Analyse of the endowment model employed by Harvard and Yale and identify the reasons why Harvard made more losses than the other endowment funds in 2009

1. H A RVA R D
ENDOWNMENT FUND
Tian Lun
Donavan Lim
Foo Wei Shing
Ng Wenying
The Endowment Model

2. Content
1 Background on Harvard & Yale Endowment
2 Harvard vs Yale
3 What went wrong in 2009?
4 Current Risk Environment and Harvard’s Changing Obligation
5 How Harvard Modified Swensen Model Post Crisis
6 Portfolio Optimisation Analysis and Recommendations

3. Background: Yale & Harvard Rivalry
• Yale and Harvard, rivals in the academic sphere, extended their rivalry to
the sports and financial world.
• Yale pioneered a new endowment model that returned superior returns
which resulted in many endowment fund seeking to emulate the Yale
model.
• This became known as the Yale or Swensen model.
• Not to be outdone, Harvard “pioneered” its Hybrid model.
1
Yale Harvard
Swensen Model Hybrid Model

4. • Named after David Swensen, chief
investment officer of Yale University
• Swensen had steered Yale’s endowment
1985: US$1bn  2008: US$22.9bn
• Under Swensen, Yale pioneered an
unconventional approach to managing its
endowment  Swensen Model
• In the model, significant investments were
made in less efficient equity markets
o private equity (venture capital and
buyouts),
o real assets (real estate, timber, oil,
and gas), and
o absolute-return investments (hedge
funds).
Background: Swensen Model1
History Principles
• Equities, whether publicly traded or
private. He pointed out that equities are
a claim on a real stream of income, as
opposed to a contractual sequence of
nominal cash flows (such as bonds)
• Diversification. In general, Yale believed
that risk could be more effectively
reduced by limiting aggregate exposure
to any single asset class, rather than by
attempting to time markets.
• Seek opportunities in less efficient
markets
• Fourth, Swensen believed strongly in
using outside managers for all but the
most routine or indexed investments

5. Yale Harvard
Size About 20 staff About 150 staff
Location Inside campus Outside campus
Model Function as Fund of funds Hybrid
Internal vs
External
[ ] 60:40
PE capabilities Strong Weak
Needs
Yale vs Harvard: Capacity2

6. Return % 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Yale 41 9.2 0.7 8.8 19.4 22.3 22.9 28 4.5 -24.6 8.9 14.6
Harvard 32.2 -2.7 -0.5 12.5 21.1 19.2 16.7 23 8.6 -27.3 11.0 21.4
S&P 500 7.2 -14.8 -18 0.3 19.1 6.3 8.6 20.6 -15 -32 15 10.5
Wilshire
5000
9.5 -15.3 -16.6 1.3 21.2 8.4 10.2 21 -14 -32 18 10.5
Governmen
t bond
index
7 9.6 8.8 20.2 -4.3 18.8 -7.3 5.9 12.4 7.7 11.9 9.5
Consumer
price index
3.7 3.2 1.1 2.1 3.3 2.5 4.3 2.9 5.2 -0.4 1.9 3.7
Source: Bloomberg and Cases
Yale vs Harvard: Performance2

7. Source: Bloomberg and company documents
Asset Class
(%)
Yale Harvard Yale Harvard
2008 2008 2010 2010
Domestic
equity
10.1 12.0 7.0
11.0
Foreign
equity
15.2 22.0 9.9
22.0
Bonds 4.0 15.0 4.0 11.0
Cash -3.9 -5.0 0.4 2.0
Real assets 29.3 9.0 27.5 9.0
Private equity 20.2 11.0 30.3 13.0
Absolute
return
25.1 18.0 21.0
16.0
Commodities 0.0 17.0 0.0 14.0
High Yield 0.0 1.0 0.0 2.0
Yale vs Harvard: Asset Allocation2

