Harvard Management Corporation (HMC), which
runs the world’s largest endowment fund, has had until
recently an incredible record. Over the past six years,
it succeeded in more than doubling the notional value of
Harvard’s wealth to a $36.9 billion in fiscal 2008
(which ended on June 30th) even after paying for about one-third
of Harvard’s operating expenses. So its recent loss
of $8.2 billion between from July 1 through Oct. 31 2008
came as a stunning blow . This huge loss, as staggering
as it sounds, may only be the tip of the iceberg of illiquid
investments. According to a source close the Harvard Management
Corporation, the damage, if the fund’s illiquid investment
are realistically appraised, may be closer to $18 billion.
The lack of clarity as to size of the loss proceeds from
the illiquid nature of the financial exotica in which Harvard
is now heavily invested. Its team of highly incentivized
money managers– who themselves earned $26.8 million
in 2008– adopted a strategy aimed at taking maximum
advantage of an inflationary global boom in the early 2000s
by shifting the lion’s share of Harvard’s money
from conventional endowment assets, such as bonds, preferred
stocks, Treasury bills and cash, into more esoteric investments
that would presumably rise as more money chased after scarcer
goods. They bought, for example, oil in storage tanks, timber
forests, and farm lands. While by the proliferation of trillions
of dollars worth of sub-prime mortgages further expanded
the bubble, driving up the price of oil, lumber and land
rose, the notional value of Harvard’s portfolio soared.
The price of oil, for example, which Harvard and other speculators
were storing, more than quadrupled to $153 a barrel on commodity
exchanges, allowing Harvard to hugely appreciate the notional
value of its portfolio. So, between fiscal 2003 and 2008,
Harvard’s “real assets” showed a gain
of nearly 25% annually. But even after the subprime mortgage
crisis began to unfold and a number of financial institutions.
Including Bear Stearns had collapsed, Harvard’s money
managers persisted in focusing on countering the risk of
“continued longer term inflationary pressures - exacerbated
by supply/demand considerations for various commodities.”
Consequently, as late as June 2008 , the fund kept no reserve
of cash or treasury bills and allocated a mere 6 percent
of its money to fixed interest bonds. It also borrowed over
one billion dollars to amplify the returns on its less conventional
investments. So, by the time the bubble burst in the fall
of 2008, only a small fraction of the endowment fund investment
was even under the jurisdiction of the SEC. According to
the 13F holding report it filed with the SEC in September
2008, Harvard had only $2.86 billion of its funds in exchange-listed
stocks, options or other derivatives. What had happened
to the rest of the more than $35 billion* it had allocated
to investments at the start of Fiscal 2009 (in July) 2008?*
[*- From the $36.9 it had on June 30th, it had distributed
$1.6 to the University which financed one-third of its budget,
and another $200 million went to pay to HMC for the costs
or administration and bonuses.]
Most of the balance had been allocated to investments, which
if not totally illiquid, could not be valued by market activity.
The breakdown that follows illuminates how far HMC had strayed
from the path of traditional endowment investing.
More than a quarter of Harvard’s funds were still
sunk in “real assets”; 8% in stockpiled oil,
9% in timber and other agricultural land, and 9% in real
estate participation. Then came the financial crises, and
prices plunged. Oil fell to under $40 a barrel. Lumber suffered
almost as badly. And, with the drying up of bank lending,
the value of its real estates holding became at best, problematic.
One indication of how steep the loss may be is that CalPERS,
the giant pension fund of the California Public Employees’
Retirement System, which owned even more real estate acreage
than Harvard, reported in this period a 103% loss on real
estate deals in which, like Harvard, it had borrowed to
amplify its profits.
Another huge portion of Harvard’s endowment had been
farmed out to hedge funds (18%) and private equity funds
(13%). While these funds provided some diversification,
many of them also impose restrictions on withdrawals, including
ones, like Citadel, that suffered substantial losses. To
get back its money under such circumstance, it was often
necessary to sell at a steep discount to a “secondary”
hedge fund. One major player in the private equity business
tells me that Harvard had tried this Fall to sell its private
equity stakes at 30 to 35 percent discounts but find no
buyers even at those prices. Even worse, the typical private-equity
fund has a provision for "capital calls," requiring
investors to put up another 50 cents to 75 cents for every
dollar they already have committed. If so with Harvard,
the $4 billion it has allocated to private equity may not
only o be drastically reduced in value, but might lead to
a massive drain on its remaining capital.
