Index and other passively managed mutual funds provided attractive returns in 2016. Yet even after good years, investors can be forgiven for wondering how much better returns might have been had they been able to access more exclusive opportunities. Imagine an investment portfolio filled with the world’s best hedge funds, exciting private equity and venture capital offerings, and real estate deals in the most promising communities. In fact, it takes no imagination to understand what rates of return are made possible by such privileged access. We can read all about it on the website of the in-house company that manages the $35 billion Harvard University endowment. As it turns out, Harvard’s results haven’t been bad, but they haven’t been all that great, either. The results at Harvard point to a perhaps reassuring truth: the investment advantages conferred by special access are typically modest.

The Endowment Model

From an asset allocation perspective, about 10% of the Harvard endowment is invested in publicly traded stocks of companies domiciled in the United States, and about 20% of the portfolio consists of foreign stocks. Famous U.S. universities often regard themselves as global entities, and domestic/foreign splits of this nature are not especially unusual. Atop this 30% of the portfolio in public equities, Harvard has about 10% of its portfolio in safe, liquid bonds. And that’s pretty much it in the category of what most of us think of as “normal” investments. The other 60% of the portfolio consists of hedge funds, private equity, venture capital, real estate and natural resources – different categories of investments often lumped together under the “alternatives” label.

Why do endowments such as Harvard often allocate so much money to these types of alternatives? Not surprisingly, they expect to earn higher rates of return. In a well-functioning capitalist system, diversified investors who pay fair prices for their investments should be compensated in accordance with undertaken risks. Parting with your money for long periods of time and with little or no opportunity for exit along the way -what in the investment world is called illiquidity- is surely one such form of risk. Academics differ widely as to how much incremental return investors should expect to get paid for enduring illiquidity, but it seems reasonable to expect the reward should be greater than zero (though some say it is zero.)

In addition, universities such as Harvard confidently believe they will be able to access not just the sexiest alternative asset classes but also the best investments available within each of these categories. The data may rudely say that the average hedge fund isn’t worth investing in, for example, but surely the hedge funds (and so forth) Harvard invests in aren’t going to be average, are they?

Survey Says

Adjusted for risk, Harvard’s returns over the past 15 years have been roughly in line with the returns earned by balanced index fund investors. Over the past 5 and 10 years the, returns at Harvard have been lower than those earned by index fund investors.

It is thought that disappointments at Harvard may be due in part to the frequent re-allocation of investments in alignment with the changing convictions of whoever happens to be top dog. Indeed, Harvard Management Company just appointed its 8th CEO (counting interim heads) in 15 years, the same level of turnover the woeful San Francisco 49ers have seen. So many changing faces created a sense of dysfunction, and Harvard recently hired McKinsey & Co. to evaluate things.

Among other criticisms rumored to be contained within its unreleased study, McKinsey criticized Harvard for electing to benchmark its returns relative to portfolios with allocations of 60% stocks and 40% bonds. If Harvard has had only 10% of its portfolio in safe securities, why would it choose to compare its returns against portfolios that are far less volatile? You get no prize for guessing that its top investment managers earn multi-million dollar bonuses for winning this unfair fight.

Measuring returns relative to the experienced riskiness of a portfolio is a necessary component of accurate performance evaluation. Those who own aggressive portfolios expect to earn higher rates of return than those who own safer portfolios. Harvard’s highly aggressive asset allocation is appropriate in light of its permanent time horizon and its bullet-proof balance sheet. During the financial crisis, for example, portfolio losses were huge, and when Harvard was hesitant or unable to dip into its endowment to meet fixed obligations it simply used its AAA credit rating to sell bonds (borrow money) at attractively low interest rates. Individuals such as David Bowie have also been able to sell bonds linked to a promising financial future, but typical investors must weigh their appetite for risk in light of the potential need to draw down savings at unforeseen and inopportune times – to say nothing of the desire to sell risky assets in response to a diminished appetite for volatility.

(Harvard has other ways of boosting the value of its endowment. In 2014, for example, billionaire hedge fund manager John Paulson gave Harvard $400 million. The relatively poor long-term performance of Paulson’s flagship hedge fund was the subject of a Summer 2014 newsletter piece written by my colleague, Aaron Waxman. Since we published Aaron’s piece, the performance of Paulson’s fund has gotten even worse.)

Harvard’s disappointing returns have proven to be rather common among institutional investors, ever more of which are trimming (if not eliminating) allocations to alternative asset classes in favor of “vanilla” stocks and bonds. To be fair, there are, of course, other big endowments that continue to embrace alternatives, the most closely followed of which is surely rival Yale, whose endowment has recorded fabulous long-term rates of return. As with any bell-shaped distribution, there must be both winners and losers. Within the rarefied world of multi-billion dollar institutions, the difference between them will be a function not of “smart” and “dumb” so much as the possession of some insight yet to be validated. Looking ahead, public market investors may again enter a season in which relative disappointments will encourage some to try to mimic Yale’s approach without ending up with Harvard’s result.

Addendum: On January 25, and subsequent to the writing of the above, the Wall Street Journal reported sweeping changes at Harvard Management Co., including the intention to outsource management of most of the endowment. The Journal noted that the changes “reflect the challenges even the most sophisticated institutions face in actively managing their assets.”08

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