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Harvard Endowment Rises 5.7 Percent to $36.9 Billion

9.12.08

Harvard Management Company (HMC) reported on September 12 that the University's endowment had increased by $2.0 billion, or 5.7 percent, during the fiscal year ended June 30. The new total of $36.9 billion represents an 8.6 percent investment return on endowment assets after expenses and fees; plus endowment gifts received during the year; minus the $1.6-billion distribution of funds to support University operations and—according to the news release—substantial capital outlays (see discussion below).

Jane L. Mendillo, HMC's president and chief executive officer since July 1, said, "Results for HMC for fiscal year 2008 were very solid" in light of "pretty turbulent market conditions." She said that Robert S. Kaplan, who served as acting president and CEO from last November through June 30, had done a "fantastic job" managing the organization during a time of senior management transition and very challenging market circumstances. Kaplan, who has now joined HMC's board, cited the work of the "great team here" in the investment organization.

The 8.6 percent return on investments follows a stellar 23 percent return in the prior fiscal year, which ended June 30, 2007 (see "The Endowment: Up, and Upheaval," November-December 2007). That returns in fiscal year 2008 were less robust is hardly surprising, given the adverse conditions in world financial markets during fiscal year 2008. The endowment assets are diversified among many categories of investments (domestic, foreign, and emerging-market equities, private equities, commodities, real estate, various kinds of bonds, etc.), but HMC noted, as it does traditionally, that popular market measures such as Standard & Poor's 500 index (of large U.S. stocks) had declined 13.1 percent during the fiscal year, while the Lehman Aggregate Index (a broad proxy for the bond market) gained 7.1 percent.

In seven investment classes, HMC results exceeded those for the appropriate market benchmarks: domestic, emerging-market, and private equities; real assets (including all three subcategories of commodities, timber and agricultural land, and real estate); and domestic, foreign, and inflation-indexed bonds. In three classes, HMC performance fell short of market benchmarks: foreign equities, absolute-return funds, and high-yield assets. In the aggregate, HMC's 8.6 percent investment return exceeded its market benchmarks' 6.9 percent return, providing a "value-added" margin of investment performance of 170 basis points, worth some $600 million-plus in extra endowment return. (The median return of a group of large institutional investors, aggregated by the Trust Universe Comparison Service was negative 4.4 percent. Peer universities such as Princeton, Stanford, Yale, and others, whose investment strategies are similar to Harvard's in several respects, have yet to report results individually.)

The star performers in HMC's portfolio were the three components of "real assets," which in the aggregate produced a 35.8 percent investment return for fiscal year 2008, slightly ahead of the 33.0 percent benchmark return in those classes. Real assets comprise "liquid commodities" (oil and gas, agricultural goods, metals, and so on), which soared in value during the year, driven by strong demand from developing nations and from investors' perception of rising inflation; timber and agricultural land, an inflation hedge for which values fluctuate on a different cycle, but where results were apparently also good; and real estate, both commercial (offices, warehouses, retail facilities, and so on) and residential (apartment and condominium buildings, for instance)—where results in the recent fiscal year appear to have been least favorable. As might be expected, all of the fixed-income asset classes performed strongly during the year, with domestic bonds up 16.1 percent, foreign bonds up 21.3 percent, and inflation-indexed bonds up 20.3 percent. In total, the real assets account for about one-quarter of endowment holdings, and the bond portfolios another 15 percent; the gains there offset the negative returns in the large domestic and foreign equity portfolios (12.7 percent and 12.1 percent, respectively)—about another quarter of total assets.

In their written narrative on the year's results, Kaplan and Mendillo cited "periods of intense market turmoil highlighted by liquidity disruptions, severe dislocations in various financial markets (examples include residential mortgages, commercial paper, consumer loan markets, leveraged loan markets, and municipal auction rate preferred markets), and emergency policy responses." (Those "responses" ranged from sharp cuts in U.S. interest rates by the Federal Reserve Board to the supervised takeover of the Bear Stearns investment bank, and continued in late summer with the government assumption of control over the Fannie Mae and Freddie Mac housing-finance enterprises.) The result, Kaplan and Mendillo wrote, was "the early to middle stages of a fundamental financial market de-leveraging"—as banks, other institutions, and investors shed assets and pared down debt, often leading to the distressed sale of assets, sharp volatility in investment markets, and unusual movements in the prices of commodities such as oil, all prompting concerns about slower economic growth and, simultaneously, rising inflation worldwide. In the immediate future, they wrote, "[W]e expect to see a continuation of the process of financial market de-leveraging. This process will likely create periods of disruption and market volatility."

