Guiding Harvard’s endowment

Call it fate. Just as the world’s financial markets started tumbling, a woman with unique understanding of the Harvard endowment took over the helm of the Harvard Management Company (HMC). Jane Mendillo came to the endowment from Wellesley College, where she restructured that school’s portfolio to strengthen investment results over the long term. Before that, she spent 15 years at HMC, handling everything from domestic equities to alternative assets and developing an appreciation for the team at HMC, which she says provides “important insight and flexibility” to the management of Harvard’s assets. Mendillo spoke with the Gazette about guiding the University’s portfolio through challenging economic times.

GAZETTE: By all measures, this has been an extraordinary year in the markets. How would you characterize your first 10 months at the helm of HMC?

MENDILLO: The markets during this time have been unprecedented in the strength of their movements and the suddenness of their corrections. We’re fortunate that the Harvard endowment is very well diversified, both globally and with regard to individual asset classes and strategies. We’re also fortunate that the strong team here at HMC was able to very actively manage the portfolio, throughout this crisis. The Harvard portfolio was certainly not immune to strong market forces over the last year, and we have felt their impact. But over the long term, the endowment has done very well and we’re confident it will continue to do well in the future, given the strategies and the plans we have in place.

GAZETTE: Back in December, the University reported that the endowment was down at least 22 percent through the end of October and that you’re anticipating a negative 30 percent return for the fiscal year. Do those predictions hold?

MENDILLO: We’re still estimating a negative 30 percent for the fiscal year, but given the volatility in the markets and the many assets we hold that are not traded on the public markets, it is difficult to predict with total accuracy where we will ultimately end the year. It is important to keep in mind that over the 10 years ending June 30, 2008, the average annual return on the endowment was 13.8 percent. It was 14.2 percent over the 20-year period ending June 30. Those returns are significantly higher than what we expect on average over the long term. So it stands to reason that returns going forward may well be lower than they have been over the last couple of decades. But we believe that we are well positioned, with a good mix of assets and strategies for facing the future.

We should note that although our returns during the economic crisis have been negative, they are not as sharply negative as many of the markets in which we participate. During this time period we have been very active in our management of the endowment — with the goal of increasing the flexibility of the overall portfolio and incrementally taking advantage of new investment opportunities. We continue to beat the returns generated by many other investors and believe our returns are in line with those being experienced by many of our peer universities. Many of the asset classes that gave us exceptional returns over the last decade have experienced strong reversals in the last several months, and we’re all experiencing similar things.

GAZETTE: What have you learned as an investor over the past year?

MENDILLO: I think all investors have gotten a lesson in how fast and how far the markets can move. In recent months the value of our hybrid model of money management has become even more apparent — we are able to have a very close feel for the markets, trading every day here at HMC, and we can react to opportunities and threats on a more immediate basis than the average endowment. The combination of our team of internal money managers, who work exclusively for Harvard, with a set of carefully chosen external managers in different markets and asset classes across the globe is immensely powerful. The depth of understanding and the close feel for the markets we gain through the internal staff, and the breadth and global perspective we get through our external managers, give us a perspective that we think is unique to endowment management. The hybrid model really gives us the best of both worlds.

GAZETTE: Some have raised concerns about aggressive investment strategies pursued by HMC. How would you respond?

MENDILLO: The Harvard portfolio was positioned very well for the market conditions of the last several years. We benefited from significant positive returns from areas such as commodities and private equity, which contributed significantly to the total return of our endowment for many years running. Yes, some of these investments caused us some pain this year — but this needs to be viewed in the context of the long-term positive that has been gained by these strategies. As the financial crisis has evolved over the last year, we have further developed our thinking about flexibility, risk, and diversification. This thinking has led us to new considerations and additional factors that we will be weaving into our long-term strategy and our active management of the portfolio going forward.

GAZETTE: Did diversification fail?

MENDILLO: First, let’s remember that diversification is not a guarantee of positive annual returns — it can only work over the long term, and I would argue that over the long term, diversification has done very well for Harvard and many other investors. Second, I would not advocate that any investor pursue diversification simply for diversification’s sake. The combination of assets and strategies we put into place must offer real value, through risk control and return potential.

To your question, over a short period this year, in the extreme market conditions that we experienced, all asset classes moved together in a financial wind shear. Such a sudden and abrupt correction isn’t something that we can structure our portfolio to avoid. In most market conditions, wisely constructed diversification will provide a good degree of protection and benefit to the endowment portfolio.

This past year, despite the fact that all asset classes moved in the same direction at the same time, we did get some benefit in the portfolio from tail risk hedging strategies that were designed to gain from outlier events in the financial markets. So, as we saw some of these very unusual outlier events come to fruition, our tail risk hedges worked to help counterbalance some of the negative forces we were feeling throughout the rest of the portfolio.

GAZETTE: Talk further about the investment strategy you’re employing now. Where are you focusing your team’s efforts?

MENDILLO: Beginning last summer, we began actively taking some profits off the table in areas where we believed that pricing might have been peaking, and aggressively analyzing new investment opportunities in both liquid and illiquid markets where, over the next two to three years, there may be unusual return potential because of the disruption of normal investment activity that’s occurred across markets over the last several months.

GAZETTE: Some blame the level of leverage in Harvard’s portfolio for its current challenges. Is this fair?