8. What Went Wrong in 2009?3
2008 Sept: Lehman Brothers
Holdings collapsed,
precipitating an economic
decline that had begun with
the subprime mortgage crisis
and setting off a global rout
across financial markets.
The Dow Jones fell over 500
points (−4.4%) on a single day.
Continue to decline through
early 2009, whereupon it fell
below 7,000 points – less than
half of its 2007 high.
2009 June: Harvard University’s
endowment fund manager
booked losses of 27% and a
staggering US$10.1 billion of its
assets were wiped out.
Yale: Lost 24.6% of assets
(FY09)
Harvard underperformed
Policy Portfolio (a smaller
25.2% loss)
Harvard underperformed
more than any other Ivy
League school
 Cutbacks in capital
spending & student services
Both Yale and Harvard were
plagued by liquidity issue due
to investment in alternative
assets as market tanked  Such
assets take considerable time to
unwind. Hedge fund even
halted redemptions in 2008
Interest-rate swaps:
Former President entered into
series of Interest-rate swap to
cap I/r on future debt
issuance but required posting
collateral when I/r declined
HMC lost more than
US$550mn because of I/r
decline

9. Capital Market conditions
• Given high unemployment in the US and uncertain economic conditions , the equity markets pursued a strong
upward climb through the first months of 2010
• Bond markets were functioning fairly normally for the most part, with reasonable liquidity and persistently low
rates.
• High yield spreads declined, indicating that the risk of default was lessening
• Long rates on US Treasuries were pushed lower as investors sought safe haven investments.
Current Environment: Capital Market4

10. Harvard Business School Considerations
• Harvard’s need to Maintain the “vigour” and “Longevity” of the
endowment
• Ongoing stagnation in median household income growth and
Federal Budget Cuts in education across the has put increasing
pressure on grant aid expenditures ( The endowment now funds
35% of the total University budget. )
• As Private Equity landscape evolves and becomes more global,
Challenge for Harvard to look for the best opportunities
• Close attention to liquidity, capital commitments and risk
management ( avoid the mistake of 2009 )
Source: Harvard 2009 Annual Report
4 Current Environment: Harvard’s Obligations

11. 4 Current Environment: Asset Correlations
Correlation of assets changes during times of crisis

12. 4 Current Environment: Analysis of Asset Classes
Asset Class Suitability Optimality Diversification Illiquidity of Assets Potential Conflicts of Interest
Domestic Equities
Foreign Equities
Emerging Markets
Suitable
Potentially High Returns
Emerging markets has
tremendous opportunities
due to both their greater
inefficiencies and their
dynamic, growing
economies
Overall portfolio risk can be
diversified if managed
properly
Liquid
(Marketable securities
can be illiquid during
crisis?)
Collateral for short-term
loans (security lending
agreement)
Money managers may tend to
emphasize asset growth at the
expense of performance
Private Equity
Suitable**
Investors cannot
withdraw their
invested capital
whenever they
wish
Potentially High Returns
With high returns
attracting new investors
who flooded money into
the sector until returns
deteriorated
Diversification across
General partners and
industries
Illiquid
Key principle was to select
organizations in which the
incentives were properly aligned
Absolute Returns Suitable ** Potentially High Returns
Historically provided
retunes largely
independent of overall
market moves
Illiquid
Money managers may tend to
emphasize asset growth at the
expense of performance
Commodities
Real Estate
Suitable **
Potentially High Returns
High and visible current
cash flow and opportunity
to exploit inefficiencies
Sensitivity to inflationary
force
Illiquid
Misalignment or conflicts of
interest in external firm’s
compensation motivation
Domestic Bonds
Foreign Bonds
Inflation-indexed
Bonds
Suitable Low Returns
Relative low covariance
with other asset classes and
serves as a hedge against
financial accidents or
periods of unanticipated
deflation
Liquid
In situations of severe
liquidity shortages,
Bonds can be used as
collateral for short-term
loans

13. Post Crisis – How Harvard Modified Swensen?
1
Objective: Increase flexibility, reduce leverage and explore attractive investment themes foreseen
emerging after the crisis.
Decrease uncalled capital commitments by roughly $3 Billion
2 Increased the depth and breadth of talents in the investment team
- in fixed income/Asian markets, in equity arbitrage, in real estate and in externally managed funds
3 Continuation of the Hybrid Model
• No change to the mix of internal and
external managers (as it would allow
access to best strategy for each asset
class)
• To give the portfolio the breath and
depth.
• Look to increase the share of internally
managed assets instead
‒ Added a COO from Pimco, a new
CFO and CTO, other restructuring
within investment team
5

