Harvard's 'Lazy, Fat, Stupid' Endowment?
Harvard University’s money managers collected tens of millions in bonuses by exceeding “easy-to-beat” investment goals even as the college’s endowment languished, employees complained in an internal review.
The consulting firm McKinsey & Co., in a wide-ranging examination, zeroed in on the endowment’s benchmarks, or investment targets. Some of those surveyed said Harvard allowed a kind of grade inflation when it came to evaluating its money managers.
“This is the only place I’ve seen where people can negotiate the benchmark they get compensated on,” read a “representative quote" in the McKinsey report.
The McKinsey assessment offered an explanation of what it called the “performance paradox” at Harvard’s $35.7 billion endowment, the largest in higher education. Year after year, Harvard would report benchmark-beating performance while falling further behind rivals such as Yale, Princeton, Columbia and the Massachusetts Institute of Technology.
The April 2015 report, which has never been made public, spells out why the fund paid more than peers for lagging performance, as well as its management’s strategy for shifting course. Harvard said it has since revamped its compensation.
Soaring Pay
McKinsey’s review took a rare, unvarnished look into the culture of a secretive organization, where employees and others complained to McKinsey of an inattentive board and complacent culture -- in their words, “stable, rather than smart, capital” or, less charitably, “lazy, fat and stupid.”
As Harvard’s Cambridge, Massachusetts campus braces for possible budget cuts after a recent decline in the endowment, McKinsey’s conclusions are likely to raise concern. For years, faculty and alumni have complained about money manager pay, which they have called inappropriate for a nonprofit.
The consultant’s report focused on the five years ended June 2014, a period when manager compensation soared. During that half-decade, Harvard paid 11 money managers a total of $242 million, 90 percent of which was made up of bonuses, tax filings show. In the final year, total compensation amounted to $65 million, more than twice the amount five years earlier.
Harvard’s endowment has “redesigned its compensation to further align the interest of investment professionals with those of the university,” spokeswoman Emily Guadagnoli said in an e-mail. Because of under-performance in the most recent year, “current and former employees will forfeit compensation that was held back in prior years.”Ah, the trials and tribulations of Harvard's mighty endowment fund. Once renowned for its investment prowess, now it's being heavily criticized for overpaying investment officers who "manipulated" their benchmarks to make it look as if they were adding more value than they actually did.
The new plan ties pay to “appropriate industry benchmarks” and a “significant portion” is held back and won’t be awarded for performance that isn’t sustained, she said.
In the report, the consultants cited a “representative” quote from within the endowment stating that benchmarks are “easy to beat, inconsistent and often manipulated.” McKinsey summed up this sentiment in a PowerPoint slide: “The benchmarks are considered ‘slow rabbits.”’
People familiar with the report said some at Harvard considered McKinsey’s comparisons unfair because each school had such a different mix of investments and risks. They also took issue with the idea that benchmarks were manipulated.
Then Chief Executive Officer Jane Mendillo, who oversaw the endowment during the period McKinsey studied, had a goal of making the endowment less volatile after steep losses during the 2008 financial crisis. Even adjusted for risk, however, Harvard’s performance lagged, McKinsey said. Mendillo declined to comment.
Key Targets
Universities and other organizations with money managers must strike a balance when setting performance targets, according to Ashby Monk, who directs a Stanford University research center and is a senior adviser to the University of California endowment. Setting goals too high encourages excessive risk, while setting them too low results in overpaying money managers, he said.
“You’ve got to get the benchmarks right,” Monk said.
Harvard commissioned the study after it promoted Stephen Blyth, a former Deutsche Bank AG bond trader from head of public markets to chief executive officer in 2014. McKinsey delivered a 78-page PowerPoint presentation, which was reviewed by Bloomberg, to executives and money managers.
Afterward, Blyth overhauled Harvard’s compensation and benchmarks, making targets harder to beat. Blyth stepped down in July after taking a medical leave. In December Nirmal P. Narvekar, the top-performing endowment manager from Columbia, will take over at Harvard. He will become the eighth permanent or interim chief executive since 2005.
