Meyer Makes Convexity Exceed Targets Harvard Fails to Replicate

Lou Morrell wasted no time putting money into Convexity Capital Management LP after Jack Meyer, the former Harvard University chief investment officer, started the firm in 2005.

Morrell, who was CIO at Wake Forest University in Winston- Salem, North Carolina, flew to Boston to visit Meyer at his new offices in the John Hancock Tower, the tallest in New England. Meyer, flanked by top lieutenant David Mittelman, explained how they would offer strategies similar to those they used to quintuple assets from 1990 at the world’s richest university.

“He brought Mittelman in there and talked about strategies and how the whole thing worked and the next thing we knew, we were an investor,” Morrell, who retired last year, said in a telephone interview. Meyer’s fund “was totally committed in a few days,” he said.

Since he began trading in February 2006, Meyer’s returns have exceeded a group of market indexes by an annual average of about 8 percentage points, or double Convexity’s target, according to four investors. The firm, which attracted a record $6.3 billion from endowments and foundations as a hedge-fund startup, had $11.1 billion in assets as of March 31, said the clients, who asked not to be named because the firm is private.

Photographer: Richard Howard. Source: Harvard via Bloomberg

Former Harvard University chief investment officer Jack Meyer. Close

Former Harvard University chief investment officer Jack Meyer.

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Photographer: Richard Howard. Source: Harvard via Bloomberg

Former Harvard University chief investment officer Jack Meyer.

Harvard Management Co., which runs the university’s endowment, had an annual average gain of 4.7 percent over the past five years, compared with a 3 percent increase for its internal benchmark.

Leadership Changes

The endowment had four different leaders since Meyer departed with more than 30 employees amid an outcry over pay. Mohamed El-Erian spent less than two years there before returning in December 2007 to Pacific Investment Management Co. in Newport Beach, California. Two interim heads, Peter Nadosy and Robert Kaplan, ran the fund before and after his tenure.

Under Jane Mendillo, who was hired as Harvard Management’s chief executive officer in July 2008, the endowment missed its internal benchmark in the first year. Investments lost a record 27 percent, compared with a 25 percent decline for the benchmark, as the worst financial crisis in three generations slashed the fund in June 2009 to roughly the same level as when Meyer and his team departed. Investments rose 11 percent in the past year, beating the school’s own benchmark while trailing the returns of a broad group of institutions.

Harvard’s fund stood at $25.9 billion in 2005, more than five times its $4.7 billion level 15 years earlier, when Meyer became CEO of Harvard Management. Meyer averaged gains of 16 percent a year in his last decade. Among the biggest U.S. endowments, it trailed Yale University, in New Haven, Connecticut, and Duke University in Durham, North Carolina, which averaged 17 percent.

Meyer, 65, declined to comment, as did John Longbrake, a spokesman for Harvard in Cambridge, Massachusetts.

Aiming for Alpha

Convexity seeks to track the returns of indexes selected by its clients while providing an additional gain, known as alpha, of about 4 percentage points at each investment pool, according to an investor document obtained by Bloomberg News. The amount of alpha depends on the “success of long/short and other relative value strategies executed principally in the fixed- income and related markets,” the document says.

Investors can choose among 15 indexes, allowing funds to use a mix of asset classes for diversification. The benchmarks with the most investor assets as of Dec. 31 were Barclays Capital More Than Five Years TIPS Index, with 24 percent; MSCI EAFE Net Dividends Reinvested, with 18 percent; and Standard & Poor’s 500 Total Return, with 16 percent.

Client Fees

The firm levies a management fee of 1.25 percent a year on assets, and takes 20 percent of returns generated above benchmarks.

It also charges clients as much as 50 basis points if they choose to switch between benchmarks at the start of each quarter, and a monthly fee of 2.3 basis points to replicate some indexes. A basis point is one-hundredth of a percent.

For an investor that chose the S&P 500 Total Return Index, which lost an average of 2.4 percent a year from February 2006 through August, the annualized gain after fees was about 4.7 percent. The HFR Equity Hedge Index returned an annual average of 1.6 percent in that span.

Convexity uses 10 investing strategies centered on options trading and asset swaps that are similar to those Meyer and his team employed at Harvard, seeking to take advantage of different market climates.

Meyer’s Strategy

At Harvard, Meyer, like Yale’s David Swensen, cut holdings of stocks and bonds and loaded up on real estate, private equity and natural resources. Unlike Swensen, who invested most of his school’s money with outside managers, Meyer built up internal trading teams that managed as much as 85 percent of the fund.

Investment firms including Highfields Capital Management LP and Adage Capital Partners LP were founded by former Meyer traders Jonathon Jacobson, Phillip Gross and Robert Atchinson and occupy offices in the same building as Convexity.

Meyer’s former employees who joined him at Convexity included bond traders Maurice Samuels and Mittelman, Harvard’s highest-paid endowment managers in 2003, earning $35.1 million and $34.1 million, respectively.

Members of the class of 1969 wrote a letter to then- President Lawrence Summers, saying the money would be better spent on scholarships.

When Convexity opened, Harvard Management pledged $500 million to the fund. Endowments make up more than half of Meyer’s clients.

Endowment Losses

As U.S. endowments suffered record losses from the global financial crisis in fiscal 2009, Convexity’s three-year lock-up on capital expired. Investors including Harvard, facing a cash crunch, withdrew $1.59 billion, while making $1.24 billion in deposits. Convexity ended the year with $10.6 billion.

The firm’s employee count rose to 67 as of Dec. 31, including 18 money managers, from 43 at the end of 2005.

Convexity takes its name from a term used by fixed-income traders in measuring a bond’s sensitivity to movements in interest rates. Traders stand to win more than they can lose in trades with “positive convexity.” The strategy works best in volatile markets.

In Meyer’s first year, the fund trailed benchmarks by 4 percentage points to 6 percentage points, the investors said. The Chicago Board Options Exchange Volatility Index, a measure of U.S. stock market swings known as the VIX, reached a low of 9.90 on Nov. 21, 2006, as it declined for the fourth straight year.

His performance improved as market fluctuations returned, with the VIX averaging 28.7 since the start of August 2007. Convexity’s best year was in 2009, when the fund beat indexes by about 20 percentage points, investors said.

Risks

“There’s always a chance of something blowing up,” said William T. Spitz, Vanderbilt University’s chief investment officer of 23 years, who committed at least $50 million after Meyer visited him in Nashville, Tennessee, to pitch the fund as he was raising capital. “You have to make sure they have the correct systems and controls. The other major risk is if we go back into a period of low volatility, you might have the same experience as the first year or two.”

Mendillo took over Harvard’s management two months before the Lehman Brothers Holdings Inc.’s bankruptcy helped trigger the market rout leading to the deepest loss in the school’s 374- year history. The plunge in assets prompted the university to cut jobs, freeze salaries and postpone construction of a $1 billion science center.

As the fund tumbled, Mendillo accelerated a return to Meyer’s playbook and added staff, expanding internal trading beyond 30 percent of assets to allow for more control and flexibility.

Over the past two years, the endowment has lagged behind its peers tracked by Wilshire Associates, a consulting firm in Santa Monica, California.

Institutional funds, including public and corporate pensions, endowments and foundations, returned a median of 13 percent in the year ended June 30, according to Wilshire Associates. Harvard’s endowment climbed to $27.6 billion.

To contact the reporter on this story: Gillian Wee in New York at gwee3@bloomberg.net.

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net.

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