Were institutional investors swimming naked? The Harvard endowment fund case

(I wrote this post about a month ago but decided to finish it. Perhaps given my mood of late, it has turned more critical than the initial write-up.)

I ran across an article, originally mentioned by Naked Capitalism, which referred to a Felix Salmon blog entry, on Harvard university's endowment fund mess. The article, Drew Gilpin Faust and the Incredible Shrinking Harvard by Richard Bradley, is an attack on Harvard University's president and is not important to me, but it did have some information on how the university's endowment fund was investing its assets. I have decided to quote a huge chunk of the text in order to provide full details contained in the article:

The roots of Harvard's fiscal crisis go all the way back to 1990, when money manager Jack Meyer left the Rockefeller Foundation and assumed the reins at the Harvard Management Company (HMC). Breaking with the traditionally conservative approach, Meyer was in the forefront of university portfolio managers who integrated complicated financial instruments into endowment investments. He reduced the amount of stocks and bonds in Harvard's portfolio to less than 30 percent and diversified into illiquid assets such as commodities, real estate, timber, hedge funds, and private equity. He also ventured into financial tools such as derivatives and emerging market debt that carried more risk than stocks and bonds but promised much larger returns. "There's not much plain vanilla in our portfolio," Meyer told BusinessWeek in late 2004.

When Meyer came to Harvard, the endowment stood at $4.7 billion. When he left 15 years later, that number was $22.6 billion. From 1995 to 2005, the endowment averaged a nearly 16 percent annual return, beating the benchmark for peer universities by more than 50 percent.

...

Meyer left in 2005 amid controversy over the multimillion-dollar bonuses paid to some of his money managers. Rumors also swirled that he had clashed with Larry Summers over control of HMC. It's hard to know: Neither man is talking. Still, there is no question that Summers took a much more active role in Harvard's money management than his predecessors.

After Meyer stepped down, he was replaced by Mohamed El-Erian, a managing director at the bond giant Pimco, who lasted just under two years in the post. He was followed by Jane Mendillo, who had been managing Wellesley College's endowment, and whose assumption of the job last July would become the very definition of bad timing.

The turnover may have hurt, because last fall's stock market meltdown seemed to catch HMC asleep at the wheel. As of June 30, 2008, the Harvard endowment was 105 percent invested: HMC had borrowed above the endowment's value in order to make additional bets. With the vast majority of its money tied up in holdings from which it could not easily be extracted, the university was ill prepared when the tanking Dow spurred anxious counterparties to call in their chits. Those margin calls forced Harvard to put up collateral—cash that it did not have. And it couldn't unload its illiquid investments to come up with that money, because their value had fallen so precipitously that no one had any idea what they were really worth.

Further squeezing Harvard was a transaction Summers had pushed it into in 2004, when he successfully argued that the university should engage in a multibillion-dollar interest rate swap with Goldman Sachs and other large banks. Under the terms of the deal, Harvard would pay Goldman a long-term fixed rate while Goldman paid Harvard the Federal Reserve rate. The main goal was to lock in a low rate for future debt, and if the Fed had raised rates, Harvard would have made hundreds of millions. But when the Fed slashed rates to historic lows to try to goose stalled credit markets, the deal turned equally sour for Harvard: By last November, the value of the swaps had fallen to negative $570 million. The university found itself needing to post more collateral to guarantee those swaps, and would ultimately buy its way out of them at an undisclosed cost.

...

And so last fall HMC had no choice but to sell some $2 billion worth of stock into a plunging market. Harvard also raised an additional $2.5 billion by selling bonds on which—again because of the awful timing—it will pay interest at a significantly greater rate than identically rated corporate debt. As Bloomberg News has reported, the terms of Harvard's bond sale mean that its interest costs will mushroom to as much as $550 million over three decades. In February, HMC, suddenly not looking so smart anymore, started laying off about a quarter of its staff.

...

Though the stock market hemorrhaging appears to be over, Harvard isn't out of trouble. According to the university's 2008 financial report, in the next 10 years it must pay various private investors some $11 billion in capital commitments. Where will that money come from if, as seems likely, endowment growth over those years is minimal or nonexistent, and alumni's own strained budgets limit their generosity?

The Harvard case is a good one to study because it is representative of many other institutional funds. I have referred to some massive losses at some Canadian pension funds in the past so this isn't a Harvard-only issue. The question in my mind is whether institutional managers were simply lucky, rather than being skilled. Many of the funds in question beat the stock market but keep in mind that these funds are supposed to own "safer" and less volatile instruments like bonds. These funds should not be posting massive losses since they are not supposed to pursue risky strategies. But were they actually doing risky stuff?


The first thing that will jump out, in the Harvard case or others, is the fact that a big chunk of their portfolio consists of illiquid assets, like hedge fund holdings, private equity, and commodity holdings. It's amazing to me that the fund had only 30% in stocks and bonds at one point (not sure what it holds right now.) Institutional funds profitted immensely—given how it is difficult to sell illiquid assets, I assume the profits are mostly paper profits—from alternative assets in the last two decades but was that simply luck or was it skill? To make matters worse, as I have speculated several time befores, there is likely a lot of unrealized losses embedded in private equity positions. As the article mentions, Harvard may need to provide up to $11 billion in capital calls over the next 10 years. I am not familiar with private equity and am not sure what the legal rights of fund investors are, but it wouldn't surprise me if most of the future capital calls will be to fund failing enterprises on the verge of failure. There is a lot of shady behaviour undertaken by private equity during downturns (consider this New York Times story dealing with Archway and Mothers cookie company.)

Another remarkable thing is how the Harvard fund was leveraged slightly (105% long) going into the bust. I am not a fan of debt and will probably never use it for investing throughout my life but it's surprising to see a fund with largely illiquid assets use even a little bit of leverage. Admittedly, debt was cheap and it was in everyone's interest to borrow as much as they can. But if you didn't have liquid assets to service the debt, it was risky no matter what the debt servicing cost or terms of the debt were.

The interest swap bet by Lawrence Summers, who is now the key economic advisor to Obama, was ill-advised but I don't you can fault the fund for that move. Almost everyone was expecting interest rates to rise post-2004 so the swap wasn't necessarily bad. Unless you were expecting a major credit bust and* was anticipating deflation, it was hard to see rates declining below the already historically-low rates in 2004. So, yes, the public and Harvard members, who expect professional investors to be correct, can blame the bet but, speaking as an investor, I think it was a reasonable decision.

Finally, I am surprised to learn that endowment funds, like the Harvard fund, were selling into the market crash. I always thought that endowment funds, along with some investors such as value investors, were liquidity providers during crashes (i.e. they buy during crashes). But it seems that a large fund like Harvard was actually selling into the chaos. I thought it was mostly retail investors and hedge funds but it seems some institutional funds were selling too.

One other point is something the article doesn't go into. I am not sure what role Mohamed El-Erian had in the blow-up of the Harvard fund. He only worked there for a short while before returning to PIMCO but he surely must have been aware of the portfolio holdings for an year or so, just before the major bust.


(* You had to have called not just a credit bust but also major deflation. There were quite a few who called a major bust but did not anticipate that prices of nearly all assets would be chopped in half. Many super-bears were expecting an inflationary bust.)