MENDILLO: Our endowment’s exposure to the markets provided exceptional gains over the last several years, but also involved investment strategies that decreased the flexibility in the portfolio. When I started at HMC in July, the board had already begun to increase the endowment’s cash position, in order to increase flexibility. I accelerated the move in this direction over my first few months in the job, the early part of the fiscal year. Feeling that there were some disruptive elements in the markets and that we would see significant positive and attractive opportunities for new investments coming out the other side of the financial storm, we felt it was critical to create more flexibility for the portfolio going forward.

GAZETTE: Is there anything in hindsight that could have been done to prevent the market meltdown?

MENDILLO: From where we stand today, we can see there was a lot of mis-pricing of risk in many markets over the last several years. Investors simply were not being paid a very high price to assume risk, and so many overly eager investors across the world added increasing levels of risk to their portfolios, as they attempted to earn higher returns. The sense of balance between the expected return from those incremental investments and the amount of risk that was being added to the portfolios was lost. Some of Harvard’s tail risk hedging strategies were based on this imbalance. After many years, the markets reached a tipping point this past year — risk was suddenly apparent everywhere — and prices dropped precipitously as investors sought to curb their losses. Looking back, such a meltdown was probably in the cards for many reasons, whether we cite easy lending practices, inadequate credit ratings, or an excess of capital, on a worldwide basis. The trade-off between return and risk was clearly out of kilter.

GAZETTE: HMC’s compensation practices have received a great deal of scrutiny in recent years, and in the past year, executive compensation in the finance industry has received much wider scrutiny. Can you talk about the compensation structure and whether you think you’ll be making changes?

MENDILLO: The compensation structure at HMC is based on the principle that managers are eligible for incentive compensation if they beat their market benchmark through active portfolio management. If they’re able to beat the market, they receive a bonus that is partly paid out in the first year and partly held back for potential underperformance in future years. So we pay for outperformance, but only if it is sustained over time. Market-beating investment performance that can be sustained over time is rare, and adds much, much more value to the portfolio than the associated compensation costs.

GAZETTE: Can you estimate how much it might cost if we paid only external managers to manage the University’s investments?

MENDILLO: The all-in cost of external management can easily be in the range of 300 to 500 basis points per year, depending on asset class and performance of the manager, and it is not always based on market-beating performance. The total cost of Harvard Management Company, relative to assets under management, including base salary, incentive compensation, and overhead costs last year was a small fraction of the external management cost, and is driven by investment performance.

GAZETTE: What is an appropriate level of compensation for investment managers?

MENDILLO: Harvard University’s enduring excellence is due in large part to its ability to attract the best of the best. That is as apparent at the Harvard Management Company as it is at the University. In truth, however, the cost of investment management at HMC, where we use internal managers to actively manage a good portion of the endowment portfolio, is significantly less than the average in the field of investment management, and our performance is significantly better. The HMC board also reviews the HMC compensation system regularly to ensure that it is consistent with the trends in the industry and appropriate for the University.

Unlike employees at a traditional investment company, our top managers are attracted to HMC because they want to help support the University’s goals of education and research. I am continually impressed by those who are willing to forgo top-dollar compensation arrangements in order to be a part of this mission and team.

GAZETTE: HMC announced layoffs at the beginning of the year. Are you shrinking the size of the endowment management unit to reflect a shrinking endowment?

MENDILLO: No. The recent staffing changes were part of a rebalancing plan that I implemented as the new CEO, a plan that was formed beginning in the first days after I returned to HMC. Remember, I had 15 years of prior experience with the company, and with how we managed the portfolio and the staffing and support related to the variety of asset classes in which we operate. As a result, I already had some thoughts on how the company should be organized when I returned. I developed a plan for optimizing the structure of the company with the new COO of HMC and the heads of our internal and external management teams. The staffing plan currently reflects a strategic balance between investment strategy and support functions that we think is very appropriate to the portfolio and the management activities we anticipate going forward. We are planning to add a few key investment and support professionals to the team over the coming months, and we’re excited about the talent that we are attracting. As a result of these changes, I believe that the company and the team are exceptionally well positioned to provide excellent stewardship of the current portfolio and for the new and exciting investment environment we see going forward.

GAZETTE: Are there asset classes where you see particular opportunity for growth going forward?

MENDILLO: Again, I wouldn’t predict over the next year or two where any market might be, especially after the financial upheaval of the last year. But over the next three to five years, I expect we’ll see some interesting opportunities across the board, for example in real assets — real estate and natural resources — where we are uniquely positioned, given our experienced and pioneering teams. We also expect to see some attractive growth potential in equity markets as underlying world economies improve. And as individual companies recover from the effects of the credit crisis and seek capital to regain momentum, public and private debt markets may offer some interesting and potentially lucrative opportunities for investors.

GAZETTE: What advice would you give an individual investor reading this interview? What lessons can be learned from the last year, and how should we think about the year or years ahead?

MENDILLO: For an individual investor, I think that the most valuable lesson of the last year is that none of us can predict where the markets are going to go next week or next month, and so we should avoid positioning ourselves too aggressively for one set of conditions versus another. Keep your focus on the long-term goal — positive long-term average returns with tolerable volatility. If we maintain the principles of balancing risk and return, looking for market inefficiencies and investing in assets that hold growth potential for the future, our portfolios, over time, will recover and flourish.