CASE STUDY ANALYSIS

ON INVESTMENT
MANAGEMENT AT
HARVARD MANAGEMENT
COMPANY

SUBMITTED BY: 20BSP_NAYANIKA_SAHA, 20BSP2597_SWATI CHOUDHARY,20BSP2597_NISHANT

BHARTI, 20BSP1005_KANKAN MOHAN MANDAL,
ICFAI BUSINESS SCHOOL, KOLKATA
 CONTENT

1) Abstract
2) Introduction
3) Background
4) Analysis and Interpretation
5) Problems
6) Outcomes

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 ABSTRACT

The case examines the investment management strategies adopted by the Harvard
Management Company (HMC). HMC managed Harvard University's endowment funds, the
largest in the industry. The case explains the hybrid fund management strategy followed at
HMC and how the strategy led to phenomenal growth of Harvard's endowment funds over
the decades. The case describes the investment performance of the endowment fund, asset
allocation, portfolio mix and risk management strategies under various fund managers of
HMC since its inception. The case also explains the recent problems faced by HMC due to
the frequent changes in its leadership and the sub-prime crisis that emerged in the US in
late 2007 resulting in significant losses for Harvard's endowment fund.

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 INTRODUCTION

On February 17, 2009, 1,600 non-faculty employees of Harvard University (Harvard) received a
crimson folder containing details of the early retirement benefits offered to them. Earlier, on
February 11, 2009, Harvard had announced the eligibility criteria for those employees who would be
offered early retirement. The objective of the move was to save on operating expenses. The
University also announced other cost-cutting measures that included budget cuts varying between
10% and 15% in all Harvard departments. Besides, it announced a 3.5% increase in tuition fees for
the academic year 2009-10. The University attributed these cost-cutting measures to the losses
incurred by Harvard Management Company (HMC).

Harvard depended on its endowment to fund more than one-third of its operational budget every
year. It withdrew US$ 1.6 billion from its endowment fund in the fiscal year 2008 that ended on June
30, 2008 which was the largest endowment payout to the university. HMC announced that it would
lay off 25% of its 200 employees as a part of its reorganization and rebalancing strategy.

It consistently outperformed the average returns posted by the industry which invested in similar
asset classes in which HMC invested. For instance, HMC posted a positive return of 8.6% on its funds
for the year ended June 2008 as compared to a 13% negative return posted by the S&P 500 index
during the same period. HMC was renowned for its asset allocation strategy. It followed a hybrid
model in managing its funds.

Most of HMC’s investments in real assets, which amounted to 26% of its total investments as on
June 30, 2008, were illiquid and hence was difficult to value. Analysts remarked that HMC was facing
problems in retaining its top management which could be one of the reasons for its disappointing
performance in the fiscal year 2009.

Jeffery Larson (Larson), who was a foreign equities manager at HMC, left the firm along with his 14-
member team to form a hedge fund called Sowood Capital in July 2004 and Harvard invested US$
700 million with Sowood. Harvard had to suffer losses due to several changes in its management and
because of brain drain. Analysts said compensation related issues were one of the main reasons for
the brain drain at HMC.

Supporters of HMC’s fund management strategy opined that the sub-prime crisis in the US had
affected almost all the asset classes and hence HMC’s diversification of investments across various
asset classes could not have helped too much in preventing HMC from incurring losses.

The losses incurred by HMC had led to a squeeze on Harvard’s budgets. Harvard’s cash inflows
included gifts from alumni and donors, funds for research from the corporate sector, and the tuition
fees it charged from its students under various academic programs. It had the discretion to increase
tuition fees but could not resort to a significant increase during recessionary times.

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 BACKGROUND

HMC was incorporated in 1974 to manage the endowments, pension assets, working capital, and
non-cash gifts of Harvard. Its objective was to provide financial support to the operations of Harvard.
To conform with that objective, HMC’s Board and the management laid down the investment
philosophy to allocate assets across various markets and asset classes in their effort to generate the
optimum rate of return in line with Harvard’s risk tolerance level.

