Year of transition sees rethinking, rebuilding

With change comes opportunity, the adage goes.

That old saying has become words to live by at Harvard Management Company (HMC).

With a new president and CEO in Mohamed El-Erian, with new heads of five critical areas beneath him, and with new staff in those five areas just starting to filter in, it may be a while before it feels like same old, same old on the 16th floor of Boston’s Federal Reserve Building where HMC has its offices.

El-Erian, in fact, predicts that it will be another year before all the changes have taken place and new people settled in.

The challenge, of course, during a transition for any entity like HMC — which invests Harvard’s endowment, pension funds, and trusts — is that the markets don’t care if you’re in transition.

“We don’t have the ability to press the pause button on the markets,” El-Erian said during a recent interview.

While the markets march on, existing HMC staff have stepped up to fill the void left by the departure of some 30 employees with former HMC President Jack Meyer. Meyer left last fall to begin his own investment company, Convexity Capital. Despite the months of transition, Harvard’s endowment earned 16.7 percent on its investments in fiscal 2005. It beat the 13 percent return on its benchmark, pushing the endowment’s total value to $29.2 billion from $25.9 billion the prior year, after taking into account the net distributions to the University.

At a 5 percent annual payout rate, the $3.3 billion increase in the total value of the endowment would mean $165 million more each year for programs, professors, and teaching at Harvard.

The continued strong returns reinforce the endowment’s critical support for Harvard’s academic programs and mission. In the 2006 fiscal year, endowment dollars provided almost a third of Harvard’s operating budget, or over $930 million.

Distributions from the endowment pay for specific activities donors have endowed over time, including financial aid, faculty salaries, and facilities maintenance. For example, endowment income supports Harvard’s student financial aid programs, which permit the University to admit qualified students regardless of their ability to pay. From fiscal 2001 to fiscal 2006, for example, scholarships and awards to students from University funds increased by over 70 percent, to $269 million from $156 million. Endowment dollars distributed for overall Harvard programs rose more than 50 percent during the same period, from $615 million to $933 million.

Though the times are challenging and busy at HMC, El-Erian said that, in a way, HMC is lucky. The world is changing, he said, and the transition at HMC has prompted a well-timed re-examination of Harvard Management Company by its board and staff. And in many ways, the re-examiners liked what they found.

For starters, the review reaffirmed Harvard’s commitment to HMC’s mixed investment management strategy, employing both in-house and external managers. With a stellar track record of returns over the past decade — averaging 15 percent a year — and at a cost lower than it would be to shift to all external managers, officials decided the mixed internal/external management system should be retained. With its internal management dimension, the system also improves the transparency and risk management capabilities of the endowment, El-Erian said.

The self-examination began months before El-Erian arrived at HMC in February 2006, starting after he was hired in October 2005 and continuing as he transitioned out of his prior post at Pacific Investment Management Co. (PIMCO).

For the four months before he arrived at HMC, El-Erian juggled responsibilities of both posts, with his HMC work gradually taking up more and more of his time until he moved full time into his office in February.

“The first half of our fiscal year was taken up with questions of how we best position HMC organizationally to ensure it continues to deliver superior performance over the long term,” El-Erian said.

El-Erian characterized the changes at HMC as both “rebuilding” and “reinventing.” The rebuilding component, he said, involves mainly replacing the human infrastructure and knowledge that was lost through departures. The reinventing involves adding new capacity and retooling existing resources where appropriate.

The rebuilding is moving forward, with El-Erian hiring Marc Seidner as vice president of domestic fixed income, Stephen Blyth as vice president of international fixed income, and Mark Taborsky as vice president of external management. With those senior managers hired — Blyth starts in October — they can begin to build the teams of people below them.

On the reinventing side, El-Erian has hired two senior managers to head new areas at HMC — Karen Parker Feld as vice president of a foreign exchange portfolio, an area El-Erian believes can be fertile for HMC and one that enhances risk management capabilities — and Kate Murtagh as chief compliance officer, to ensure HMC conducts its business in accordance with the increasingly complex legal and regulatory requirements associated with the investment industry and in line with governance best practices and ethical standards.

There seemed to be a pregnant pause in the investment world as it waited last winter to see how HMC would weather the transition. The submission of resumes for open positions shrank to a trickle, El-Erian said. Since then, the job market at least appears to have reacted well to the choices, El-Erian said, as resumes began flooding in as the senior team members were announced.

“We have been able to get top talent,” El-Erian said. “The next step now is for them to develop their teams, thereby enhancing the tremendous resources that we already have in place at HMC.”

El-Erian is determined to leverage HMC’s unique capabilities in the investment world, such as its access to stable capital and long-term investing horizon. Another capability, however, is its linkage to the broader Harvard community. When he was at PIMCO, El-Erian said they’d occasionally invite in and benefit from interactions with scholars.

El-Erian said he’s already begun such brainstorming sessions at HMC, inviting scholars and international experts to HMC to talk about specific international issues.

“We’re not looking for specific views on investments per se,” El-Erian said. “We’re looking for broader thinking about the parameters that underlie investments.”

El-Erian and Blyth will further the ties between Harvard’s academic and investment worlds. Both will have an academic connection — El-Erian with the Harvard Business School and Blyth with the Statistics Department. Both, however, will limit their forays into academia until the transition is over.

“It will be limited initially until the rebuilding process at HMC is well advanced,” El-Erian said. “Both of us realize our ability to teach is dependent on the rebuilding process here.”