Foregone Billions
In the five years scrutinized by McKinsey, the fund reported an average annual return of 11.2 percent, compared with Princeton’s 14 percent, Yale’s 13.5 percent and MIT’s 13.2 percent. Harvard’s relative under-performance cost the school $3.5 billion. Because of such results, McKinsey warned that Harvard could lose its perch as the world’s largest endowment to Yale within 20 years. On a 10-year basis, Harvard’s performance was “slightly better,” McKinsey said.
The review focused on what endowments call a “policy portfolio.” It reflects the mix of each kind of asset a school owns -- from stocks and bonds to South American timberland. The university picks benchmarks, such as an equity index, to evaluate the performance of the different investments.
Over the five-year period, Harvard reported that its 11.2 percent average annual return beat its benchmarks -- its so-called policy portfolio -- by 1 percentage point, a significant margin for a money manager.
Then, McKinsey compared the college’s performance to Stanford’s policy portfolio, which it viewed as more ambitious. Had it been measured by the more rigorous standard, Harvard would have underperformed by half a percentage point.
Side Deals
In fact, merely running a portfolio of index-tracking funds -– 65 percent in the S&P 500 Index and 35 percent in a government bond index -– would have generated a 14.2 percent annual return.
During the financial crisis, managers took steps to move out poorly performing investments and adjust benchmarks, muddying performance judgments, according to one of the quotations from the survey: “There were so many side deals cut during the crisis – bad stuff moved out of portfolios and benchmarks adjusted – individual performance bears little resemblance to fund performance and we somehow seem OK with that.”
The McKinsey report singled out alternative investments such as real estate and natural resources. They make up more than half of Harvard’s portfolio, and McKinsey noted they performed strongly. At the same time, they were judged on benchmarks -- particularly for natural resources -- that were “less aggressive” compared with those at Yale, Princeton and Stanford, according to the report.
Highest Pay
In the five-year period, the university paid Andrew Wiltshire, who oversaw alternative investments, a total of $38 million, more than anyone else. Alvaro Aguirre, who oversaw holdings in natural resources like farmland and timber, made $25 million during the four years for which his compensation was disclosed. Wiltshire, who declined to comment, and Aguirre, who didn’t return messages, both left Harvard last year.
During the entire five years, Harvard paid then CEO Mendillo $37 million, twice as much as top-performing David Swensen at Yale University.
The report recommended expanding Harvard’s internal trading operations, which it said had an annual cost of almost $75 million, including performance bonuses for employees. Harvard did so, but later backtracked, eliminating at least a dozen positions.
Thanking Klarman
Blyth, who headed public markets, including the trading operation, was paid a total of $34 million over the five years. McKinsey found that Blyth’s unit contribute strongly to the fund’s performance, and its benchmarks fell in line with the school’s peers. Blyth didn’t return messages.
The report also noted that some of the best-performing investments in the portfolio were picked years ago. They included Baupost Group LLC, the hedge fund run by Seth Klarman, stock-picking hedge fund Adage Capital Management, and venture firm Sequoia Capital, an early backer of Google and PayPal Holdings Inc. “Thank God for Seth Klarman,” one employee told the consultants.
McKinsey cited interviews describing recent commitments to strongly performing investments, such as Baker Brothers Advisors, a biotechnology stock-focused fund, as “incremental, scattershot and lacking in conviction.”
Consultants heard complaints about the board overseeing Harvard Management Co., the school’s investment arm: “The board doesn’t ask the hard, searching questions around benchmarks and compensation.”
Falling Behind
James Rothenberg, chairman of Capital Research & Management Co., the Los Angeles mutual-fund manager, chaired the board during this period. Rothenberg, who was also Harvard’s treasurer, died in July 2015.
Paul Finnegan, founder of a private equity fund, joined the board in 2014 and succeeded Rothenberg as chairman last year. Most of the current members of the board joined in the last two years. Harvard President Drew Faust was also on the board during the period and remains a member.