In this context, HMC did not itself need internal instability. The unexpected resignation of HMC president and CEO Mohamed El-Erian in the fall of 2007 (see "An Unexpected Risk Factor," November-December 2007) raised the specter of just such disruptions, given that he had only recently put in place a new operating structure and the personnel—several of them new to the management company—to staff it. But the indications are that such fears were not realized. Noting superior relative investment returns in certain of HMC's assets, Kaplan and Mendillo cited "the outperformance of our internal portfolio management group"; successful execution of midyear adjustments to respond to market risks, and of "overlay strategies" to insure the endowment portfolios; and "strong results delivered by a number of our longstanding and recently added external managers." (As Kaplan pointed out, HMC's hybrid structure, with internal and external money management, may yield dividends in turbulent years like the past one. Because HMC manages some funds in-house, the senior management team can have immediate, direct insights into market conditions from their colleagues; such information would be less readily available and timely were they relying solely on third-party firms to invest endowment funds.)

Reflecting on the transitional year, Kaplan and Mendillo cited further recruiting of investment personnel who complement "our existing strengths"; further steps to encourage investigation of new investment ideas and themes; continuing work on asset allocation in a changing world, and on the evolving dynamics of the private-equity and hedge-fund industries (which have been important sources of superior investment performance for Harvard and other diversified endowments); and appropriate responses in light of the rising risks of inflation.

The fiscal year 2008 results and the accompanying commentary bear importantly on the two topics most pressing for the University itself: the availability of funds from the endowment to support Harvard's academic mission; and the investment environment in the near and intermediate future.

As noted, the HMC release put at $1.6 billion the distributions of funds in support of the University's operating budget and capital spending. Details of that distribution will be forthcoming in the next few weeks, when Harvard's annual financial report is published—and will be carefully scrutinized, in light of Congressional interest in private universities' use of their tax-exempt investment returns on their growing endowments (see "Endowments—Under a Tax?" July-August; the most recent hearing on the issue took place in the U.S. Senate on September 8).

It is reasonable to assume that this total combines three kinds of outlays, in a manner first used in the fiscal year 2007 report (see "Getting and Spending," November-December 2007). In that year, endowment income distributed for operations—the conventional measure of distributions—totaled $1.04 billion, up just less than 12 percent from fiscal year 2006; the "strategic infrastructure fund" assessment for Allston campus development totaled $140.5 million; and a $100-million "decapitalization" was made for Faculty of Arts and Sciences construction programs. The sum of those figures totaled about $1.3 billion. Rough estimates for the fiscal 2008 distribution would be operating funds of $1.2 billion, in part reflecting increases in financial aid across the University; an Allston fund assessment of perhaps $180 million or so; and further decapitalizations, to be specified, of roughly a quarter-billion dollars.

As to the investment environment, Kaplan and Mendillo sounded unusually wary. "During these challenging times," they wrote, "we continue to emphasize the importance of HMC’s hedging and risk management strategies. We are quite cognizant of the near-term risk of subpar investment returns from many of the asset classes in which we and other investors participate. We are closely monitoring the deterioration in certain underlying debt and equity markets and the potential impact of these declines on the ultimate realizable value of investments in our private equity portfolio and on certain of the investments held by our hedge fund managers."

Citing what Kaplan calls "very successful" past performance—five-year annualized returns of 17.6 percent, and 10-year annualized returns of 13.8 percent, with very large margins of performance in excess of the market benchmarks and the median returns of large institutions—they were "keenly aware that returns produced in the next few years may fall well short of these robust historical levels. We will continue to aggressively pursue our key investment strategies, as well as appropriate risk management, in order to help the endowment navigate these challenging market conditions. Even with this said, our expectations for the endowment’s returns in fiscal year 2009 and over the next several years are very cautious."

The positioning of HMC's model portfolios and its management strategies suggest confidence in long-term performance for the endowment—Mendillo describes "the great talent working at Harvard Management Company" now, and Kaplan foresees "strong prospects" in the future—but with the real likelihood of a much rougher ride in the next few years than in the comparatively tranquil decade and more that preceded fiscal year 2008.