The Sorry Tale of the Harvard Endowment

by: Felix Salmon

Forbes and the NYT ran curiously similar pieces on the Harvard endowment over the weekend, and the message I get from them is that it's in serious trouble. The new boss, Jane Mendillo, arrived seven full months after the old boss, Mohamed El-Erian, left -- and it seems as though nothing good or sensible transpired in the interim, although it's not entirely clear whose fault that is.

El-Erian certainly catches some flak:

Though the Harvard endowment posted a strong 8.6 percent gain in the year before Ms. Mendillo arrived, David A. Salem, who heads the Investment Fund for Foundations, says he believes that Mr. El-Erian did the school a disservice by hiring people to implement certain strategies and then "jumping ship."
Mr. Salem, who knows Ms. Mendillo from the board of the investment fund, also said that Mr. El-Erian appeared to have left Harvard with an extremely illiquid portfolio, a situation complicated when a permanent replacement was not named for seven months after his departure.

El-Erian is the kind of money manager who has a very active and hands-on investment strategy. He's constantly on top of his positions, and when they get too risky, he's quick to hedge:

Fearing all markets could soon fall, El-Erian injected what he referred to as "Armageddon insurance" into HMC's portfolio for the first time by buying interest rate floors, or a wager that rates would fall, and betting, via credit default swaps, that companies could soon struggle to pay their debts.
For the following year, through June 2008, Harvard gained 8.6%, versus a 13% fall in the S&P. El-Erian's insurance accounted for much of HMC's outperformance.

After El-Erian left, it seems that his riskier investments were simply held on to, while his hedges were allowed to expire. And a similar thing was happening with positions put on by Larry Summers:

A few years ago, as Harvard was preparing to issue billions of dollars of debt to finance an ambitious building expansion, the university entered into interest rate swaps to lock in seemingly low interest rates. The swaps were huge, with a notional value of $3.7 billion on June 30, 2005...
The university could have easily gotten out of the swaps after Summers left Harvard in 2006. But it did not. Near the end of 2008, Libor rates plummeted, forcing the university to post collateral.

Once again, all of this made sense at the time. Summers was very worried about America's twin deficits, and the risk of a sharp spike in interest rates; the likes of Nouriel Roubini shared those concerns. Locking in low interest rates seemed like a good idea. But after Summers left and the housing bubble burst, it became clear to Summers, Roubini, and others that the big rate shock they should be worried about was to the downside, not the upside. Unfortunately, Summers had left Harvard by then -- and so had El-Erian -- and it seems that no one felt empowered to unwind the swaps (an action which could have been taken at very low cost).

The picture one gets of the Harvard endowment right now is that it's suffering from a major liquidity crunch: it just doesn't have the cash on hand that it needs. In that respect it stands in stark contrast to Yale, where David Swensen seems quite unworried about his liquidity situation.

Once again, the culprit would seem to be legacy positions from the era of Summers and El-Erian: positions which might well have made perfect sense as part of an actively-managed portfolio which was run by people who were fully aware at all times of potential liquidity needs, but which certainly didn't make sense as part of a portfolio which became much more passively managed upon El-Erian's departure, with no one really in charge of making sure that the endowment was able to make good on all its obligations.

It's hard to know how any of this can be avoided. El-Erian can't be faulted for making decisions on the basis of his staying at Harvard on a permanent basis -- after all, he was hired on just such a basis. Such decisions can't, by their nature, be easily unwound, which means that he necessarily ended up bequeathing to his successor a portfolio which would have been very difficult to understand and to hedge. El-Erian might well have been able to do it, because he constructed the portfolio in the first place. But it's not clear that anybody else could.

So did El-Erian's decision to move back to California from Boston cause billions of dollars in losses for the Harvard endowment? And is there any way for an endowment to hedge against that kind of personnel risk? If El-Erian had been at the Harvard Management Company a bit longer, perhaps he could have endowed it with more of an institutional knowledge base. As it is, he stayed just long enough to implement a large-scale strategy, but not long enough to allow the office to be able to run it without him. And now Mendillo is left to try to pick up the pieces as best she can.