SATURDAY, FEBRUARY 8, 2014

Lessons Learned at Harvard

Slammed in the financial crisis, the universitys endowment has been tweaked, in part to add liquidity.

Jane Mendillo has one of the most prominent jobs in the investment world. As the CEO of Harvard Management, she oversees the $32.7 billion Harvard endowment, the largest university endowment in the country.

She began the job at an inauspicious time, in July 2008, just months before the financial crisis hammered the Harvard endowment and exposed its weaknesses, including a lot of illiquid investments. The endowment declined by 27.3% in its fiscal year ended in June 2009 and still hasnt gotten back to its pre-crisis peak of $36.9 billion.

Mendillo has restructured the endowment to improve liquidity and has successfully pushed for initiatives such as greater direct real-estate investments, which have produced strong results. Overall, returns have been good, not great, during her tenure. Harvard was up 1.7% annually in the five years ended in June 2013, ahead of its benchmarks in a policy portfolio—or targeted asset allocations—by 0.5 percentage points, but behind endowments at peers such as Stanford. Part of this reflects a weak performance in fiscal 2009, which had a lot to do with the portfolio left by her predecessor, Mohamed El-Erian, who recently quit a top job at Pimco.

Harvards return in the past four years, arguably a more telling measure of Mendillos performance, looks better at 10.6% annually, 1.4 percentage points above the endowments benchmark.

Harvards endowment remains widely diversified, with a modest 11% in U.S. stocks, and 55% allocated to alternative investments, including private equity, hedge funds, real estate, and natural resources. The Harvard model was distinctive a decade ago, but has since been widely imitated by foundations, endowments, and many individuals.

Harvards unusual hybrid approach combines an internal team of investment managers, who run about a third of the portfolio, and outside firms, who manage the rest. Most big endowments farm out nearly all of their money. Harvards strategy has lifted its returns, but also led to some unfavorable publicity about high compensation for top-performing internal managers. Harvard Management (HMC) is part of the university, which must disclose the compensation of its top-paid employees each year. Mendillo made $5.3 million, and one of her colleagues netted $6.6 million in 2011, the most recent year for which data are available.

Mendillo came to Harvard after running the Wellesley College endowment for six years. Before that, she spent 15 years at Harvard Management. Barrons  spoke with her recently at HMCs Boston offices. She discussed stocks, bonds, and private equity, as well as the endowments returns and how individuals can invest like Harvard Management.

Barrons:   What have been your biggest accomplishments in five years running the endowment?

Mendillo:  Since the financial crisis in 2008 to 2009, weve rebuilt and restructured the portfolio. Weve also rebuilt the team here at HMC.

Can you talk about specifics?

Were doing most of our real-estate investing in direct deals and joint ventures, instead of through private funds, and that gives us a lot more control over buy-and-sell decisions and leverage. Probably 50% of our real-estate portfolio is held directly. Theres been a huge difference in the performance of our direct investments and our legacy real-estate portfolio. The direct investments have added a lot of value. Weve invested in a range of assets, including senior-living facilities and projects that couldnt be funded by the original developers.

What did you learn from Harvards experience in the financial crisis?

It was a stressful period for us and for a lot of portfolios. The liquidity in the endowment was not what it should have been. We now have fewer investments locked up for multiyear periods with outside managers, and that was one of my goals coming in.

Harvard has a widely diversified portfolio. In the past few years, a simple approach of buying the S&P 500 or using a 60/40 mix of stocks and bonds has done as well or better than the Harvard endowment. Does your strategy still make sense?

It does. If you are a long-term investor, you want to be diversified across markets and geographies. Thats our approach. In one particular year, the S&P 500 may beat our portfolio and may beat every endowment portfolio. And in another particular year, a 60/40 stock/bond portfolio may beat our portfolio. But over time, there is a really significant difference between our portfolio and a 60/40 portfolio.

What are the numbers?

In the 10 years ended June 30, Harvards endowment returned 9.4% annually, versus 6.8% for a 60/40 mix of global stocks and bonds. That difference of almost three percentage points is worth billions of dollars of value to the endowment. When theres a year or two in which the 60/40 portfolio beats the endowment portfolio, people love to write about how the endowment model may be inferior, but thats very short-term thinking. The evidence looking back, and, I think, looking forward, is that being more diversified is going to pay off.

What about volatility?

Theres a lot more volatility in the stock market and in a 60/40 portfolio than there is in our diversified portfolio. So not only has the portfolio added a lot more value over the last 10 and 20 years than a 60/40 blend, but the portfolio has done it with less volatility.

Harvard has just 11% of the portfolio in domestic stocks. Why would you want such a small allocation to the worlds biggest equity market and some of the best companies?

