Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

The Harvard endowment -- a $37.6 billion treasure chest that is Harvard University's largest financial asset and is the world's biggest academic endowment -- is in need of a steady hand. The latest jolt came when Stephen Blyth recently stepped down as chief executive of the Harvard Management Company, which manages the mammoth endowment. HMC is now on to its sixth CEO since 2005.

If you looked at the Harvard endowment’s long-term investment returns, you might wonder what all the turmoil is about. According to HMC, the endowment returned a hefty 12.2 percent annually from July 1973 to June 2015. That handily beat a traditional 60/40 portfolio of U.S. stocks and bonds, which returned 9.7 percent annually over the same period. (Results for the Harvard endowment's most recent fiscal year that ended in June 2016 are not yet available.)

In recent years, however, Harvard’s investment returns have dropped off considerably. The endowment lagged a 60/40 U.S. portfolio by 1.3 percent annually over the five years that ended in June 2015. And while the endowment beat a 60/40 portfolio by 0.8 percent annually over ten years, it achieved only a 7.6 percent annual return over that period, which is just barely enough to satisfy HMC’s long-term objective of a minimum real return of 5 percent annually.

Crimson Chronicle
The Harvard endowment has historically achieved market-beating returns by taking more risk, but that strategy hasn't worked in recent years.
SOURCES: HMC, Bloomberg
Note: Returns are annualized returns for fiscal years through 2015.

Harvard isn’t alone. According to numbers compiled by Wilshire Trust Universe Comparison Service (which tracks endowments' investment performance), the median return for endowments greater than $500 million trailed a 60/40 U.S. portfolio by 0.9 percent annually over five years through June 2015. And the median endowment return over ten years was just 7 percent annually – a mere 0.2 percent annually better than a 60/40 portfolio.

There is nothing unusual -- or even concerning -- about cyclical periods of low returns, but the problem may be more deep-seated. The Harvard endowment’s rolling ten-year returns have been trending down ever since HMC’s first decade at the helm ended in June 1983. Harvard’s ten-year returns peaked 16 years ago, and since 2009 the endowment has struggled to achieve a ten-year return that numbers in the double-digits.       

What happened?

The so-called endowment model of investing pioneered by Yale and Harvard and other big university endowments -- and later popularized by Yale’s David Swensen in his best-selling book “Pioneering Portfolio Management” – is widely admired and imitated by institutional investors (and increasingly by individual investors). In essence, the endowment model calls for greater investment in private assets and hedge funds and less reliance on traditional investments such as stocks and bonds.

The endowment model worked wonders for a while because private equity and hedge funds posted astonishing returns. The HFRI Fund Weighted Composite Index – a widely followed gauge of hedge fund performance – returned 18.3 percent annually during its first decade from 1990 to 1999. Private equity did even better. Cambridge Associates’ U.S. Private Equity Index returned 20.4 percent annually over that period.  

But success breeds imitation. According to Wilshire, the median allocation to private equity and hedge funds and other alternative investments among endowments greater than $500 million was a paltry 14.6 percent in June 2005. That number swelled to 49.2 percent by June 2015.

The popularity of private equity and hedge funds among endowments has mirrored the explosion of interest in those investments more generally. According to HFR, hedge funds grew from $39 billion under management in 1990 to nearly $3 trillion in 2015. Private equity saw similar growth. According to Preqin, private equity grew from $580 billion in 2000 to $2.4 trillion in June 2015.

Elusive Alpha
The Harvard endowment's rolling ten-year returns have trended down since the first ten-year period under the Harvard Management Company's direction that ended in June 1983.
SOURCE: HMC
Note: Annualized returns for fiscal years 1974 to 2015.

Nothing squashes investment returns like a stampeding herd of investors. The HFRI Index returned just 5.2 percent annually over ten years through June 2015, and the Private Equity Index returned 13.1 percent annually over the same period. Those returns are nothing to weep about, but both results are a far cry from the heady days when private equity and hedge funds were the exclusive playground of elite institutional investors.

Shine Off
The rolling ten-year returns for private equity and hedge funds have been on the decline since 2000.
SOURCES: Cambridge Associates, Bloomberg

Okay, so what should Harvard do now?

It should start by taking an honest look at the endowment’s historical performance. Despite Harvard’s pioneering pivot into private equity and hedge fund investments – and the resulting spectacular returns it snared in those early days – it turns out that the endowment’s risk-adjusted returns are no better than a simple 60/40 U.S. portfolio of stocks and bonds.

Using the simplest measure of risk-adjusted returns – a ratio of annual return over standard deviation -- both the Harvard endowment and a 60/40 U.S. portfolio achieved exactly the same ratio of 0.97 from July 1973 to June 2015. (Standard deviation measures the volatility of an investment and is a commonly-used proxy for risk.)

In reality, Harvard’s risk-adjusted return is likely even worse. Harvard’s private assets aren’t subject to the daily gyrations of public markets, so their volatility is understated.

If those results are the best that Harvard could achieve in the golden age of private equity and hedge funds, it’s unlikely to do any better with those investments going forward. And it could do worse because the combination of high fees and crowded trades have become formidable headwinds for private equity and hedge funds. Private equity and hedge funds also often rely on leverage -- an advantage that may disappear as banks grow more conservative about exposure to outsize risks -- and rock-bottom interest rates won’t stay so low forever.  

That’s not to say that Harvard or any other endowment should dump its private equity or hedge fund investments. If priced reasonably (a big if), private equity and hedge funds are useful diversifiers. But the idea that those investments magically boost portfolio returns is just another investing fable.

Harvard helped lead the move into private equity and hedge funds. It should now help lead the move back into traditional investments that have long stood the test of time.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net