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John Harvard's Journal

Money-Management Makeover

November-December 2006

The value of Harvards endowment increased by $3.3 billion during the fiscal year ended June 30, rising to $29.2 billion. The 12.7 percent growth, from the year-earlier total of $25.9 billion, reflects a 16.7 percent investment return on endowment assets after expenses, plus gifts received, offset by the distribution of funds to support University operations (about $930 million in the fiscal year, plus more than $100 million set aside for Allston development).

The results, released on September 19, usually attract attention, because Harvards endowment is the largest of its kind. This year, there is added interest because the report on investment performance is the first since Mohamed A. El-Erian became president and CEO of Harvard Management Company (HMC) in February. His arrival began a period of extensive hiring for the senior staff and of long-range reevaluation of HMCs operations in the face of rapidly changing financial markets. The outcome of those actions will influence Harvards future significantly: endowment distributions now account for much the largest sharenearly one-thirdof University revenue.

El-Erian characterized the fiscal year as pretty strong, especially given market conditions. (During the 12-month period, large domestic stocks returned 8.6 percent, and bonds declined in the face of rising interest rates.) HMCs fundamental goal is to enhance the value of the endowment after accounting for both distributions to Harvard and inflation; that requires annual returns on investment of 8.25 percent over time. Beyond more than doubling that goal, the 16.7 percent return during the fiscal year exceeded the benchmark (market) rate of return of 13 percent for the asset classes in HMCs model portfolio. The margin of outperformance relative to the median return of large institutional funds measured by the Trust Universe Comparison Service was wider still: 5.9 percentage points.

Harvard Management Company is restaffing its in-house portfolio group, shown here at the offices in downtown Boston.
Photograph by Jim Harrison

Those competitive rankings were achieved even as approximately one-quarter of the funds under HMCs management were passively invested, simply to match the market. That became necessary during the transition caused by the departure of the entire fixed-income portfolio team, which left on September 30, 2005, along with much of the senior staff, to found a private hedge fund, Convexity Capital Management (see Money-Manager Transition, March-April 2005, page 59). During the prior five years, the domestic and foreign bond portfolios had produced annualized returns of more than 20 percent and more than 24 percent, respectively, more than double and triple their benchmarks, providing a powerful boost to endowment results. Some peer universities endowments, not comparably penalized during the year, reported stronger returns than Harvards. Yale announced a 22.9 percent rate of return for fiscal year 2006 (bringing its endowment to $18 billion), and Stanford achieved a 19.4 percent investment gainthe second consecutive year both schools outperformed HMC.

In absolute terms, particularly strong contributions to HMCs results came from investments in emerging-market equities, commodities, foreign equities, real estate, and private equities. On a relative basis, the largest margins of performance in excess of market returns were realized in commodities, real estate, and high-yield and absolute-return funds. The domestic and foreign bond assets also outperformed the market, but only the latter produced a positive return for the year. All categories of investments except foreign equities and private equities outpaced their benchmarks.

Summing up those results, El-Erian observed that Harvard had been well served by the progressive diversification and internationalization of endowment assets. The 1980 mix of investmentsprincipally domestic stocks and bondswould have yielded returns well below the Universitys basic goal during the year ended last June 30. The endowment has for more than a decade been much more broadly invested; today, he indicated, about 40 percent of assets are non-U.S. holdings.

Harvard
Benchmark
Difference
Equities
Domestic
11.3
9.6
1.7
Emerging markets
37.8
36.2
1.6
Developed foreign
26.5
27.2
-0.7
Private equity
22.7
24.3
-1.6
Fixed Income
Domestic
-2.3
-4.9
206
Foreign
2.6
-.02
2.8
High-yield
7.9
4.6
3.3
Real Assets
Commodities
26.7
14.5
12.2
Inflation-indexed bonds
-3.1
-3.2
0.1
Real estate
22.7
16.8
5.9
Absolute return
and special situations
15.0
11.9
3.1
TOTAL
16.7
13.0
3.7

During the past 18 months, HMC has operated in an environment of enormous fluidity, El-Erian said, weathering the loss of tremendous talent. Walking out the door to create Convexity were his predecessor, Jack R. Meyer; HMCs heads of risk management, operations, human resources, and technology, and the fixed-income portfolio team. That exodus created the obligation but also the luxury of saying, How is it you want to design an organization that will serve Harvard well for the next five to 10 years at least? El-Erian said.

HMC concluded that it would be worthwhile to rebuild in-house money-management capabilities, rather than relying entirely on external managers. About half of the endowment assets are managed externally, either in areas where HMC has relied on special expertise (venture-capital funds, for instance), or where it has entrusted funds to employees with strong track records who left to set up their own firms, like Convexity (as has happened a half-dozen times in recent years).

