Wednesday, November 8, 2017

Entire Ivy League Outpaces Harvard?

Brandon J. Dixon of the Harvard Crimson reports, Entire Ivy League Outpaces Harvard Endowment in Fiscal Year 2017:
In a year when most institutional investors rode out robust public markets, Harvard’s 8.1 percent investment return for fiscal year 2017 placed it last among Ivy League endowments.

Dartmouth, which has one of the smallest endowments in the Ivy League at $4.96 billion, did the best during the year. Its 14.6 percent return, buoyed by strong growth in public equities, grew its endowment to the largest it has ever been.

Yale, often the leader of Ivy League endowments, came in seventh place this year with an 11.3 percent investment return. Experts attribute it to the university’s heavy investment in alternative assets which, they argue, buffer Yale from an unexpected swings in the market or financial crashes.

While most Ivy League endowments were able to capitalize on the bull market in fiscal year 2017, Harvard’s performance was weighed down by a series of high-value markdowns it took on some of its investments. The University’s financial report, released last week, detailed a nearly $10 billion markdown on domestic fixed income assets, which include investments like treasury bonds, junk bonds, and corporate bonds.

It was a surprisingly high markdown for Charles A. Skorina, a financial headhunter who often analyzes the performance of institutional investors. He said the size of the markdown indicates that Harvard Management Company’s new CEO, N.P. Narvekar, has recognized that the portfolio was poorly constructed.

“You seldom see that,” Skorina said. “We usually see markdowns when the market crashes. If they’re writing down stuff, there must’ve been just awful stuff in their portfolio.”

Skorina added that Narvekar likely “bit the bullet,” intentionally setting the markdowns in his first year of leadership so any damaging assets won’t affect future years of performance.

“Narv’s smart. Better to take the big write off now and have nice returns after,” Skorina said. “Everyone will forgive you for the early years if you perform well.”

Narvekar said the firm will spend the next few years “repositioning” its portfolio in his annual endowment report. In some cases, that might mean selling off assets, as HMC has done with some private equity and natural resources investments. In others, the firm might simply mark down an asset. For the fiscal year, Harvard marked down its natural resources portfolio by $1 billion.

The changes are part of an ambitious restructuring Narvekar has launched since he started his tenure in January to address “deep structural problems at HMC.”

David E. Kaiser ’69, an alum who has regularly criticized the firm and pushed for it to become more transparent, said Narvekar’s letter was “the first time that anybody in authority at HMC or the University has admitted that something is seriously wrong, which had been fairly clear for some time.”

These returns mark the first under Narvekar’s leadership, but because he took the helm of the firm in the middle of the fiscal year, next year’s returns may provide a fuller picture of HMC’s performance with him in charge.

Narvekar led Columbia University’s endowment during the first part of the fiscal year. It returned 13.7 percent, the third best in the Ivy League.
So what happened? Why did the entire Ivy League outpace Harvard in FY2017?

The article above discusses the main culprit from the University’s financial report, released in late October, detailing a nearly $10 billion markdown on domestic fixed income assets, which include investments like treasury bonds, junk bonds, and corporate bonds. Add to this that Harvard marked down its natural resources portfolio by $1 billion.

These markdowns are significant and raise concerns. At the end of this Crimson article, Nancy Morris posted this comment which caught my attention:
Once again, the Crimson cannot seem to grasp that Harvard is in a big capital drive, and its revenues are seriously affected by (and distorted by) recognition of campaign gifts. Those effects are almost certainly huge.

Many Harvard Campaign gifts are bequests or otherwise currently unavailable to Harvard, but contribute hugely to "revenues." Accordingly, the Harvard budget numbers provided in this article, without much more explanation, tell very little about what is happening to the university's finances.

The disposition of assets representing $10 Billion (more than 25 percent of the entire endowment) and the abrupt markdown of the natural resources portfolio, again suggest that, prior to this year, known losses were concealed and not recognized, possibly (but not assuredly) in the vain hope that they might recover. Call it the Haena Park school of endowment fund management, reporting and accounting.