We want equity exposure, but weve spread it across U.S. public equities, private equity, and international markets, and that has created a lot of opportunity.

Youve talked about some of the challenges now in the private-equity industry.

Private equity is a much more crowded place than it was 10 or 20 years ago. So you need to be choosy and pick the right managers and opportunities. It has been estimated there is a trillion dollars of dry powder in the private-equity industry today.

So thats money committed by investors, waiting to be deployed?

Thats right. That is going to create a competitive environment for private-equity managers who are putting money to work. It will drive up deal prices and drive down returns to more modest levels.

How much added return do you need in private equity, in return for tying up your money for five or 10 years?

We should be getting an incremental return for that illiquidity—and we call that our illiquidity premium—of at least 300 basis points [three percentage points] annually on average over what we are expecting in publicly traded stocks.

Given the hurdles for private-equity managers, why does Harvard have such a big allocation there?

Our portfolio is a combination of private equity and venture capital. Its worldwide. We have positions in some very good funds. If we were building a private portfolio from scratch today, it would be very difficult to get to a 16% allocation, which is our policy-portfolio allocation in the asset class, because of the overcrowding and all that dry powder.

The endowment is critical to the financial health of the university. About 5% of the endowment each year is used for the university operating budget.

Its actually a little bit north of 5%, and the endowment delivers about 36% of Harvards operating budget. To support that spending rate and to protect against inflation, we need to generate about an 8% annual nominal return over time.

Is that hard to do, given low rates?

Just about everybody would say that it is harder today than it was 10 or 20 years ago. Part of that is the interest-rate environment and part of that is that less-efficient asset classes are more crowded.

Over the next five to 10 years, can the endowment return 8% to 9% annually?

I certainly hope so. I think were well positioned to do that.

Why such a low allocation to bonds, at about 11%?

Bonds are traditionally a stabilizer in the portfolio. But with interest rates where they are, the potential return on bonds seems asymmetric. There seems to be more downside, more chance that interest rates are going to go up than that they are going to go down further. The coupon [interest rate] on the bonds just isnt that attractive. So over time, we have taken money out of bonds and put it into other places in the portfolio.

You manage the bonds in-house?

Thats right.

What portion of the Harvard endowment is run internally?

Its about 30% to 35%. Fixed income is a great example. We manage all of our money in fixed income through an internal team here, and theyre active traders. They look across markets globally for opportunities, and theyve been really successful. So although our allocation to fixed income has declined, weve added a lot of value, relative to our benchmarks, and we are very happy with that.

When your internal managers do well, they can get paid millions of dollars annually. That led to some criticism in the Harvard community. Does it bother you?

The compensation issue has cropped up from time to time. There is a big difference between what we pay for our fixed-income management and performance through our internal team and what we would have to pay for the same performance from an outside manager. The cost for an outside manager would be a multiple of what we pay for inside management. Overall, our approach has been very cost-effective for the university.

How can an individual invest like Harvard?

Individuals shouldnt try to be as complicated as Harvard, and they need to keep their investment horizon in mind. Harvard has been around for almost 400 years. It is going to be around for another 400 years, at least. We have a very long-term horizon, and so we can afford to be opportunistic and illiquid with a lot of the portfolio. Individuals have a shorter time horizon, and they may have different sensitivities, including a need for income. So if they want to invest like Harvard, they should be diversified.

Which means?

That means a mix of assets: stocks and bonds, as well as other assets like real estate. Id also suggest that they invest across geographies. Although things have looked very good in the U.S. equity market in the past year or two, that can change.

Anything else?

Individuals should do research before they make investments. Im surprised by the number of individuals—even smart and sophisticated individuals—who will make investments in their personal portfolios that they havent really investigated. We do a tremendous amount of research before we invest any money on Harvards behalf.

What do you think of emerging-market equities now?

Given our long-term view, emerging markets look attractive. There is a lot of consternation out there about emerging markets, and there is good reason for some of it. But those concerns really are for the next six months or a year or two. Were looking at investments over a five-to-10-year time frame, and in that context, emerging markets are attractively priced today.

Harvard often is compared with other endowments, including those of Yale, Stanford, and Princeton. While Harvards performance has been good relative to your benchmarks, it has trailed some of your peers. Whats happening?

The difference between Harvards performance and our peers performance is something the press is always going to be interested in. But other institutions may have different risk profiles and different needs. So we think our policy portfolio meets Harvards needs, and we are very happy when we beat that and add value, which we did last year [by more than two percentage points] to the tune of over $600 million. So Im pretty happy about that.

How much longer do you want to spend running the Harvard endowment?

This is a great place to be for someone in my field. Its the best job in the world. Id like to be here for as long as Im adding value.

Thanks, Jane. •