But, El-Erian said, If you rely exclusively on external management, then you significantly undercut your edge. In Harvards case, he cited three internal advantages. First, the University manages its endowment funds with a long investment horizon in a world thats increasingly short-term, giving it opportunities other investors do not pursue. Second, the institution itself has an AAA-rated balance sheet (conferring cost advantages in pursuing certain investment strategies). Third, HMC has a repeated, demonstrated ability to identify new investment activities and to be a first mover, as indicated in its diverse and international holdings. Moving from the current hybrid model to entirely external fund management, he said, would mean outsourcing all three advantages to other, less favorably positioned parties.

Further, El-Erian said, for funds retained internally there is full transparency, we get timely information, and we can manage our risk better than for assets spread across external managers. Moreover, given the size of the endowment, there were doubts that Harvard could get capacity where we want capacity, should HMC decide to move entirely to external management. Finally, he said, HMC has found that it cost half as much to manage the funds internally as for equivalent external expertise.

But the last point poses two practical problems. The lure of higher earnings has become a principal factor in the departure of fund managers from HMC to make up that difference by working privately. Moreover, because HMC is a University entity, the pay of its most highly compensated professionals (in one case, $35 million; see Extraordinary Bonuses, March-April 2004, page 69) is disclosed annuallya source of controversy, and a possible impediment to recruiting (external managers fees arent disclosed).

Having determined to rebuild its depleted staff, HMC had to see whether it could do so. As of early October, five senior professionals appointed by El-Erian will be in place at the management company. Stephen Blyth, previously of Deutsche Bank, is now responsible for international fixed-income investments. Karen Parker Feld, who was Wellington Management Companys director of foreign exchange, assumes similar responsibilities for HMC. Marc Seidner, from Standish Mellon Asset Management, is the new domestic fixed-income leader. Mark Taborsky, formerly at Stanford Management Company, is now in charge of external management for HMC. Those four new vice presidents are joined by Kate Murtagh, who moved from the Goodwin Procter law firm to become HMCs new chief compliance officer. Each, in turn, is now hiring a staff.

As a group, these HMC staff members represent both the beginning of building a new fixed-income investment capability, and El-Erians decision to add some complementary skills. He cited creating a true compliance culture (Murtagh); helping the other portfolio managers deal with foreign-currency and sovereign risk when they invest internationally, and perhaps pursuing active currency management as an investment strategy (Feld); and being more systematic about certain asset categories, including commodities and fixed income, managed externally (Taborsky).

Those structural decisions have been accompanied by a fresh look at the investing world. We are at a new phase of the globalization process, said El-Erian, whose experience ranges widely across the developing economies in particular (see El-Erian for the Endowment, January-February, page 55). Markets have opened to external in- vestments, and new forms of securities make international diversification much easier. But with these opportunities come new participants whose behavior is not as yet well understood. Other nations central banks have become substantial owners of U.S. financial assets, for example, and hedge funds accelerate trading in many exchanges. Differences in interest rates around the world are lessening, and economic cycles may be converging, at least for a whilereducing opportunities to diversify portfolios, and perhaps increasing the odds that adverse conditions could depress investment returns, even severely, everywhere at once.

Such challenges make it important to examine both the proper asset allocation for the endowment (given Harvards long-term financial goals) and fresh opportunities to realize extra value from investments. El-Erian accordingly met with groups of faculty members in business, economics, and government in August to solicit views on the synchronization of economic cycles and investment markets versus historic decoupling of performance (of current relevance as the American economy cools), on the correlations among asset classes (which could erode or accentuate intended diversification), and other issues. Comparable discussions are being pursued among HMC board members. HMC is also working to insure the portfolio as a whole against low probability, but severe, events (a terrorist attack that freezes world trade) that could hamstring the endowment even as the Universitys dependence on it increases.

Thus, as HMC personnel effect a protracted transition in portfolio-management staff and begin to build new expertise in foreign exchange, selection and oversight of external investment managers, and global risk management, they must contend with a reconfigured financial environment. El-Erian suggested that HMC will have to review its model allocation of assets. It will have to be sure that changing views are communicated among the staff members, many in new roles, through newly constituted portfolio and operations committees. And it will have to do so at a moment when, as he put it, certain valuations are very stretched.

In his first letter on HMCs results, accompanying the September 19 news release, El-Erian said that Harvards long-term superior investment returns, realized during the recent period of generally favorable global market conditions, enabled the University to build an important margin for the future should conditions revert to the mean. Looking ahead, he concluded, by necessity, HMC needs to be able to navigate an increasingly fluid economic and financial landscape. In proceeding, [W]e are firmly anchored by the clarity of our mission, the longer-term nature of our investment horizon, the strength of Harvards balance sheet, and our access to a large community of talented people and ideas.