The polite phrase “deep structural problems at HMC” hardly begins to express what must be going at HMC on to warrant such a huge asset turnover and write down. And the pain is not over. In the natural resources portfolio, Narvekar said that “markdowns do not imply sales,” noting that Harvard may hold onto some investments and that it will take years to reposition this part of the portfolio.
Mrs. Morris then followed up with this comment on the article above:
That 8.1% return looks awfully massaged. It’s almost exactly the number needed to leave the real value (after inflation) of the endowment unchanged after withdrawals for expenses. The “writedowns” described in this article and in the one to which it links (Harvard Sheds Portfolio Assets in Fiscal Year 2017: “Harvard marked down nearly $10 billion in domestic fixed income assets and nearly $1 billion in natural resource assets during fiscal year 2017...”) are belated recognition of previously concealed losses. There are probably more to come. A lot more: “there must’ve been just awful stuff in their portfolio.” Yes, and there probably still is. That Skorina! So droll and understated. Always good for a quote. And a laugh! Love him.

By the way, a big first-year write down of the type Narvekar has effected (if only to date in part) should also have been pushed through by Mendillo. It’s increasingly obvious that she was not permitted to do so, but was forced to live with huge concealed losses and their drag on performance for her entire time at the helm. Her preposterously large compensation package presumably helped her bear the pain of liquidating her reputation. Or did nobody else ever wonder why Mendillo, a perennially underperforming endowment manager, was paid far more than David Swensen?

Oh, and by the way, this article naively states: “In some cases, that might mean selling off assets, as HMC has done with some private equity and natural resources investments.” That sentence links to articles describing HMC’s intent and desire to sell “some private equity and natural resources investments.” Bloomberg and many other financial news outlets also noted the endowment’s INTENT to sell such assets. But I can find no article or other confirmation that such sales were actually consummated. That suggests that HMC may retain those assets on its books at inflated valuations: more concealed losses.
It makes you wonder what did Narvekar uncover at Harvard to make him take such drastic writedowns and how much more hidden surprises are going to come back to haunt Harvard's portfolio in the future?

To be fair, it's possible he just wanted to take drastic measures now to begin with a clean slate but if I was a major donor at Harvard, I'd be asking some very poignant questions because something really stinks in these writedowns, and I think there needs to be a lot more transparency as to why they took such drastic writedowns.

Now, looking at the broader group of top endowments, Denis Parisien sent me an excellent comment from Markov Research Center, Measuring the Ivy 2017: A Year in the Upside Down for Endowment Returns:
Summary


Ivy League Endowment Assets

As of July 2017, the total AUM among the Ivy League endowments was $125.56 billion, representing 24.38% of the assets held by universities and related endowments [1]. While final numbers for fiscal year 2017 are still pending, here is a look at how 2016 AUM was distributed across the Ivies.

Endowment          FY 2016 AUM (in Billions)

Harvard                             37.10
Yale                                   27.20
Princeton                           23.80
Penn                                  12.20
Columbia                          10.00
Cornell                                6.80
Dartmouth                          4.96
Brown                                3.50

Performance

In stark contrast to FY 2016, this past year was a strong one for most endowments. In fact, nearly all the Ivy League endowments, Harvard being the only exception, beat the 60-40 portfolio, a commonly cited benchmark that endowments measure their performance against. Only Columbia and Princeton have beaten the 60-40, on average, over the past 10 years.

All endowments managed returns well above their historical payouts of 5%, even after adding 1.65% inflation. Dartmouth, with a return of 14.60%, beat the rest of its Ivy peers, continuing its fairly consistent trend of ranking among top Ivy performers. In fact, only Yale has performed as well as Dartmouth has during the last five years. University of Pennsylvania (UPenn) reversed course this year, ranking a close second with 14.30% returns. And Harvard continues its six-year trend of performing at or near the bottom of the class with 8.10% returns in FY 2017. Yale, which has landed in the top three every year since 2011, delivered mediocre returns this year, relative to its peers, at 11.30%.



By most measures, however, FY 2017 was an unusual year. In fact, Ivy endowments that have historically under-performed their peer group outperformed this year, with Brown and Cornell being the most notable examples. Both endowments beat perennial juggernauts, Yale and Princeton, this year, a feat we’ve only seen once since 2011. Much of this year’s outperformance can be attributed to larger exposure to public equities, which have seen a remarkable rise since Q4 2016.