McKinsey said staffers were proud to work for such a prestigious college, which they said could use its name to attract talent and gain access to investments. As one of those interviewed told the consultant: “Harvard shouldn’t stand for mediocrity, but that’s where we’re heading if this continues.”
What is the connection to pensions and why cover this article on my blog when I should be covering markets on a Friday? Quite a bit because this story sounds a few alarm bells for all endowment funds, pension funds, hedge funds, private equity funds, and mutual funds.
Last Friday, I covered the elusive search for alpha, where I warned investors not to read too much into the latest performance of established or less well-known hedge funds and private equity funds, even if they are performing exceptionally well.
Now we read that Harvard's mighty endowment has some real serious issues to contend with. What are my thoughts and what is the link to pensions? I will try to be short and sweet:
- First, whenever you hear the board or senior management is hiring McKinsey, Boston Consulting Group, or some other big name consultant, brace yourselves, bad news is coming. I'd love to see the 78-page PowerPoint presentation to Harvard endowment's board and I am sure Canada's large pension funds would love to see it too.
- Second, I actually welcome this McKinsey study and think it or another consulting group should provide a similar study to the Auditor General of Canada and provincial auditor generals reviewing all the benchmarks used across public and private markets at Canada's large pensions, the leverage they take to achieve their results, and whether they're all adding the value they claim when adjusting for illiquidity, leverage, and other factors. I recently praised Canada's new masters of the universe but I also noted that oversight and governance needs to be improved by commissioning independent, comprehensive assessments of operational, investment and risk management risks (and these reports should be made public).
- Third, related to second point, not all boards are created equal. Some are doing a much better job than others overseeing the operations of the endowments and pensions they are responsible for. I'm not claiming the board members at Harvard or any of Canada's large pensions are incompetent as they clearly aren't, but they need to fulfill their fiduciary duty and make sure there is nothing remotely shady going on, especially when it comes to benchmarking performance which is used to gauge performance and determine compensation.
- Fourth, the compensation at Harvard's endowment is mind-blowing, not only by Canadian pension standards, but also relative to other large US endowments. When I read that during the entire five years, Harvard paid then CEO Mendillo $37 million, twice as much as top-performing David Swensen at Yale University, I was floored. I believe in paying for real performance (adjusted for risk) and this was clearly not the case at Harvard. Moreover, when you read the absurd compensation at Harvard's endowment, you wonder what are they smoking? If these "investment superstars' are that great, why aren't they opening up their own hedge fund or private equity fund to make some serious money? Also, I openly question whether on a risk-adjusted basis Canada's top large pensions are not outperforming some of the large US endowments. If that's the case, we can argue that Canada's senior pension investment officers are a real bargain (I'm serious!).
- Fifth, I wrote a comment on Harvard betting on farmland back in 2012, stating that "Harvard's push into timberland was not revolutionary" and it was fraught with risks. I'm extremely surprised that Alvaro Aguirre, who oversaw holdings in natural resources like farmland and timber, made $25 million during the four years for which his compensation was disclosed. That is outrageous and absurd and I wonder how well these investments are doing nowadays after the bubble in agriculture burst (I've seen mixed performance figures and some bombs from big pensions like CalPERS).
- Sixth, I don't know what happened to Stephen Blyth, I hope his medical leave of absence isn't serious, but he seemed to me to be the most qualified CEO and his internal trading group was delivering stellar results. Last September, Harvard's endowment was warning of market froth and Blyth was actively looking for investment managers with expertise as short-sellers. His timing might have been off by a year and even now, I am not sure we should be bracing for a violent shift in markets.
- Seventh, take all this stuff about "Thank God for Seth Klarman" with a shaker of salt! I admire Klarman, his protege, David Abrams, the one-man wealth machine, and many other top funds Harvard's endowment has invested in, including Adage Capital and the Baker Brothers. I track their holdings as well as those of other top funds every quarter on my blog. But these are tough markets for everyone, especially for biotech investors like the Baker Bros (I know, I trade biotechs and they swing like crazy both ways). It is also interesting to note that Klarman and Abrams hold some big positions in biotechs that got massacred recently so I am not sure how they are performing lately (remember, don't fall in love with your managers, grill them, that is your job!).
