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November-December 2007
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< previous | 1 | 2 With HMC’s in-house organization restaffed during the year, El-Erian said, the internal investment team had very strong results. He also augmented the process for evaluating and selecting external managers, resulting in the reallocation of billions of dollars among existing and new firms. This reallocation in part reflects the redeployment of fixed-income funds that had been passively invested during the prior year, after the departure of HMC’s senior management and fixed-income team in late 2005 to set up their own firm, Convexity Capital Management. That shift boosted returns, El-Erian said, and other external managers performed well, too. • A changed environment. All the assumptions that boosted the markets during the past year have since been rudely undercut. China and other developing nations, which have led economic growth and accumulated large cash reserves, may be less willing to buy U.S. Treasury bonds (a practice that has helped keep domestic credit available and inexpensive). Problems with subprime mortgages broadly disrupted the credit markets in mid summer, sparking fears of recession, choking off acquisitions, and spurring sharp swings on world stock exchanges. In turn, confidence in the ability of central bankers and policymakers to sustain stable growth was shaken. The consequences were especially harsh in certain investment sectors. As previously reported (see “Hedge-fund Hemorrhage,” Brevia, September-October, page 69), Sowood Capital Management, founded by a former HMC fund manager in 2004, collapsed over the last weekend in July; Harvard’s loss from the firm’s forced liquidation totaled about $350 million. In HMC’s August 21 release, El-Erian took the unusual step of disclosing endowment performance during July 2007, when the Standard & Poor’s index declined 3.1 percent, while the Lehman aggregate rose 0.8 percent. Despite those factors and the Sowood loss, the value of the endowment actually appreciated 0.4 percent. That positive outcome, he said, indicates the value of HMC asset-allocation and diversification decisions, effective action by portfolio managers, and the utility of portfolio insurance to protect against such sharp breaks in the market. One contributing factor may have been strong performance by Convexity, which continues to manage fixed-income funds for HMC. That firm’s volatility-driven strategies yielded a double-digit gain in June and July. Recent events aside, El-Erian said that HMC has been pursuing five longer-term themes. First, economic growth outside the United States is expected to exceed domestic growth, opening new investment opportunities. Second, the external factors helping to rein in inflation—inexpensive labor in emerging markets, and the sharp rise in global trade—are lessening in effect. Third, emerging economies are beginning to use their financial reserves to seek higher returns. Fourth, 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). Finally, financial risks are changing as traditional intermediaries, such as banks, assume new roles, and checks on credit quality weaken. Broadly, these factors drive HMC’s asset allocation and strategies: increased investment in foreign equities; greater use of real assets to protect against higher inflation; and—in light of globalization and maturing alternative investment vehicles—greater wariness about the efficacy of traditional diversification to boost returns and protect against risk. For example, if globalization of trade and finance makes economies act more alike, geographic diversification loses its effect in protecting against recession or inflation in any one region. Hence, El-Erian said, HMC is emphasizing risk management (witness Sowood’s demise), and its ability to move first into novel investment areas such as infrastructure and foreign-currency portfolios. Neither of those are consequential today, but they are promising parts of a growing commitment to “special situation” investments. • Shedding light. Given the eventful year for the endowment, El-Erian wrote an unusually long, detailed annual letter. In it, he promised further changes in HMC’s public communications, including a website (www.hmc.harvard.edu) intended to demystify some of its operations (for another example, see the University of Virginia’s site, http://uvm-web.eservices.virginia. edu/public). Beginning next fall, he wrote, HMC will issue its own annual report, as Yale University Investments Office has done since 2000 (see www.yale.edu/investments), complementing a leaned-down University Financial Report, which now covers endowment management and performance. In conclusion, El-Erian observed— given continuing large imbalances in global payments, insufficient tests of the “robustness” of new financial derivatives, and “a certain amount of hubris” among other investors—“[W]e are resisting the temptation to extrapolate the recent strong investment performance. Instead, it is more prudent to view it as involving a ‘windfall gain’ component.”  
 
 
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