Exposures

To capture exposures, we analyze each endowment return time series using a common factor set across all endowments, so that we ensure an apples-to-apples comparison. This enables us to create a factor-mimicking portfolio for each endowment that can provide further performance insight. Table 1 displays the factors we used to represent each of the asset classes found in the Ivy League endowment portfolios.

Table 1. Factor Proxies by Asset Class [2]

Asset Class                                           Factor
Bonds and Cash                         Bloomberg Aggregate Bond
US Equity                                  S&P 500
Foreign Developed Equity        MSCI EAFE*
Emerging Market Equity          MSCI Emerging Markets*
Real Estate                                Cambridge Associates Real Estate
Private Equity                           Cambridge Associates Private Equity
Venture Capital                         Cambridge Associates Venture Capital
Natural Resources                     Bloomberg Commodity
Hedge Funds                             Eurekahedge 50

*USD based exposure, assuming no currency hedging

The analysis was conducted using our proprietary Dynamic Style Analysis (DSA) model. DSA is an enhanced (returns-based) quantitative analysis model that provides a more transparent view of opaque or complex investment strategies, funds and products.[3] Through this model, we compared the returns of the endowments since 2005 to the factors shown in Table 1. The chart displays the asset class exposures obtained for all Ivy League endowments over the past 10 years.


Our factor mimicking portfolios are able to capture the majority of each endowment’s performance. The chart below depicts the cumulative returns of the endowments against the returns of the factor mimicking portfolios:


Performance Attribution


Exposure to Private Equity was the largest contributor to aggregate endowment performance in FY 2017. Additionally, Hedge Funds, US Equity, Venture Capital, Real Estate, Foreign Developed Equity and Emerging Markets also contributed positively to endowment performance. Natural Resources was the only major asset exposure to be a negative contributor to performance in FY 2017.

All public equities outperformed Private Equity in FY 2017. To put that into context, US Equity has outperformed Private Equity only five times since 2001, Developed Foreign Equity has done it six times, and Emerging Market Equity has out-performed 10 of those 17 years. All three outperformed Private Equity this year, just the second time that’s happened in the last 10 years. Additionally, Real Estate and Venture Capital were soundly beaten by public markets, adding to the under-performance of Yale, which had the highest Real Estate exposure, and Princeton, which had the highest Venture Capital exposure.

Looking at the differences in performance in the underlying asset classes and considering the exposure of endowments to these asset classes, it’s easy to see why the performance of FY 2017 was so different from FY 2016: markets, in general, performed well over the last 12 months.


In fact, all asset classes, except for Bonds and Cash, performed significantly better during FY 2017 than they did in FY 2016. The largest magnitude of difference can be seen in foreign equities. Developed Foreign Equities returned 30.42% more in FY 2017 than in FY 2016, and Emerging Markets returned 35.81% more.[4] Yale shows the lowest exposure to these asset classes; with Dartmouth, UPenn and Columbia (the three highest performing endowments) showing the highest exposure.

Unexplained Returns Explained

Clearly, our factor model is not expected to capture 100% of endowment returns variation. And while its explanatory power is high, as we noted in our previous studies and as evidenced by the cumulative growth chart above, we observe some unexplained returns every year. These unexplained returns could be due to security, sector, country, style and strategy bets by underlying managers for marketable securities as well as valuation fluctuations and adjustments for private investments.

Unexplained returns were mostly positive this year, with the exception of Harvard and Yale, hinting[5] at the ability by the funds to earn abnormal returns over and above their asset allocations. Harvard, in particular, stands out with a negative -2.9% unexplained return after final analysis. In his 2017 fiscal year letter, Narv Narvekar, CEO of Harvard Management Company, pointed to a number of internal changes enacted during the year. Those included markdowns of Natural Resources; unloading of Private Equity, Venture Capital and Real Estate funds in the secondary market; and increased allocations to external managers.

It is important to note that markdowns that affect the performance of the endowment, which are not related to market performance, are captured as a negative unexplained return. It is also important to note that the large positive selection returns by other endowments this year could be a source of concern for the future, especially if related to similar adjustments to the values of illiquid investments.

