Financial Markets

Q1.
HMCs aims to provide relatively predictable cash flows from the endowment to the
different schools within the university. As stated in the case, the general objective
was to preserve the real value (adjusted for Harvards expense growth) of the
endowment and its income distribution in perpetuity. In recent years, the payout ratio
(Endowment spending as a % of total Endowment value) has had a target range of
4.5% to 5.0%.
In the cases example, the average growth rate of Harvards expenses is 3% above
CPI inflation rate and annual gifts to the endowment average about 1.5%.
Hence, with a payout ratio target of 4.75%, we would get an Expected Return of
6.25%:
4.75% + 3% - 1.5% = 6.25%

Q2.
The Policy Portfolio is the neutral guide of long-term asset allocation set by the
HMC board and it serves as a benchmark of actual performance and as a metric
against which compensation of portfolio managers is measured. The aim of the Policy
Portfolio is to provide targets for different asset categories as a percentage of the total
portfolio, in order to achieve a long-term expected return with the least risk possible.
The policy portfolio is reviewed every year and it is modified as a result of changes in
market conditions, needs for long-term expected returns, and risk aversion.
Jack Meyers vision was to keep the actual asset mix fairly close to the Policy
Portfolio. Fairly close means that the Policy Portfolio included a minimum and a
maximum percentage range for each asset class within which portfolio managers
could invest, without a previous authorization of the HMC board.
If Meyer is correct in the perception of portfolio managers skill to capture relative
mispricing among similar securities, then the Policy Portfolio could be a very useful
investment guide. In this scenario, portfolio managers would continuously outperform
the benchmarks for each asset class.

Q3.

Harvard managed most (65% in 2000) of its assets internally whereas virtually all of
the assets of other prominent research-oriented universities were managed by outside
firms. Not paying any management fees or transaction costs for the proportion of the
overall portfolio managed by HMC could be considered an advantage.
Another important factor is Harvards triple A credit rating. As given in the case, the
credit rating A helped Harvard finance large positions and place HMC as a preferred
counterparty for swap transactions, which was sometimes a key link in the overall
process.

Furthermore, HMC employed a compensation system that not only helped to attract
and retain some of the most adept portfolio managers in the market, but also permitted
to align the economic objectives of portfolio managers with those of the university. In
other words, the structure and compensation system of HMC was designed
specifically to achieve its objectives and to maintain the real long-term value of
Harvards endowment



Q4.

In exhibit 9, it compares the returns of the Harvard Endowment to the Harvard Policy
Portfolio, and to TUCS Median (Large funds (mostly pension funds). Overall the
average annual differences in returns over the past 9 years between the Harvard
Endowment and the TUCS Median have been 5.2%. This can further be broken down
into excess returns due to asset allocation 2.2% and due to active stock selection
3.0%.

Probable reasons for the superior Asset Allocation returns over TUCS median:

- TUCS is composed mainly of pension funds. Traditionally Pension Funds
have been comparatively less efficiently diversified (though this trend has now
changed somewhat).
- Ability of HMC to capitalize on its advantages (as depicted above), and invest
in diverse asset classes
- Lower constraints of risk tolerance and annual payout requirements.
- A carefully crafted, superior allocation policy which optimizes the risk return
tradeoff.

Probable reasons for the superior active investment selection over the policy portfolio:

Judicious deviation from the policy allocation
Competent and skilled investment managers
Significantly high proportion of internal asset management, which works well
when having competent managers and it reduces investment management
overheads.

Of course, the higher returns, being post-facto and just over might be due to post-
facto favorable outcome. We can statistically test the significance of the difference
through a hypothesis testing.

The policy portfolio had lower returns 4 years out of the total 9 years, whereas the
HMC Endowment had lower returns than the policy portfolio 2 years out of the 9
years mentioned.






Q5.

