Tuesday, May 10, 2005

Sometimes It’s Not Enough To Be Well-Endowed

In January of this year Harvard Management Company (HMC), the wholly owned subsidiary set up to manage the university’s $22.6 billion endowment, announced the departure of its President and CEO Jack Meyer, who will be launching his own firm along with four HMC colleagues. This event perpetuates a continuing trend at the university, where HMC investment professionals who have achieved superior performance results, have then left to form private asset management firms. More troubling for Harvard is the tendency for these departing managers to also take with them contracts to manage funds for the university, reducing the proportion of assets managed in-house by HMC.

HMC was established in 1974 to manage the University’s endowment, pension assets, working capital, and certain other assets. Like most other endowed institutions, Harvard pursues an active management strategy to maintain the value of its existing endowment in real terms while providing a steady, sustainable, and predictable flow of funds to support current operations. In 1999, endowment income was over 25% of total university income, with tuition coming in at a mere 30%. This fraction of the University budget financed by endowment income had grown steadily each year for the past decade. Unlike all other academic institutions, Harvard relies largely on the internal management provided by HMC.

Due to the sheer size of its endowment, Harvard was able to establish and retain a world-class in-house management company, producing a notable competitive advantage among its peer endowment funds. With assets of over $22 billion, Harvard can afford to maintain a staff of approximately 200 investment professionals, who have consistently outperformed both their target portfolio benchmarks as well as their peers. In 2004, HMC was able to generate net returns of 21.1%, beating their benchmark measures of market performance by 4.7%, the median performance of a universe of large institutional funds by nearly 5%, and of the 25 largest university endowments by about 4%. Over the long-term (10 years), HMC managers have outperformed their market benchmarks for all nine categories with 10-year histories.

Despite these impressive and consistent investment gains, HMC has not been without criticism from insiders and outsiders alike. Professors, who can earn up to approximately $170,000, have joined alumni in complaining that the approximately $66 million paid out to top HMC managers in 2004 is inappropriate as the University’s assets should not be managed and charged fees as “individual or corporate funds”. Although some of the compensation figures published by HMC in 2004 do seem truly outrageous at first glance ($25.4M to a domestic bond manager and $25.4M to a foreign bond manager), the total expenses generated by HMC (including all incentive fees) amount to a less than market rate of just 0.49%, compared to typical active endowment management fees of 1.00%. Criticism over excessive compensation is no doubt rampant due to Harvard’s policy of making all HMC performance and expense data public. As Jack Meyer stated the day his departure was announced “I would like to drop out of the public spotlight a bit." At Harvard, he said, HMC's performance is subject to "close scrutiny of returns, to the last basis point," and there is the "annual compensation thorn" prompted by disclosure of the top portfolio managers' pay. The vast divide in compensation between HMC professionals and professors, has led to the development of a toxic culture where excessive attention is paid to bottom line payout numbers rather than total HMC endowment expenses. This pressure and attention has surely contributed to regular departures of talented HMC professionals over the years. Furthermore, these departures have had the dismal effect of gradually decreasing assets managed internally by HMC (from 100% at its inception, to approximately 88% in 1996, to a meager 50% in 2004).

This decline in assets managed internally is more troubling once we consider exactly how fees are being charged by external managers. Even if we assume an extremely modest management fee of 1%, it is apparent that HMC is throwing away their competitive advantage of having a low-cost, highly successful in-house team. If HMC were to manage the entirety of their endowment in-house, total fees of $110,740,000 would be incurred, assuming their current fee structure of 0.49%. At the current level of approximately 50% of assets managed internally at a rate of 0.49%, and the remaining 50% managed at a modest 1% rate, total fees of approximately $168,370,000 would be incurred.

From these figures, it is quite clear that Harvard needs to take drastic actions in order to preserve the successful legacy of the HMC’s performance. Although the intellectual and capital contributions of the University’s renowned professors and alumni cannot be overstated, Harvard must implement a new system in which HMC professionals are allowed to focus on performing rather than worrying about the criticism surrounding their much deserved compensation. The key to resolving this problem is to make the critics of the HMC’s compensation policy realize that the fund managers’ provide an incomparable value added by their investment knowledge and commitment to the growing the fund and preserving the Harvard culture for future generations.

Matthew Rodrigues

Reshma Patel

Charlotte Ho

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