Changes to Fund Exposures (Movement toward private investments)

The Yale model, pioneered by David Swensen, the manager of the Yale endowment, has swept through the endowment world. This model calls for increased investment in illiquid and higher risk assets in order to harvest the illiquidity premium. These investment properties are more easily sustained by endowments due to their having a larger asset base and a longer time frame than most institutional investors. Using our portfolios of exposure, we can see how investment portfolios have changed over time, especially focusing on illiquid private investments.


The chart above depicts the exposure of the endowments to private investments (Private Equity, Venture Capital, Real Estate and Hedge Funds). We can see that most endowments have increased their exposure to private investments since 2005, indicating broad adoption of the Yale model.

Conclusion

FY 2017 was an unusual year for endowment performance. Ivy League endowment returns were all positive, rebounding from a tough FY 2016. Traditional under-performers outperformed, with traditional outperformers posting more moderate returns. Public equity markets rallied strongly, boosting the returns of the Ivy endowments. Longer term trends show that endowments continue to increase exposures to illiquid investments, moving more toward the Yale model of a high-risk, high-return portfolio.

References

1. http://www.nacubo.org/Research/NACUBO-Commonfund_Study_of_Endowments.html
2. We used preliminary data for the quarter ending on June 30, 2017, representing 61% of active funds updated compared to the prior quarter’s NAV for US Buyout and 68% for US Venture Capital.
3. DISCLAIMER: MPI conducts performance-based analyses and, beyond any public information, does not claim to know or insinuate what the actual strategy, positions or holdings of the funds or companies discussed are, nor are we commenting on the quality or merits of the strategies. This analysis is purely returns-based and does not reflect actual holdings. Deviations between our analysis and the actual holdings and/or management decisions made by funds are expected and inherent in any quantitative analysis. MPI makes no warranties or guarantees as to the accuracy of this statistical analysis, nor does it take any responsibility for investment decisions made by any parties based on this analysis.
4. Foreign equity returns are US Dollar based, and assume no currency hedging. The dollar currency index fell by .5% over FY 2017, indicating small gains from currency translation.
5. This has to be carefully evaluated given the unexplained portion of the returns also contains noise.
This is an excellent comment and I wish we had a similar way of analyzing the long-term performance of Canada's large pensions.

The key difference between Canada's large pensions and large US endowments is they're bigger, have a much longer investment horizon and they're increasingly shifting assets into infrastructure, a long-term asset class endowments have traditionally shunned away from (pensions want to match assets with long-dated liabilities whereas endowments want to cover operating costs indexed to inflation).

But all that might change with Jagdeep Bachher, who oversees the University of California’s $100 billion portfolio, which includes retirement funds for one of the country’s largest public university systems in addition to the school’s $10 billion endowment, the 12th largest in the US:
The group has committed to putting more than $1 billion into clean energy- and water-related projects that the Obama White House promoted two years ago. In addition, the investors helped create an advisory group called Aligned Intermediary Inc., which functions like a co-op for them, sourcing investments.

The deals Aligned Intermediary identifies are big: They range from $50 million to $500 million, according to co-founder and Chief Executive Officer Peter Davidson. Its members, which also include the Ontario Public Service Employees Union Trust and the New Zealand Superannuation Fund, seek real returns from direct investments in infrastructure—renewable energy, water, even garbage—as well as from loans to projects that help reduce greenhouse gas emissions. “The economic returns are there,” Davidson says. “The responsible investing idea is there. It’s a market imperfection that we need to solve.” The University of California has committed $500 million to these types of projects. While the group’s first transaction, an investment of about $50 million involving water infrastructure in the Western U.S., is on the books, details haven’t been disclosed.

For endowments, these types of direct investments have advantages. They skirt private equity and hedge funds’ controversial 2-and-20 fees, and the projects’ timetables run into the decades, substantially longer than a typical fund life of up to 10 years.
In September, I covered Jagdeep Bachher in my comment on the University of California's pension scandal. He's not only running an endowment but if it's one guy who really knows his stuff, including investing in infrastructure, it's him.

Below,  hedge fund manager Kenneth Griffin is giving $125 million to the University of Chicago, the second-largest donation in the university’s history.

Interestingly, Griffin graduated with a degree in economics from Harvard but it doesn't surprise me one bit that he donated such a large amount to the Chicago school of economics which boasts the most "free market" economists with a Nobel-prize, including the most recent winner, Richard Thaler (who is a behavioral economist).

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