HMC followed a hybrid management structure where it utilized both internal and external managers
to manage its funds. The Board of Directors for HMC was selected by the President and Fellows of
Harvard. According to HMC’s policies, the Board of Directors should have experience in policy-
making in business, government, education, financial services, or public service. The responsibilities
of the Board included selecting its Chairman and Officers, and overseeing the management of the
fund and risks involved.

HMC managed almost 90% of its assets internally till the late 1980s. However, this had come down
to 30% by 2008. Harvard was one of the very few universities that internally managed its
endowment funds like Princeton, Yale, and Stanford which employed their own internal investment
managers. However, the proportion of assets managed internally was the highest at HMC. It
followed a hybrid management structure mainly to make the best use of its own academic
resources.

Harvard had a huge pool of knowledgeable people in the form of faculty, students, and alumni who
helped HMC in decision making regarding investments and also in risk management. Analysts felt
that using the knowledge pool to arrive at investment decisions was a major strength of HMC as
different people brought in different perspectives.

HMC selected its external managers after careful consideration of their capabilities. However, it had
to depend on whatever information was provided by its external managers on its investments and
hence it lacked direct control on the risks associated with such investments.

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 ANALYSIS AND INTERPRETATION

Asset Allocation at Harvard management company:

HMC had managed the largest university endowment fund in the world. (Shown in Exhibit IV for Top
Ten University Endowments in the US by the End of June 2008). It followed a well-diversified asset
allocation strategy. For instance, for the fiscal ended June 2008, HMC had investments in 12 non-
cash asset classes. Each year, the HMC Board and management decided on an optimal mix of assets
which they termed as Neutral Asset Allocation (Shown below for Neutral Asset Allocation of HMC in
June 2008). After arriving at the Neutral Asset Allocation, HMC selected an appropriate mix of
investment vehicles to invest in respective asset classes.

HMC selected a wide variety of assets ranging from fixed income securities, high yield bonds.
equities, private equity, inflation indexed bonds", commodities, and hedge funds to assets like
agricultural/timberland which were beta neutral. By constantly reviewing the performance of its

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investment strategy, HMC aimed at generating returns higher than a passively managed portfolio.
According to experts, HMC's asset allocation model was one of the main reasons for its consistent
market beating results.

HMC used three different metrics to measure the performance of its portfolio:

 It sought to preserve and enhance the purchasing power of Harvard after discounting the
pay out to Harvard from the endowment and the negative impact of inflation.
 It sought to outperform the Neutral Asset mix it had designed by actively managing the
portfolio. HMC aimed to outperform the returns from comparable benchmarks that would
result from passive management.
 HMC compared its performance against its peers in Trust Universe Comparison Service.

Fund Management at HMC:

Walter Cabot (Cabot) was nominated as the first President and CEO for HMC in 1974. HMC's assets
grew from US$ 1.3 billion in 1974 to US$ 4.7 billion in 1990 under his leadership. Cabot resigned
from HMC after his 16-year tenure in 1990 when Meyer was nominated as his successor. Meyer led
HMC between 1990 and 2005 and grew HMC's asset value from US$ 4.7 billion to US$ 22.6 billion.
HMC nominated Mohammed El-Erian (El-Erian) as successor to Meyer.

HMC UNDER WALTER CABOT

HMC had US$ 1.3 billion endowment funds to manage when Cabot became the President and CEO.
Cabot's initial task was to build HMC's staff and also to find a few outside firms to manage a small
portion of the fund.

HMC UNDER JACK MEYER

While Cabot focused on investments with an objective of achieving returns above the rate of
inflation, Meyer focused more on the spending requirements and risk tolerance of Harvard. He also
hinted at increased external management help in managing the endowment funds unlike Cabot who
had outsourced only a small portion of the endowment funds to the external managers.

Meyer designed a schedule for asset allocation and developed a policy portfolio for several years. He
also changed the then existing benchmark to measure performance from a plain vanilla portfolio of
stocks and bonds to use internal benchmarks based on the policy portfolio.