14. 4 Continue to emphasize on having risk tolerance as critical factor in asset allocation decisions.
5 Re-engineered the Policy Portfolio
Greater concentration in areas where HMC has unique
competitive strengths such as fixed income and real assets
Fewer distinctions among the finely tuned asset classes to
encourage greater collaboration among our teams in
exploring investment themes
Rigorous reassessment of the fit between the endowment’s
risk profile and the University’s needs.
Spectrum of Horizon introduced; short term, medium term,
long term.
Post Crisis – How Harvard Modified Swensen?5

15. 6 Integrate Risk management, liquidity and leverage management with portfolio management:
o Risk: Wider range of stress tests, Buying of Insurance as protection instead of cutting exposure which may
reduce flexibility
• However stress test results were subjected to accuracy of information on external manager’s
position which are often lagged, infrequent and imprecise
o Asset allocation: Usage of optimal portfolio analysis, reexamining assumptions such as the range of
historical data used to reflect more current market conditions, reexamining inter-asset assumptions used
to produce the efficient frontier
• However the limitations of the efficient frontier is that it is very sensitive to the relative structure of
input assumptions particularly with 12 asset classes involved
7 Actions by External Managers
o A subset of our external hedge fund managers, changed their investors’ ability to redeem capital,
ostensibly to protect their funds’ remaining assets.
Post Crisis – How Harvard Modified Swensen?5

16. Harvard’s Modification – Is it Enough?
Remaining Issues:
• Liquidity position:
o Will Harvard meet liquidity needs?
o Should there be a liquidity benchmark in addition to policy portfolio benchmark?
o With endowment spending accounting for more than one third of total university
budget, what should change?
• Asset allocation:
o Will alternative investments continue to provide high return in future?
5

17. Portfolio Optimization Analysis: Inputs6
• Optimize the Policy Portfolio with benchmark indexes being proxies.
• Mean-variance approach. Follow the original asset allocation of the policy
portfolio. Allow permissible range of 5%.
• Take into consideration that the increasing correlation pattern during
crisis time.
• Adjust asset allocation in line with Harvard’s liquidity needs, risk
tolerance, etc.

18. Portfolio Optimization Analysis: Benchmarks6
• 10-year-long time horizon. Fully captured a complete economic cycle.
• Monthly return, 120 neutralized data points.

19. Portfolio Optimization Analysis: Return & StdDv6

20. Portfolio Optimization Analysis:
Increases Correlations
6
1999-2009 “Pre-Crisis” Correlation “In-Crisis” Increased Correlation

21. Exp. Return: 7.10%
Sharpe Ratio: 0.59
Portfolio Optimization Analysis: Results6

22. • Monthly review of liquidity position vs Annual review
• Forecast spending (Yale uses a forecast model)
• Given the difference in absolute return between top tier and other fund managers,
applying Yale’s strategy of employing more Private Equity in their portfolio may not
work for all  Harvard should focus on assets where they have a niche; Equity
• Use of high illiquidity hurdle rates to enter illiquid investments
Other Recommendations6
Liquidity Premium Benchmarking
Source: Columbia Business School
Other Recommendations

23. H A RVA R D
ENDOWNMENT FUND
Tian Lun
Donavan Lim
Foo Wei Shing
Ng Wenying
APPENDIX

24. Source: Columbia Business School
Appendix: Private Equity7

25. • Another is the focus on hunting for the best hedge funds, private-equity managers and stock pickers it's
impossible for every institution to have the best managers.
• By definition, many institutions end up hiring managers who are below average. Consequently, many of them
would be better off investing in index funds rather than finding themselves on the wrong side of the wide
gulf that separates the performance of the best and worst managers.
Appendix7

26. • The Policy Portfolio is a theoretical portfolio allocated among asset classes in a mix that is judged to be
most appropriate for Harvard University from both the perspective of potential return and risk over the
long term.
• The Policy Portfolio differs from a traditional stock/bond portfolio, including allocations to less-
traditional and less-liquid asset categories, such as private equity, real estate, and absolute return
strategies.
• The Policy Portfolio provides us with a guide as to the actual allocation in the investment portfolio and
also serves as a measuring stick against which we judge the success of our active investment
management activities.
Appendix: Policy Portfolio7

27. Appendix: Policy Portfolio7