HMC (Harvard Management Company) case study questions PDF

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Prof. Yang's investments class. Mandatory case study. ...

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4/21/16 Harvard Management Company Case

1. Compare the performance of the Harvard endowment vs a 60/40 portfolio and vs TUCS Median. How much value have they added over the last 30 years? Compared to the 60/40 portfolio and the TUCS Median, the Harvard endowment has performed much better than both of the above. According to Exhibit 7 in the case, within the last 30 years, the Harvard endowment has yielded an average annual percentage return on 13% while the 60/40 portfolio yielded 10.2% and the TUCS median 10.1%. The Harvard endowment outperformed both the 60/40 portfolio and the TUCS median by almost 3%. In summary, the Harvard Management Company has on average added a 13% yearly return for the endowment. 2. HMC constructed the stress test in Exhibit 15 by creating a table listing different asset classes and the returns these classes would yield in different market stresses such as deflation and a global depression. They also calculated the absolute and relative portfolio returns for these different types of market stresses. To construct this table, HMC had to use the expected return formula to estimate all the returns given different market stresses. Like we discussed in lecture, the return of a single asset is not as important as the return of the whole portfolio itself. That is why HMC lists the returns on single assets as well as the overall portfolio return. In lecture, we also discussed how returns fluctuate depending on the landscape of the market, economy, etc… 3. Explain how HMC conducted their optimal portfolio analysis. a. Which table displayed their inputs? Exhibit 17 displays their inputs. b. How did they arrive at these inputs? HMC arrived at the inputs of risk, real return and correlations of 12 asset classes by examining both long and short-term records of each asset class in terms of the three inputs. They also consulted with experts that specialized in optimal portfolio analysis to get their input. Lastly, HMC adjusted the inputs to correspond with current market conditions. c. How did they optimize the portfolio? Which equations, concepts, or diagrams from class would they have used? HMC optimized the portfolio by using an optimization algorithm that found the efficient frontier and the mix of portfolios that would provide the maximum return for a given maximum and minimum risk. To optimize the portfolio, HMC had to calculate their utility function to find out their risk aversion. In addition they utilized the concepts of mean-variance analysis (Markowitz portfolio analysis) which takes into account finding portfolio variance, standard deviation, correlation and the

efficient frontier. The goal of all of this is the find the right mix between investing in risky and risk-free assets in order to produce the highest return possible. d. Why did HMC constrain the results of the optimization? HMC constrained the results of the optimization because they thought that some of the optimal portfolios were “too nontraditional to be acceptable.” By constraining the optimization within plus/minus ten percentage points of the Policy Portfolio weights, they could observe how the optimizer would respond. It was found that the efficient frontier was quite sensitive to their input assumptions and that it was hard to actually assume anything about future returns. 4. How did HMC’s asset allocations change over time? As stated in the case, “Before 1990, the endowment’s asset allocation was fairly simple— primarily a mix of U.S. stocks and bonds with small allocations to foreign markets and alternative assets such as private equity and real estate.” According to Exhibit 3, investment in domestic equities had declined significantly over an approximate 20 year period. Investment in foreign equities, domestic bonds, and foreign bonds have also declined while investment in emerging markets and commodities has gone up. The allocation in emerging markets has remained fairly stagnant. HMC’s asset allocation seems to have more diversity now in more recent years. Their policy portfolio, according to Exhibit 4, is almost split 50/50 amongst different types of equities and other assets. 5. According to Exhibit 17, commodities are worse than foreign equity because they have lower real return and higher risk. The Policy Portfolio allocates 11% to foreign equities and 14% to commodities. On Exhibit 4, it’s noted that the commodities class includes both commodities and natural resources. Natural resources, according to Exhibit 17, produces a real return slightly higher than commodities and slightly lower than that of foreign equity; however, natural resources’ risk is significantly lower than both commodities and foreign equity. This could possibly explain why there is a 3% higher allocation in commodities than the “better” foreign equities. There is less risk with natural resources and it produces a solid return. The concept of diversification is clearly seen in HMC’s asset allocation policy. Also, it’s interesting to note that natural resources have quite a lower correlation with all other asset classes compared to the correlations associated with foreign equity and commodities. This contributes to the overall lower risk of natural resources. 6. Relative to other investors in the market Harvard has the huge advantage of a large endowment. Harvard has a lot more money than the average investor and can thus use this resource to hire investment consultants to help them craft the best possible investment portfolio. It is even discussed in the case that Harvard has 33% of its endowment managed by internal investment professionals while 64% of it is managed externally. 7. How does HMC think about active vs passive management? Do you agree or disagree? a. Passive: I believe before 1990, HMC took a more passive management approach by investing mostly in U.S. stocks and bonds. The case said that under Jack Meyer,

Harvard started to look deeper into managing their endowment by setting long-term goals for the policy portfolio. b. Active: I think that, now, HMC definitely takes a more active approach with management. For example, Harvard has a whole team of analyst that are trying to look for alpha and find the best possible assets to invest in. All of the exhibits included in the case are also testaments to the thorough analysis HMC has done to produce the most optimal portfolio. I agree with HMC’s views on active management. Given their situation, I think that active management is a necessity given that they are a large institution with a very large endowment to manage. They have the resources to be active investors and they should be looking for ways to beat the index. However, I don’t agree with active management for the regular investor. Some studies have shown that there really isn’t a difference in return if someone actively or passively manages their portfolio. Active management is costly and the normal person does not have the finances that Harvard has. 8. If I were the CEO of HMC, I would keep the management of the endowment relatively the same. I like how HMC currently has quite a diverse portfolio of assets that yields a solid return on average. Of course this case was written in 2010, two years after the 2008 crash, so it was the overall economic conditions that can account for Harvard’s endowment underperformance. I think the only thing I would change would be the allocation of assets in term of liquidation. I would move more of the assets to a later liquidation time interval because generally investments in illiquid, long-term assets yield a stronger return than short-term assets. 24% of assets can be liquidated within 0-5 days. I think I would make that percent closer to 20% and invest the other 4% in other longterm projects/assets....