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From the above bar chart, it can be observed that in 1980, the policy portfolio of Harvard
Management Company used to consist around 65% of domestic equities and remaining used to be
fixed income securities and the portfolio was illiquid in nature. In 1988, it has been observed that
about 45% of the portfolio were domestic equities, 30% were fixed income, 10% were private
equities, 10% were real assets and remaining 5% were cash. In 1991, developed foreign equities
were introduced in the portfolio which is approximately 18%, major portion which was about 40%
were domestic equities, 10% were private equities, 12% were real assets and remaining were fixed
income security and the portfolio was also illiquid in nature. In 1996, it is observed that 35% were
domestic equities, 15% were developed foreign equities, 10% were emerging markets equities, 15%
were private equities, 10% were real assets and remaining 25% were fixed income securities. In
2000, about 22% were domestic equities, 18% were developed foreign equities, 7% were emerging
market equities, 15% were private equities, 20% were real assets, 13% were fixed income securities
and remaining 5% were absolute return and special situations. In 2007, about 15% were domestic
equities, 7% were developed foreign equities, 13% were emerging markets equities, about 8% were
private equities, 36% were real assets, about 10% were fixed income securities and remaining 20%
were absolute return and special situations. In 2008, about 15% were domestic equities, 7% were
developed foreign equities, 13% were emerging markets equities, 10% were private equities, 33%
were real assets, 7% were fixed income securities and remaining 20% were absolute return and
special situations. The portfolio from 1991 to 2008 has been observed to be illiquid in nature.
Gradually many instruments have introduced by Harvard Management Company to increase the
return and reduce risks.

Every year, HMC's board of directors and management team determined the policy portfolio for
HMC's funds. They considered various markets and asset classes where HMC should invest that year.
The investment decision that was taken had to comply with Harvard's risk tolerance level. Members
on the decision making team considered several things like potential of existing investments to
generate returns, risk to reward ratios, and emerging new investment opportunities. The investment
decision was also based on the correlation that new investments would have with the existing
investments. As HMC believed in diversification to achieve consistent returns, a lower correlation

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among its investments in various asset classes was given importance. Below Table shows the
changes in the composition of policy portfolio.

After, that HMC posted a return of just 1.1% for the fiscal year ended June 30, 1991, taking the
endowment value to US$ 5.1 billion. The returns were pulled down mainly because of the unstable
economic scenario in the US and also the US$ 195 million write-down HMC had incurred in assets
held by Aeneas Venture Corp, HMC's venture capital arm. HMC's performance in 1991 was
outperformed by 95% of endowments of US Universities and colleges.

In the year 1992, HMC posted a return of 11.8% on its investments of US$ 5.1 billion. HMC was
outperformed by 71% of endowments of US Universities and colleges as their average return was
13.1 %.

Poor relative performance by the largest endowment funds in the US became a matter of concern.
So, Harvard's faculty met Meyer to review the fund's performance. Meyer explained that the
diversification strategy was the reason for lower relative return as certain asset classes like
commodities, real estate, and foreign investments had underperformed. He explained that the
diversification strategy followed at HMC would benefit the fund in the long term as it was designed
to have the least correlation among the assets it held and could withstand wild swings in a few asset
classes. Below is the table shows the return generated by HMC’s Funds in the following years.

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HMC reported a 12.2% return for the fiscal ended June 30, 1999, which was lower by 7% from its
benchmark rate. HMC maintained that the results had been dwarfed by its inability to invest higher
amounts in venture capital funds as venture capital funds, at that time, had capped the amount any
one firm could invest so that they could diversify their investor base.

Even though HMC's fund was double that of its nearest competitor, Yale, it could not invest a higher
amount in venture capital firms. Thus, its size became its competitive disadvantage as it could not
earn higher returns on percentage basis. In 1999, venture capital firms did well and posted an
average return of 136%. HMC intended to invest 15% of endowment funds in venture capital but
could invest only 10%.

