It has long been routine Harvard practice to issue a detailed annual report on the condition of the University’s finances. But last year was anything but a routine year. In a time of steep and broad declines in the financial markets, the University experienced unprecedented investment losses, mainly in its endowment, but also in its pooled cash investments and through interest-rate exchange agreements undertaken when Harvard was planning to move forward aggressively with an ambitious expansion of its campus. The University’s treasurer, Jim Rothenberg, and its chief financial officer, Dan Shore, were asked to discuss the report released today and some of the lessons about risk and liquidity that Harvard learned over the past year.
GAZETTE: Last year was the toughest financial year in memory. The financial report reflects that. How troubling is the University’s financial situation?
ROTHENBERG: No question, it was a sobering year. The markets dropped precipitously, and the losses were not just deep but broad. As is the case for many other institutions, our financial landscape looks very different from a year ago, even if one assumes a reasonable recovery. It’s a difficult shift in perspective for a University that’s become accustomed to steady, robust, across-the-board growth. And what’s happened in the past year gives us plenty of cause for reflection on how we think about things like liquidity and risk – especially when the world changes suddenly and dramatically and in ways that defy our usual planning assumptions.
SHORE: All that said, for all the difficulties of the past year, Harvard’s financial position remains fundamentally sound. We still have the largest university endowment, and an excellent team to manage it. Our investment approach, despite the past year, produced cumulative 10-year returns that far exceed what we would have realized from a “plain vanilla” 60-40 stock-bond portfolio. And, from what I can see, people across the University are stepping up and confronting our new realities. There are serious, broad-based efforts to reduce expenses, big and small. There’s a lot of attention to managing risk more aggressively and making sure we have the liquidity and flexibility we need when unforeseen circumstances arise. There’s a sense that, especially at a time like this, we have to face up to some redundancies and inefficiencies in how we’ve gotten used to doing things, as President Faust spoke about in her address last month.
GAZETTE: The investment losses reported in the financial report appear to be greater than the endowment losses recently reported by Harvard Management Company. How can you explain that?
ROTHENBERG: Beyond the $11B decline in the value of the endowment, the University also had a loss of approximately $1.8 billion in investments made alongside the endowment, and a loss of $500 million realized in connection with our interest rate exchange agreements. All of these losses were a function of last year’s extraordinary market conditions.
GAZETTE: How do the University’s investment strategies square with its responsibility to steward endowment funds to support the University for generations?
SHORE: There does need to be a balance between investing for long-term returns and managing for near-term needs, and we are now more conscious than ever of that balance, as Jane Mendillo made clear in HMC’s annual endowment report. But circumstances of the last year left virtually no one immune.
ROTHENBERG: It’s important to note that the University invests for the long term. If you look back over 10 years, HMC’s investment strategies generated an average annual return of 8.9%, including last year’s steep losses. That far exceeds the 1.5% that would have been generated with a “plain vanilla” portfolio. That said, we learned a great deal about risk and liquidity last year, and will incorporate those lessons going forward.
GAZETTE: Even allowing that an aggressive, nontraditional approach may make sense for investing the endowment, how do you respond to the argument that short-term funds should be invested more conservatively?
SHORE: We recognize the need to match near-term liabilities with more liquid assets. This matching was out of balance in recent years, and in fiscal 2008 we began rebalancing by moving some of these investments into safer, more liquid investment vehicles. That effort was suspended in fiscal 2009, but we already have resumed our rebalancing efforts.
At the same time, if you take the long view, the value of our pooled-cash investments is much greater today than it would have been had we invested more conservatively, even though that value dropped substantially this past year. As a result, in recent years we’ve been able to fund important “common good” investments, like graduate financial aid and the construction of graduate student housing, that we would have been hard-pressed to support otherwise.
GAZETTE: The report shows that the University saw significant losses on “interest rate exchange agreements.” Can you explain what these agreements are and why the University invested in them?
ROTHENBERG: Interest rate exchange agreements, or “swaps,” generally allow investors to convert variable-rate debt into fixed-rate debt. The University has long used such agreements, and in ordinary times it added a measure of predictability to the payments Harvard needed to make on its capital borrowing. When we were embarking on a multibillion-dollar capital expansion program in 2004, interest rates were quite low and the University entered into a large set of swaps in an effort to gain long-term budgetary protection and stability. When interest rates dropped precipitously, we scaled back our swap holdings substantially in order to relieve the liquidity pressures from their collateral requirements and strengthen our financial position moving forward.
SHORE: By terminating several of these agreements, along with other risk reduction measures, the liquidity risk of the portfolio has been managed to appropriate levels. We are constantly monitoring the changes in value of our portfolio of agreements, and if we need to take further action, we will.
GAZETTE: Other universities have used similar instruments, but aren’t the interest rate agreements Harvard entered into considerably larger and longer-term?
ROTHENBERG: Compared to most universities, our use of interest rate swaps was certainly larger because the projected capital program that we were looking at was larger.
Allston presents us with a unique opportunity among our peers to create a major new extension of our campus that’s adjacent to our current campus. In 2004, Allston expansion was a major focus, and we were planning that expansion aggressively. The financial strategies that we implemented were developed in that context. Last fall was a perfect-storm scenario: A precipitous drop in interest rates and liquidity considerations made it important for us to scale back the swaps substantially. That has come at a real cost, but at least we are now in a better risk position going forward.
