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John Harvard's Journal

The Endowment: Up, and Upheaval

November-December 2007

A strong year for investors generally was a very strong year for the University. Harvard Management Company (HMC), concluding its first full year under new leadership, reported on August 21 that the endowment had risen to $34.9 billion during the fiscal year ended June 30 from $29.2 billion 12 months earlier, an increase of $5.7 billion. That 19.5 percent growth is the product of a 23 percent investment return on endowment assets after expenses and fees, plus endowment gifts received, minus the distribution of funds to support University operations.

Those glad tidings were almost immediately overshadowed, however, by the unexpected announcement on September 11 that Mohamed A. El-Erian, HMC’s president and CEO since February 2006, would resign at year-end to assume a top management position at Pacific Investment Management Company (PIMCO), from which he had been recruited to Harvard in 2005 (see below).

The performance of the endowment matters more than ever. During the fiscal year, distributions from the endowment to fund faculty salaries, financial aid, research, library acquisitions, and the like exceeded $1 billion for the first time. (In fiscal year 2006, the sum disbursed was about $930 million.) These funds now represent more than 30 percent of Harvard’s operating budget—a substantially larger fraction than tuition and fees, support for sponsored research, or any other source. (An additional $140.5 million was set aside for the “strategic infrastructure fund,” a 0.5 percent levy on the endowment for Allston campus development.)

Investment returns. In his annual letter on the endowment, El-Erian noted that during the fiscal year, the Standard & Poor’s 500 index returned 20.6 percent, and the Lehman Aggregate—a common bond-market metric—6.1 percent. HMC’s 23 percent return was a full 5.8 percentage points above what Harvard would have earned had its diversified portfolio simply matched the market performance of each asset category in which the University invests (domestic and foreign equities, emerging-market stocks, domestic and foreign bonds, real estate, and so on; for the actual composition of the portfolio as of June 30, see the investment section of Harvard’s financial report at The extra returns augmented the endowment by $1.7 billion.

That large margin of added value boosted Harvard’s performance well above the median return of 17.7 percent in the Trust Universe Comparison Service, which aggregates data on 151 large institutional investors. (Nonetheless, El-Erian expected some other universities to report higher returns, given their relatively greater proportional investment in private equities and real estate—both exceptionally strong last year. Indeed, Yale reported returns of 28 percent during the period and Amherst only slightly less; the University of Virginia, 25 percent; and Dartmouth 23.7 percent.)

HMC no longer provides yearly returns by asset class. Instead, it offers five- and 10-year annualized performance; El-Erian said other investors could use one-year data to gain insight into certain Harvard strategies. He did disclose that among all asset categories, emerging-market equities produced the highest return for the year (44 percent), followed by private equities and real estate (both of which returned more than 30 percent). As for the dollar contribution to the growth of the endowment—reflecting the size of the portfolios as well as the rate of return—the most significant assets were emerging-market equities, domestic and international equities, and absolute-return funds (hedge funds managed to have a neutral posture toward the market overall).

The new order. The fiscal year 2007 results constitute an initial performance report on the investment disciplines El-Erian and new HMC personnel have put in place since his arrival. Reviewing historical data on Harvard’s general investment account (which includes the endowment), El-Erian said the 23 percent rate of return had been exceeded only seven times since fiscal year 1971. The 5.8 percentage point margin over market returns had been exceeded only three times: in 1988 and 2001, when market returns generally were negative, and in 2000, when Harvard harvested billions from venture-capital investments during the dot-com bull market.

He attributed HMC’s outperformance to several factors. First, the allocation of endowment assets has changed, placing more emphasis on international equities and alternative categories of investments, and much less on fixed-income holdings (see chart above). Those shifts, driven by HMC’s long-term investment perspective, were augmented by daily portfolio-management decisions that buffered the effects of several sharp market down-drafts during the year.

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 ( 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, 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.”