HMC was managing 65% of its US$ 19.2 billion funds internally as of September 2000. It attributed
the profits to its returns from venture capital firms which had invested in the then booming IT
industry and also to 49.9% returns from its investments in commodities.

In the fiscal year ended June 30, 2001, the HMC fund value dropped by around 4.5%. HMC reported
that its funds had fallen to US$ 18.3 billion in 2001 from US$ 19.2 billion in the previous year. This
included an addition of about US$ 300 in gifts, the payout of about US$ 600 million to Harvard, and a
loss of US$ 500 million on its investments.

Meyer said "It was a very harsh environment for returns in the last year. But within that
environment, a decline of only 2.7 percent" is pretty good."

As the criticism over compensation made Meyer announced on January 11, 2005, that he would be
leaving HMC by the end of fiscal year 2005 along with four of HMC's top performing managers. He
mentioned that the compensation structure in the 1990s could not be followed for ever as at that
time opportunities for money managers were lesser as many firms could not raise capital easily. But
over a period, smaller firms could raise capital and money managers had several well paid
opportunities.

So HMC had to restructure its compensation policies in keeping with the changing trends. By 2005,
50% of the funds were being outsourced to external managers. Analysts felt that Harvard would take
a relook at its management structure and might outsource all of its endowment funds to external
managers as Meyer's successor had not been decided upon. Meyer volunteered to work even after
fiscal 2004 and 2005 till Harvard could find a successor for him and he left it to the Board to take a
decision on the matter.

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HMC UNDER MOHAMMED EL-ERIAN

On October 14, 2005, Harvard announced that El-Erian, who was managing the emerging markets
debt and portfolio team at Pacific Investment Management Company (PIMCO) , would become the
CEO of HMC in mid-February 2006.

As many key people had left HMC, industry observers speculated that the firm might move all its
funds to external fund managers like many other university endowments had done. However, El
Erian said he would continue to lead the firm with its existing hybrid management structure. He said
"We went back and questioned everything from first principles because we had the obligation to do
so. We would rebuild it with the same hybrid model a mix of internal and external management-
because it is so potent in terms of delivering returns. El-Erian also mentioned that there would be no
changes in HMC's compensation structure and it would remain a factor of performance.

El-Erian mentioned that HMC would expand its presence in foreign currency management as it
already had significant exposure to foreign assets and wanted to minimize any losses resulting from
fluctuations in exchange rates.

HMC posted a return of 16.7% for the fiscal year ended June 30, 2006, and exceeded the average
return of 10.8% posted by its peers. El-Erian mentioned that the returns would have been better if
the firm had not been under transition from the previous CEO and executives to newer ones. He
added that as of June 30, 2006, 30% of the fund was in passive investments as the managers who
were managing those assets had left the firm and their replacement had not been found till then. He
also announced changes in HMC's policy portfolio. The changes included revision of allocations for
asset classes - fixed income securities' share reduced from 21% to 13%, US stocks reduced from 15%
to 12%, emerging market stocks increased from 5% to 8%, and absolute return hedge fund increased
from 12% to 17%. Real assets which included commodities and real estate was allocated the highest-
31%-of the fund.

El-Erian noticed that with the shrinking difference in interest rates globally, converging economic
cycles world over, and investors getting access to global investment opportunities, HMC's
diversification strategy might fail to produce the desired returns if it were not reviewed constantly.
In August 2006, El-Erian met Harvard's faculty members to discuss issues like synchronization of
economic cycles and investment market versus historic decoupling of performance, and correlation
among asset classes. He also conducted meetings with HMC's board to discuss similar issues. HMC,
under El-Erian's guidance, worked on insuring the whole portfolio against low probability but severe
events, like terrorist attacks, that could severely affect world trade.

El-Erian mentioned in his annual letter to the investors that HMC had been pursuing five long term
themes. They were:

 Economic growth outside the US is expected to exceed domestic growth, opening new
investment opportunities.
 The external factors helping to rein in inflation inexpensive labor in emerging markets, and
the sharp rise in global trade-are lessening in effect.
 Emerging economies are beginning to use their financial reserves to seek higher returns.
 Alternatives such as hedge funds and private-equity firms are maturing, putting pressure on
their returns (a challenge for large, diversified endowments like Harvard's).
 Financial risks are changing as traditional intermediaries, such as banks, assume new roles,
and checks on credit quality weaken."

