equities, which typically make up about 45 percent of endowment assets, produced robust returns — from 20.8 percent for private equities to 36.6 percent for emerging-markets investments (see chart) — and exceeded market returns, albeit narrowly.

Domestic and foreign bond portfolios (together, about one-sixth of total assets) exceeded their benchmarks by 12.6 and 9.8 percentage points, respectively. The fixed-income portfolio managers, Meyer said, "continued to hit the ball out of the park" in an interest-rate environment completely different from that prevailing in fiscal year 2003 — a vivid demonstration, he maintained, that their performance is based on technical trading strategies, not on making interest-rate bets or assuming extra credit risk relative to the market overall.

The only sectors where HMC lagged were in high-yield investments and real estate. In the former, Meyer said, two out of three strategies did well, but an absolute-return portfolio focused on bankruptcies underperformed. Real-estate investments, premised on improvement of acquired properties, did slightly less well than funds focused on existing top-quality buildings.

The value of the endowment reflects not only investment returns, but also the flow of funds in and out — and those capital changes are increasingly large. As a rough calculation, from the $19.3 billion value at June 30, 2003, about $810 million was distributed to support University programs, and $90 million more was applied to Allston-related activities (a special annual distribution from capital gains). Investment returns and nearly $258 million in gifts for endowment then yielded the 2004 total of $22.6 billion.

The 21.1 percent total return was calculated, as always, after all expenses and — in language new to this year's report — "negotiated fee offsets." Since the late 1990s, an increasing share of endowment assets has migrated from in-house HMC professionals to outside investment firms formed by successful HMC staff who have set up shop on their own. HMC has maintained its access to their expertise by assigning them a portion of the endowment assets to invest and, in return, sharing in their firms' growth, effectively lessening the fees Harvard pays.

That trend is notable for two reasons. First, Meyer said, the newest departure of HMC portfolio managers for greener pastures (the foreign-equity and commodities professionals) brings the portion of funds managed internally down to about 50 percent (from 80 to 85 percent in the late 1990s). That naturally prompts discussion about whether HMC will remain a stand-alone, "in-house" money-management firm. Second, the growth of hedge funds, like those formed by former HMC staff, indicates the rising challenge to maintaining Harvard's outsized investment returns.

In language much more pointed than his past cautions ("This time I really mean it"), Meyer wrote that returns on HMC's diversified asset classes in the next 10 years "will be closer to 8 percent than the 12 percent of the last decade." In conversation, he emphasized that, compared to past returns 10 percentage points greater than the rate of inflation, "We'd be lucky" to earn half that margin. He also reduced expectations about HMC's ability to outperform its benchmarks, writing, "Value-added will also drop significantly," because the proliferation of competing hedge funds has "reduced the opportunity" to exceed market returns. "We can see the opportunity set," he said, "and it's diminished."

These are not forecasts for any given year, he emphasized, but HMC's endowment managers do not expect to equal in the next decade the 15.9 percent annualized returns HMC produced in the last. Meyer concluded his report by writing, "We do not want to cut short the celebration of fiscal 2004 results, but we should not get accustomed to these outsized returns."      

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