When Down Is Up

After three years of stratospheric results, Harvard Management Company (HMC) has come part way back to earth. For the fiscal year ended June 30, the total return on the University's investment accounts was 12.2 percent after expenses, raising the value of the endowment to about $14.4 billion. That growth seems tame following the giddy 20-plus percent returns achieved from 1996 through 1998--when robust investment results and, to a lesser extent, receipts from the University Campaign swelled the endowment by nearly $6 billion.

From other perspectives, however, the most recent year's performance appears satisfactory. First, the money managers began the year in a downdraft, as default in Russia and other events roiled markets in August and September of 1998, reducing the value of the endowment by 10 percent, or $1.3 billion (see "Unlucky Number?" November-December 1998, page 99). Things obviously got better--to the tune of more than $2 billion from the low point. Second, as Jack R. Meyer, M.B.A. '69, president of HMC, noted in his report on 1999 results, Harvard's 12.2-percent return exceeded the median performance of comparable funds by a full percentage point. Third, HMC's performance exceeded the rate of inflation by more than 10 percent, handily satisfying the goal of preserving the endowment's purchasing power. That raises the possibility that more funds than anticipated could be distributed to support University priorities .

But by HMC's own standards, the year was quite disappointing. The 12.2-percent return trailed by 6.7 percentage points the hypothetical gains in HMC's "policy portfolio," the model by which it allocates investments among asset classes. HMC's large domestic and foreign equity portfolios handily outperformed their benchmarks, and the domestic and foreign bond investments exceeded market returns; these assets total slightly more than half of the money HMC manages.

Meyer attributes the shortfall principally to private equities--venture capital and corporate finance (for leveraged buyouts and other transactions). HMC was "underweighted in venture capital" during a year in which tremendous price appreciation for offerings of Internet-related securities fueled gains of 100 percent or more. Harvard's problem, Meyer says, was "something we can't do much about." Although HMC is invested in most of the best-performing venture-capital funds, he says, the funds limit each investor to, say, $20 million apiece to accommodate demand. That meant Harvard invested several hundred million dollars less than it would have liked to deploy. The underallocation reduced HMC's return in private equities to a still-torrid 29.2 percent--about 28 percentage points below the benchmark for that sector.

Performance also appeared weak in real estate, where HMC earned 6.6 percent (after 44 percent gains in 1998), well below the benchmark return of 17.1 percent. "I don't like to make excuses," Meyer says, "but here is a case where I might try. That 17.1 percent is not a realistic benchmark." He notes that real-estate financing dried up late in 1998, depressing values, "but it's tough to benchmark real estate. The indexes are sticky." In the future, he fully expects the indexes to reflect lower values, improving Harvard's relative performance.

Other results were mixed. Emerging markets, "absolute return" (a new category, consisting of hedge funds which operate in multiple asset classes), and commodities trailed their markets. In his report, Meyer noted that those results primarily reflect performance by external managers--some of whom have been changed. "Nearly all of our internal managers outperformed their benchmarks, some by significant margins," he wrote. High-yield investments did better than a weak market, but still declined slightly in value.

Looking ahead, Meyer sees a changing landscape. HMC has adjusted its model portfolio to adapt to new conditions. With the advent of inflation-indexed bonds with attractive real returns, HMC's portfolios will no longer use borrowed cash to invest in other asset classes; instead, a new allocation has been made for the inflation-indexed bonds, and the percentage of funds committed to domestic equities has been reduced. Private equity holdings are now planned to be a smaller slice of the portfolio, given the constraints on venture investing. And the absolute-return, commodities, and high-yield commitments have been increased slightly to further diversify Harvard's investments.

HMC's management of Harvard's funds has also changed structurally. In September, Timothy Peterson, manager of the very successful high-yield portfolio, resigned to form his own firm, Regiment Capital. His departure follows those of a domestic-equity manager and of HMC's private-equity and real-estate group. In all three cases, Meyer says, HMC has entrusted Harvard funds to the new outside firms and acquired an "effective revenue interest" in their growth. If they are successful, that should serve to offset the initial higher cost to HMC of having the money managed externally.

The result of these departures is to make HMC more of a hybrid. Two-thirds of its assets are now managed internally, down from an estimated 87 percent two years ago. "I welcome what's happened to date," Meyer says of the creation of the new firms, "but now I'd like to keep it where it is," particularly because the proliferation of managers means "We do lose a little bit in terms of risk control" as compared to tracking all of the managed funds internally.

In all, Meyer says, 12 percent is "not our best year, but not a negative year, either, and that can happen," as it last did in 1984. In that light, he noted in the conclusion to his report, "the strong results of recent years have provided a cushion against the inevitable rainy days, weeks, or even years that may lie ahead."

For now, however, University administrat0rs perceive sunnier conditions. Last year, recognizing the recent growth of the endowment, the Corporation authorized a special 28-percent increase in the funds distributed to the schools for spending on academic programs ("The Payoff," January-February, page 62). That $95-million boost, being spent in the current academic year, came on top of the customary annual increase in distributions from the endowment, and was meant to bring the "spending rate" to Harvard's target of 4.5 percent to 5 percent of its market value each year. In authorizing the extra payout, explained Elizabeth C. Huidekoper, vice president for finance, the Corporation examined possible fluctuations in endowment value and determined that the additional spending could be sustained.

The financial projections, Huidekoper says, are based on expected "real" endowment returns (above the rate of inflation) of 6 to 6.5 percentage points. Assuming a spending rate within the target range, and achievement of the targeted investment returns, Harvard could plan on steady increases in endowment distributions even while maintaining its purchasing power.

The 12.2-percent return recorded in 1999 clearly exceeded the real return goal by a wide margin. So it appears that the spending rate for this academic year will once again fall below the targeted range, perhaps to around 4 percent, despite the extraordinary $95-million boost.

Will the Corporation make a second extraordinary distribution of endowment funds? Its members must consider not only the outlook for the financial markets, but also such competing factors as the schools' readiness to further ramp up academic programs; higher employee-benefits costs and rising wages in a tight labor market; and suitable increases in tuition. A decision is likely around Thanksgiving.

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