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Harvard alters financial strategy

Risk to be lowered as endowment drops 27.3%

By Andrew Caffrey and Beth Healy
Globe Staff / September 11, 2009

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Harvard University’s endowment fund has adopted a less risky investment strategy and reorganized its staff following a 27.3 percent, or $11 billion, decline in the fund’s value in its most recent fiscal year, steep losses that ate away at a main source of funding for the school and led to deep cutbacks on campus.

In a report issued yesterday, Harvard Management Co. said the school’s endowment was down to $26 billion on June 30, compared to $37 billion a year earlier. The poor results also prompted the endowment to reclaim, or “claw-back,’’ millions in bonuses that were paid to some portfolio managers in previous years for outstanding returns.

One of the most crucial changes implemented by new chief executive Jane Mendillo is reducing the practice of using borrowed money to juice returns. This left the endowment without cash on hand in the worst market since the Great Depression. In such a situation, a cash shortage can force a fund to unload assets at fire-sale prices to raise money, which can compound losses.

In her report, Mendillo said that a factor in last year’s poor performance was “a lack of ready liquidity in the portfolio to meet our obligations, along with the needs of the university.’’

She added that it would be a mistake to back away from its long-term strategy, and so the endowment will continue to invest in some of the higher-risk asset classes that in previous years produced outsized returns: commodities, hedge funds, and private equity, for example.

But because the university has come to rely on the endowment for funding one-third of its operation, it has to take fewer risks, she said, and that means using less borrowed money and keeping more cash on hand. Now the fund will have a cash cushion of 2 percent, or more than $500 million.

Financial problems, including those at the endowment, compelled the university to slash expenses and lay off 275 people in June. The Faculty of Arts and Sciences, for example, has cut more than $77 million from its budget by reducing staff and administrators, freezing most academic hiring, closing a library, and reducing some student services including hot breakfasts. The university halted its ambitious expansion plans into All ston, and the completion of a new science complex there is in limbo. Many faculty viewed that decision, along with other signs of the university scaling back its academic ambition, as a deep blow that would hurt Harvard’s reputation in the long run.

Said Harvard spokesman John Longbrake: “Our endowment has seen a substantial decline, and we need to adjust our spending to this significantly changed reality.’’

For the endowment fund the last year, two things went badly: First, its mix of investment assets - from hedge funds and private equity to commodities and natural resources - failed to protect the endowment from plunging markets. As Mendillo acknowledged in the report, with few exceptions, “nearly every asset class did poorly.’’ Indeed, had the fund last year simply adopted a conventional mix of 60 percent stocks and 40 percent bonds, it would have lost only half as much money.

The second problem was the cash shortage. Historically the endowment keeps little cash available and often has a negative cash position, as it did at the start of last year, meaning it borrows money in an effort to amplify returns.

Harvard underperformed the average large fund’s 18.2 percent loss last year, according to Wilshire Associates, a consulting firm. Still over the long term, the Harvard endowment is well ahead of similar funds. It’s gained an average 6.2 percent annually for the past five years, compared with 2.5 percent for similar funds tracked by Wilshire. And over 10 years, Harvard is up 8.9 percent annually, despite last year’s huge loss, compared to an average 3.2 percent annual gain for other funds.

In addition to raising the endowment’s cash position, other moves by Mendillo include changing the way it searches for investment ideas and managing more money in-house instead of farming out money management to outside firms.

That would be a reversal from her predecessors, Mohamed A. El-Erian and Jack Meyer, who sent large sums to other firms, often those started by former Harvard Management employees. Mendillo noted that, amid the falling markets, her group had far greater control of the one-third of the assets managed in-house than the two-thirds run by outside shops. And inside portfolios afford greater transparency. She said that she is “looking to increase the share of our internally managed assets under the right conditions.’’

Steve Rose, a former tax preparer at Harvard Management who has been a critic of the firm’s practices, said Harvard lost a lot of day-to-day control by shipping money to outside firms. “They had little control as they started to move things away from in-house management,’’ Rose said. “They were very aggressive. They’ve won and lost - and lost this time.’’

In the midst of one of the most chaotic years in investing, Mendillo has also begun to put her own stamp on Harvard Management: She’s cut one-quarter of the staff, or about 50 people, and named new top executives, adding a chief operating officer for the first time, and new financial and technology chiefs. She also promoted two investment managers to jobs overseeing internal investments and external investments, and hired several new people to manage money.

Mendillo also has set out to knock down some of the traditional silos in the investment group, to create more cooperation among managers. Looking ahead from the aftermath of last year, she wrote that the group wants to be able to take advantage of investment opportunities that arise “outside of and across traditional asset class boundaries.’’

She’s predicting a “prolonged period of instability and slower growth in some markets,’’ but said she’s optimistic about how the endowment is now positioned.

Tracy Jan of the Globe staff contributed to this report.