GAZETTE: Did the unsettled leadership of the University and the Harvard Management Company in recent years result in a lack of vigilance over investment strategy?
ROTHENBERG: In times of change, there are always going to be challenges, especially when you are dealing with complicated investments. With that said, no one could have foreseen the past year’s unprecedented declines in value across practically all asset classes, exacerbated by significant liquidity constraints. That created serious challenges for us as well as many other institutions. What we have experienced financially is a product of these sudden and precipitous changes more than anything else.
GAZETTE: What is the Corporation’s responsibility for those investment decisions during this transition period?
ROTHENBERG: The President and Fellows have ultimate fiduciary responsibility for the University, including its finances. We take that responsibility very seriously, and we devote quite a lot of our time, especially these days, to matters of financial strategy and planning, thinking about how to balance present and future needs. The direct oversight of how we invest the endowment, in terms of how much we invest in different classes of assets, is carried out by Harvard Management Company’s own board of directors, which I chair. But let’s remember that this was a once-in-a-lifetime, hundred-year-storm kind of event. There weren’t any reliable predictors of precisely when and how a global economic crisis would unfold, and there were valid arguments for why the strategies in place made sense both when they were made and right up until last fall. One thing we’ve learned from the experience of last year is the importance of greater integration in how we deal with our full range of interrelated debt and asset management issues, which gets into questions of how we think across the board about leverage and liquidity and risk.
GAZETTE: Who else provides advice on these issues?
ROTHENBERG: As I mentioned, the Corporation, in addition to the President and Fellows, and the University’s financial team have primary responsibility for guiding the University’s finances. With that said, we benefit from the strong investment management team at HMC, as well as the HMC board, which includes faculty, deans, alumni, and outside experts. We’ve also expanded the role and the membership of the Financial Management Committee. It’s important that we have good systems in place to help us not only thrive when the economy is strong, but also buffer the downside for us when there are unanticipated shocks in the markets.
GAZETTE: If not for the University’s liquidity issues, would the endowment and University have benefited more from the recent upturn in the markets?
ROTHENBERG: It’s pretty clear when you look at the endowment returns for last year that Harvard did worse than some of our peers. But if you take a several-year look at it, even a two-year look at it, it’s quite a different picture. So if you think about it from a little longer-term perspective, there’s no real implication that Harvard hasn’t participated in the markets. Perhaps it is more accurate to suggest that the strategies that allowed us to outperform in prior years were the same ones that caused us to underperform last year. As the University considers how best to manage the investment portfolio for both returns and liquidity, we may end up with strategies that take us further away from these “tails” on either end. But, without a doubt, we have a bigger endowment today because of the strategies that have served us well over time, and the University has benefited greatly from that.
SHORE: HMC actually got an early start last year managing liquidity so that our managers could put us back into a position to make new investments as soon as we could reasonably do so. As Jane Mendillo, the CEO of HMC, has said, we’re actively looking at new investment opportunities, and are eager to pursue those that seem interesting to us.
GAZETTE: Given the losses reported today, should the University be braced for cuts to programs or staff?
ROTHENBERG: The losses reported in our financial statements are, to a large degree, already in the mindset of the University. We have been planning for reductions in endowment payout over a couple of years, as many other universities have. The hope is to arrive at a “new normal” reasonably soon, but thoughtfully, not abruptly.
SHORE: We have reported a significant loss, but let’s not lose sight of the fact that the substantial majority of that loss relates to the fact that the endowment, which was $37 billion, is now $26 billion. We’ve internalized that for many months now as we saw last fall’s decline in the markets. We’ve taken swift action to consider how we would adjust our budgets to accommodate significantly less income from the endowment. We’ve absorbed an 8% decrease in the amount of money we’re taking out of the endowment this year. We’re going to see another decrease of at least the same amount in the endowment payout next year. Our Schools and other units will continue to work hard to adjust to the University’s new economic reality.
GAZETTE: Will the University continue to invest its pooled cash in investments that mirror the endowment?
SHORE: We are actively seeking to reduce the risk profile of the University’s pooled cash investments. We actually began doing so in fiscal 2008, but suspended the program this past year to address high-priority efforts to manage liquidity in the General Investment Account.
ROTHENBERG: I think the likelihood is that the University will continue to invest portions of pooled cash alongside the endowment, but likely not to the same degree. We have great confidence in our investment team and their ability to provide strong, long-term returns to the University, though even with skilled investment management we certainly can’t count on the kind of outsized returns that had become familiar over the decade or more leading up to last year’s declines.
GAZETTE: How have investment strategies changed as a result of the lessons learned?
ROTHENBERG: Certainly our endowment investment model was successful for quite some time, and probably has led to something like $18 billion in greater returns over the past decade than a 60-40 stock-bond position would have yielded. But I think, yes, there are some changes already under way to increase flexibility, reduce leverage, and better position the portfolio for the future. These changes will strengthen the portfolio and better align it with the University’s needs and risk parameters. Nevertheless, it is important to be realistic about expectations for future returns. For Harvard, as for almost every major investor, regaining the market value lost as a result of the recent global economic crisis will take time.