Monday, February 09, 2009

Harvard's Casino Investing

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.