HMC uses its compensation system to ensure that managers are incentivized to
actively manage the portfolio to generate a positive alpha. The average basic salary of
the managers is comparatively quite low, however they are subjected to high
performance based commissions. Further the benchmark returns are the expected
returns from the policy portfolio. Investing in Index funds will at best give a
performance equivalent to the Policy Portfolio, and therefore not allow for
commissions to be dealt out

Further, the claw back system also plays a role in measuring the skill of the investors,
and separating it from luck. The system states that only a percentage of the
commission will be given out on the year it is perceived by the endowment. This sum
is capped at 2million dollars, and the rest is kept in reserve and handed out over the
following years depending upon the future performance of the manager. In fact, if the
investor performs below the Policy Portfolio in the following year, the remainder of
the Y-1 fund is reinserted into the endowment fund. This reduces the probability of
commission received due to chance, as it can sometimes happen that a portfolio over
performs by chance, due to certain market characteristics. In those cases, the investor
may have invested randomly, and a positive outcome may have resulted. But a
continuous over performance as compared to the Policy Portfolio would be less likely
to be achieved due to chance.


Q6.

The Modern Portfolio Theory builds on the concept of diversification as the tool for
reducing portfolio volatility of mean-variance investors, and thus concluding to invest
along Capital allocation line (which has the highest Sharpe ratio, i.e. maximizes
returns per unit of risk, or in other words minimizes risk per unit of returns).

This is important to Harvard as its objective is to achieve the highest return at an
acceptable level of risk, considering its constraints. It is within this framework that the
Policy Portfolio is created.

The MPT is a guideline that has greatly influenced the way Harvard has setup Policy
Portfolio. It is however important to point out the limitations of this framework. The
framework is based on estimations of expected returns, volatility and correlations
between asset classes, and is extremely sensitive to each of these inputs. Generally,
past historical observations are the standard estimates for these variables, and it is
well known that future may not be a perfect indicator of the past, and further that in
times of distress correlations amongst otherwise low correlated assets significantly
increase. This is the reason that the Endowment uses the MPT framework as a starting
point, and estimates upper and lower bands of each asset class. Further, the
Endowment also adjusts the expected returns for some asset classes (increasing the
expected returns of domestic bonds to 4%)

In summary, the MPT and P.P should be used as indispensable tool and as a starting
point for asset allocation, but cannot and should not replace intuition and judicious
analysis. Further since conditions internal and external change frequently, so should
the asset allocation policy.





Q7.

The input variables of the asset allocation based on the Modern Portfolio Theory
framework expected returns, standard deviations and correlations need to be
estimated. HMC gets the input estimates from the following sources:

1. Examination of both long term and short term historical records of each asset
class in terms of risk, return and correlation.
2. Information gathered from a number of consultants and investment
management firms outside HMC which specialize in this kind of analysis.
3. Final adjustment done to the assumptions of risk, return and correlations based
on the existing market conditions so that the inter asset comparisons are
logical.
4. Market intelligence through participation as both buyers and sellers in the
secondary markets for illiquid assts. (HMC endowment 2010 report).

Q8.
No, HMC does not only rely on only the historical data for estimation of expected
returns, standard deviations and correlations for various asset classes. Rather it uses
its experience and judgment to finalize the values to adjust the historical returns based
on the existing market conditions.

One example is the adjustments made in the assumption of returns for conventional
bonds in the light of the real returns of inflation-indexed bonds. It was found the real
return of inflation-indexed bonds was 3.6%. Logically the expected returns of
conventional bonds should be higher than that of inflation indexed bonds. Therefore,
although the historical data suggested that the expected returns of conventional bonds
to be 2-3%, HMC made final adjustments in its assumptions and pegged the return to
4.0%

Q9

One of the major difficulties is to predict the portfolio performance (as determined by
the expected returns and volatility of each asset classes and the correlation between
each of the classes) in case of rare events (Black swans) to capture the downside risk.