Still, expectations run much higher at Harvard and he has a very tough job ahead to transform this mighty endowment fund for the better. Will he be Harvard's answer to David Swensen? I strongly doubt it but let's give the man a chance to prove his worth over the next two or three years.
That's the other problem with these large US endowments, too much focus on short-term performance, expectations run unrealistically high given that we live in a deflationary world where the elusive search for alpha is becoming harder and harder. That goes for all investment managers.
On that note, I was a bit disappointed today when Opexa Therapeutics (OPXA) announced that the Phase 2b Abili-T clinical trial designed to evaluate the efficacy and safety of Tcelna in patients with secondary progressive multiple sclerosis (SPMS) did not meet its primary endpoint of reduction in brain volume change (atrophy), nor did it meet the secondary endpoint of reduction of the rate of sustained disease progression. Tcelna did show a favorable safety and tolerability profile.
I took part in that study and given there are no side-effects whatsoever, I still don't know if I was on the medication or placebo. All I know is that I'm feeling much better, doing well, but for thousands of patients with secondary progressive multiple sclerosis (SPMS), the elusive search for a cure or well tolerated treatment (with no nasty side-effects like PML) goes on. There are new treatments on the way but much more needs to be done to tackle the needs of patients with secondary or primary progressive MS.
But like I tell my family and friends, the best way to tackle MS or any chronic disease is through diet, exercise, vitamin D and a positive mindset (see my links on fighting MS on the bottom right-hand side).
But just like in investments, luck plays a factor in all diseases so try not to beat yourself silly if things aren't going well and just count your blessings when they are.
That reminds me, I have to get my "lazy, fat, stupid" ass in the gym and do a little workout to decompress, it's been a rough week trading biotech stocks (click on image):
Thank God I wasn't invested in Opexa, it took a massive 70% haircut today following the bad news (taking stock specific risks in biotech is extremely risky!!).
But I think this latest biotech selloff presents great opportunities and smart traders and investors are loading up here (regardless of who wins on November 8th, I would be buying the dip on the IBB and especially the XBI).
Hope you enjoyed reading this comment, as always, I don't claim to have a monopoly of wisdom on pensions and investments, so if you want to add your insights, feel free to shoot me an email at LKolivakis@gmail.com.
Also, please remember to kindly contribute to this blog on the right-hand side via PayPal. The comments are free but I appreciate your support and thank those of you who value my work. Better yet, please donate to the Montreal Neurological Institute here and support their research.
Below, Harvard University’s money managers collected tens of millions in bonuses by exceeding “easy-to-beat” investment goals even as the college’s endowment languished. Bloomberg's Michael McDonald reports. Bloomberg should disable autoplay in their clips; if it autoplays, follow these steps to disable it on your browser (I know, the music is lame but the advice is sound).
Also, Raoul Pal, who co-managed the GLG Global Macro Fund in London for GLG Partners and retired at 36 in 2004, explains why people in the hedge fund industry are "fed up" and warns others to stay away. You can watch this interview here.
Pal cites the pressure of short-term investing as one of the reasons why he left the hedge fund industry. He also talks about his new venture to "democratize" investing, to level the playing field for everyone.
After delivering a 35-page PowerPoint presentation on robo-advisors this week to a FinTech company, I take all this talk of "democratizing finance" with a shaker, not a grain of salt. There's a lot of hype out there, period.
As far as entering hedge funds, I wrote a tongue-in-cheek comment three years ago, So You Wanna Start a Hedge Fund?, where I warned all Soros wannabes to stay away and follow the wise advice of Andrew Lahde, the best hedge fund manager you probably never heard of (Michael Lewis didn't write about him in The Big Short, just like he didn't write about Haim Bodek in Flash Boys).
At the end of the day, what counts the most is your health and peace of mind, keep that in mind as you try to "deliver alpha" (aka, leveraged beta) in an increasingly difficult environment. Enjoy your weekend!
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