Harvard also allocated nearly $4 billion, or 11% of its
fund, to volatile emerging markets, such as Brazil, Mexico,
and Russia. Here its money managers bet both that the stocks
would go up and that the local currencies would at least
hold steady against the dollar, but lost on both counts.
First, the thin local stock markets, which had little liquidity,
collapsed in the financial crises. For example, Russian
stocks, lost almost 80%, of their value in a mater of days.
Then, as banks and hedge funds, got out of their currency
trades, the local currencies in many of these countries
also lost heavily against the dollar. The Brazilian Real,
for example fell about 40% . So the endowment fund took
a double hit.
Aside from emerging markets, Harvard had invested another
11 percent if its portfolio in more established foreign
economies, as those of Britain, Germany, France, Italy,
Australia, and Japan. But here the stock markets declined,
and, with the exception of the Japanese yen, so did their
currencies.
Given the true cost of getting its money out of the hedge
funds and other illiquid investments, my knowledgeable source
finds the claim by Harvard’s money managers that the
fund only lost 22 percent at best “purely pollyannaish.”
But while Harvard’s money managers may chose to look
through rose color glasses at the value of their portfolio
, Harvard University, which relies on the interest from
distribution from its endowment to fund one-third of its
operating budget, needs to be more realistic. As its President,
Drew Faust, noted in letter to the Harvard faculty, “We
need t\o be prepared to absorb unprecedented endowment losses
and plan for a period of greater financial constraint.”
To be sure, Harvard Management Corporation flight to illiquid
assets strategy did not occur in a vacuum. Harvard’s
money managers developed their ideas taking advantage of
their “connections to Harvard University researchers
and professors,” as they say in the 2008 annual report.
Up until mid 2006, Larry Summers, a former deputy secretary
of the treasury (and now the head of Obama’s Economic
Council, was Harvard’s President While it is not known
what, if any, direct liaison Summers had with the Harvard
Management Corporation,, he seemed to endorse its strategy
in 2006 at a speech at the Reserve Bank of India in Mumbai
when, citing the high returns that college endowment funds
then had been achieving, argued that “By investing
in a global menu of assets U.S. institutions have earned
substantial real returns over the years.”
Nor was Harvard alone in moving from traditional investments
to a more“global menu”. Yale’s endowment
fund, which with $22.5 billion in assets in 2008 was second
only to Harvard’s, followed a similar strategy of
finding alternate investments including hedge funds, private
equity funds, physical commodities, and emerging markets.
Its longtime manager David Swensen indeed makes the argument
in his book "Pioneering Portfolio Management"
that diversifications of this kind are safer than just investing
traditional stocks and bonds. And during the decade preceding
the present financial crises his fund actually outperformed
Harvard’s. But despite his efforts at diversification,
Yale lost at least 25% of its fund in the fall of 2008 if
one , takes into account the plunging value of its illiquid
assets.
Up until the financial crises, comparative endowment fund
performance became the financial equivalent of athletic
rivalries, with Yale President Richard Levin, for example,
pointing to the 2007 results (which beat Harvard), bragged,
“The stunning thing is how much we outperformed other
endowments,” While Harvard, using other yardsticks,
noted in its 2008 report that its “annual outperformance...
easily places Harvard in the top five percent of all institutional
funds.” Hoping to match Harvard and Yale’s dazzling
records of multiplying the notional value of their endowment
funds other universities across the country, who, followed
suite, plowing much of their endowment funds into financial
exotica and other illiquid assets. In 1995, endowments had
less than 10% of assets in these alternative type investments;
by 2008, that average had climbed to more than 30%. Consider
the plight of Columbia University. As oft June 2008, 41%
of its $7 billion endowment fund was in hedge funds and
40% in private equity funds, and is liable for another $1.6
billion in capital calls up until 2012(which would wipe
twice over all its stock, bond , cash other liquid investments.)
The collateral damage is yet to be fully reckoned, but the
damage is beginning to show. In December 2008, Berkeley
Chancellor Robert J. Birgeneau warned in a letter to students
and faculty, “As of today, we are already seeing that
the leading private universities have experienced significant
drops in the value of their endowments and are engaging
in severe budget cuts." So institutions of higher education,
like other speculators seeking enormous profits in what
is essentially a zero-sum game, learned the sad lesson that
playing for high stakes in the casino economy inexorably
entailed the risk of catastrophic losses.
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