There is a risk management team at Harvard that continuously assesses the risk of the
portfolio to extreme environments and thus monitors the exposure of the portfolio on
a regular basis

To account for the uncertainty in asset returns in case of Black Swan events, Harvard
uses the method of stress testing, which checks how the portfolio is going to behave
in an extreme market environment. For this, the case provides that Harvard has stress
tested its portfolio one based on the October 1987 market crash, and one based on
the dramatic widening of arbitrage spreads in the fall of 1998.

Stress testing is beneficial in terms that it helps to overcome limitations of static risk
testing (sensitivity analysis), as in this all the variables are set free to change. Since
variables behave significantly differently in stress times, this approach is more robust,
especially for 5 sigma and higher events.

This in turn helps in facilitating risk mitigation or contingency plans for such
situations. Continuous stress testing is extremely important so that HMC does not lose
sight of extreme conditions during a financial crisis and end up ignoring the possible
risk of such a situation.

Nevertheless, the causes and effects of Black swans are by definition unpredictable,
therefore just evaluating the portfolio performance based on two specific past events
is not sufficient. In all probability, the conditions and situations leading to the next
black swan event will be different from the past, and thus so would be the outcome.
Thus HMC stress testing should also be forward looking by assessing and modelling
various situations which might lead to such, estimating the outcomes of such and their
impact on the portfolio. More refined methods for integrated stress testing risk
analysis that incorporates plausible events that are not necessarily captured in
historical data or in historical stressed calibration of risk models may be
complimented




Q11.
Before 2005 HMCs Policy Portfolio was heavily weighted towards Domestic
Equities and with a considerable percentage dedicated to Domestic Bonds. In effect,
before 2005 HMC used a Policy Portfolio very similar to the standard US mutual fund
mix.
In 2005 we see that there is a strong shift to hedged investments and an increase in
alternative investments while retaining the leverage that was used in previous years.
In 2010 we see that an equal weight is given among domestic, foreign and emerging
equity markets while hedged investments are increased. At the same investments in
fixed income investments is considerably decreased and they stop using leverage and
start holding some cash reserves instead.
Thus, it is safe to say that there have been significant changes in HMCs Policy
Portfolio moving away from leverage and holding cash reserves to avoid liquidity
problems and reducing its investments in fixed income assets due to the low interest
rates after the crisis began.




Q12
Yes, we agree with Harvards investment strategy to a large extent. HMC understands
its financing needs, risk tolerance, and return requirements, as well as the investment
environment, and allocates and invests accordingly. We believe that they have
capitalized well their inherent and competitive advantages to achieve significant and
consistent positive alphas.

They have efficiently diversified their portfolio into diverse asset classes
internationally along their capital allocation line.
Their active investment management and selection is especially noteworthy
for its consistent and significantly superior alpha. Nevertheless, we take this
with a pinch of salt, because their hedge fund style strategies to capture
relative mispricing may leave them exposed to a greater than anticipated and
quantified risk.
They have a dynamic view of their portfolio, their strengths, and market
conditions, and constantly try to evolve accordingly.
They have leveraged their network and strong position to identify good
investments and positions at favorable terms.
Their risk assessment and management policies appear to be robust, but
nevertheless may be improved upon as discussed in our previous question.
They have overcome the administrative bottlenecks for their compensation
system which are generally prevalent in a conservative educational institution
setup. Accordingly, their compensation system matches that of peers in a more
private setup are aligned to ensure superior returns, and mitigate the
probability that such are due to chance.
However, we are concerned with the low liquidity of their portfolio, which
may not be adequate in case of any market shock or if the payout requirements
are high in any particular year. This may require fire selling their assets at low
prices in such adverse situations.
The main three points to take away from Harvards case are: a) Good
incentives are key to superior performance b) Liquidity needs should be
considered taking into account potential downturns c) The investment
landscape is a dynamic one and investment strategies need to be constantly
fine-tuned while taking a long-term approach in the overall strategy.
There are