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HMC reported a return of 8.6% for the fiscal year ended June 30, 2008, while the average return by
its peers was a negative 4.4% (Shown in the above chart on HMC's asset value performance between
1981 and 2008). HMC's return was boosted by the returns from its investment, around 8% of fund,
in commodities like oil, meat, and food that gave a return of 35.8%. Financial markets tumbled that
year because of the sub-prime crisis, making El-Erian's apprehensions come true.

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 PROBLEMS

The company has a terrific pipeline of interesting investments in the coming years for alternative assets. The
company is focusing on the extension of their internal management in the coming years. The company has
decided to be in strong connection with the University for getting the solutions related to risk management
and liquidity of assets.

According to the expectations of the company, new asset allocation policy 2008 will bring high yield for the
company in near future. Although this new asset allocation policy will bring long term risk for the company, yet
the company is ready to take this risk. The company believes that this risk can support higher rates of
spending. This risk can also alleviate the current financial pressure.

There’s one problem with that assumption that employees of Harvard Management Company already receive
multiples less than their colleagues in the private sector. Meanwhile, in the private sector, successful hedge
fund managers can earn hundreds of millions of dollars. It is telling that in Boston’s John Hancock Tower alone,
there are four investment funds run by former HMC employees. These funds have consistently beaten the
market, as well as their past employer.

Harvard has been able to hire some of the brightest minds in finance to manage its endowment; it makes
sense that these fund managers are highly in demand elsewhere in the industry. This is because Harvard is a
participant in a highly fluid job market in the upper echelons of the financial sector. The problem is that the
university is a participant in a very competitive labor market for financial professionals. Harvard must bend
over backwards to retain talent, because skilled investors realize that they can receive much higher
compensation in the private sector. However, compensation still remains a thorny issue. Sandra Korn, an
active member of the Occupy Harvard movement, argues in a recent Crimson op-ed that Harvard should
reduce executive pay for the management company by finding someone willing to work for less.

HMC's portfolio is in private-equity-like investments makes it vulnerable to the kind of problems HMC faced
the fall. HMC has made $11 billion of capital commitments to investment partnerships through 2018.

HMC move to get rid of some risky assets, assets like private equity and hedge funds which had fetched good
returns when markets were booming but had eroded most of the value added over the years in a short period.
HMC put up US$ 1.5 billion worth of its private equity holding for sale in November 2008. HMC borrowing
above its fund value to invest, so it was risky and a practice that should not be encouraged at a non-profit
organization like HMC. The sub-prime crisis and investors had lost confidence in almost all asset classes except
treasury bonds. As a result total loss of 30% for fiscal year 2009. HMC's portfolio is in private-equity-like
investments makes it vulnerable to the kind of problems HMC faced the fall.

Other problem with the HMC is that the HMC’s internal managers not renewed the hedges which El-Erian had
designed against market meltdown were partially exited. A lower hedged position created a mismatch in the
original investment strategy and made the portfolio of HMC more vulnerable to a market crash than it was
when EL-Erian was actively managing the investments during his tenure but it was too late the situation got
worse, because most of the assets had been passively managed during the transition of HMC from him to
Mendillo.

Between 2001 and 2006, for expansion the building the HMC had issued billions of debt. HMC entered into
interest rate swaps to cap the interest rates on Harvard’s debt. HMC entered into swap agreements where
Harvard paid a fixed interest rate in exchange for variable interest rates to its counterparties. During that
period, those swaps made sense as interest rates were expected to rise. But in late 2007 the sub-prime crisis
evolved, the US economy slowed down. To revive the economy, the Fed started lowering interest rates. As a
result HMC had exited those swaps in June 2007, and then the loss would have been US$ 13.3 million as
against loss of US$ 570 million in October 2008.

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OUTCOMES

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