The success of Harvard's endowment in recent decades helped popularized a new approach to university endowment investing that generated enormous gains. But when the 2008 financial crisis hit, Harvard's fund took a bath and exposed weaknesses in its asset management approach. Harvard's experience offers lessons for financial advisors increasingly interested in alternative investments.
During the period when Jack Meyer managed the Harvard Management Company (HMC), the university's endowment went from $4.7 billion in 1990 to $22.6 billion when he left in 2005. That included 15% average annual returns during his final ten years at the fund.
Meyer used a model similar to the approach articulated by David Swensen, the head of the Yale endowment, in his book Pioneering Portfolio Management. One of the chief tenets of this approach, often referred to as the Yale model, was the view that liquidity was not always desirable because liquid assets generally have lower returns.
Both Meyer and Swensen de-emphasized stocks and bonds, and added alternative assets such as hedge funds, private equity, commodities, real estate and timber acreage.
Meyer was succeeded by Pimco's Mohamed El-Erian, who left after less than two years. His replacement, Jane Mendillo took the helm in July 2008, or just in time for the financial meltdown. In the fiscal year ending June 2009, Harvard's endowment fund lost 27.3% and sank in value by an eye popping $11 billion. That forced layoffs at both HMC and at Harvard University, which curtailed planned campus expansions and prompted re-examinations of the portfolio and its underlying philosophy. (Yale's endowment plunged 24.6% during the same period.)
What went wrong? Well, many things. An attempt to lock in low interest rates backfired, and HMC lost more than $550 million on a series on interest-rate swaps. Alternative assets fell, as did public-equity holdings. Attempts to sell private-equity fund stakes were unsuccessful, and with more than $11billion in potential capital calls from private-equity firms, HMC was forced to sell more than $2 billion in stocks. It also issued debt to boost liquidity by selling $2.5 billion in bonds.
Since then, Mendillo has worked to trim commitments to private-equity funds, and announced last fall that some real estate holdings were on the block for sale. Leverage has been eliminated and Mendillo has introduced a modest cash allocation. In it's most recent report for the fiscal year ending June 2011, the endowment said it returned 21.4% and boasted assets of $32 billion, which remains below its pre-crisis peak of $36.9 billion.
Mendillo believes she is halfway through turning around the fund, and will continue to improve liquidity. And despite the crisis, HMC has still bested the market over the past decade with average annual returns of 7% from 2001 through 2010 versus the S&P 500 return of 1.7% during that period.
While HMC's long-term success is noteworthy, cautionary lessons can be drawn from its recent travails? For starters, many of the alternative investments used by HMC--such as private equity and hedge funds--don't always cushion the blow during bear markets. Specifically, HMC's private-equity investments declined by 31.6% and its hedge funds fell 18.6% fall during fiscal year 2009.
The use of alternatives should not be seen as a risk free form of diversification."Some of the proponents of the Yale model view it as a diversification decision, which is reasonable," says Brad Barber at UC Davis, who has studied endowment returns. "But some proponents argue only for the higher returns these models have achieved without acknowledging the inherently higher volatility of illiquid assets. There is no free lunch- you get these returns by giving up liquidity."
Barber also notes that these alternative investments were crucial to HMC's longer-term success. "Alternative asset class allocation explains much of the out-performance of university endowments. They were in the right place at the right time."
With the financial crisis now in the rear-view mirror, should alternatives become central to long-term portfolios? Barber is skeptical. "Its dangerous in 2012 to conclude that private equity and hedge funds will replicate the strong performance of the past," he says. "The evidence on private equity is that there is no out-performance for the asset class as a whole, after adjusting for the liquidity premium." He believes that private equity returns are largely correlated to public markets, with an additional liquidity premium, meaning there is little diversification benefit in down markets, if any.
While the future returns of alternative assets remains unknowable, one flaw in HMC's approach is clear--liquidity, or lack thereof. Prior to 2008, HMC ran a leveraged portfolio with 105% exposure, and large allocations to illiquid assets. They did this despite their need to provide annual liquidity to university's operating budget.
"The main lesson is that liabilities matter and they didn't invest according to their liabilities," says says Andrew Ang of Columbia University. "One-third of the university's operating expenses were paid by the endowment, but they managed it as though they had no explicit liabilities. Endowments achieved high returns with illiquid investments through 2008, and then that risk bit back."
The lessons of Harvard are relatively straightforward. Namely, advisors need to make sure that near-term cash needs are not neglected in asset allocation. Diversification helps, but does not prevent losses. Most importantly, the HMC debacle demonstrates the same basic lesson that felled Lehman Bros., which bet on real estate while relying on short term repos for liquidity, and Bear Stearns, which binged on sub-prime mortgage assets while funding itself with short-term paper. For all of these financial giants, the combination of leverage and illiquidity was toxic.