Harvard Management Company free essay sample

Portfolio to correspond to their benchmark, according to the modern portfolio theory (Markowitz, 1952), whose goal is to minimize the variance for a given return. The main advantage of the optimal portfolio allocation lies in its ability to provide weights on how to invest a given amount of money based on a few inputs. Optimal portfolio allocation is easy to implement, yet it faces some issues and limitations. As discussed in class, the model assumes normality in the returns, since the optimization only depends on the mean and the variance. HMC team should however take into account that the distribution of returns is not normal and that there might be outliers issues. HMC partly takes these into account by controlling the risk for the aforementioned outliers using stress test (Exhibit 7). Another important matter to point out is that the model uses historical data as input, and these data might very well not be constant or accurate. Correlation may indeed change both over time and between classes of assets. However HMC examined short-term and long-term historical records and talked with investment management firms specialized in this type of analysis in order to get the most accurate data. Finally, HMC is doing well using the optimizer as a proxy for the investment decision. Optimizers may lead to completely different investment strategies if the inputs (mean, variance, correlation) are to be changed by a small amount. In a first step optimization, Meyer and his team found out they had to take substantial position in non-traditional asset classes. They therefore constrained the optimization in a second step, which led to a more realistic and implementable Policy Portfolio. How does HMC develop its capital market assumptions? Why does HMC focus on real returns? What do HMC’s capital market assumptions imply about the U. S. equity premium and foreign equity premium? As mentioned above, HMC developed its capital market assumptions (returns, standard deviation of returns and correlation between class of assets) using historical data. They used both long-term and short-term historical data, alongside with experts’ opinion and thus adjusted the assumptions to the current market conditions. This approach seems to be appropriated however since the data may be inaccurate, the optimization might in this regard yield useless results. Moreover, because HMC provides the major part of the budgets of individual schools of Harvard, the management has to preserve the real value of the endowment so that each school would benefit forever from the distribution of the fund. Acknowledging this fact, HMC should focus on real returns. The fund has to grow at a rate of 2% to 3% to ensure the growth meets this objective. Meyer therefore decided to have a long-term vision on the global investment strategy in order to respect the purpose of the fund, which was to provide substantial and predictable cash inflow; but at the same time he developed a short-term view for the tactical asset allocation based essentially on arbitrage strategy and anticipation of short-term market moves. The final allocation suggests that the performance of the fund relies highly on the one of the market (in 2000, 61% was invested in equities) HMC should therefore invest more money in TIPS to ensure a real long-term growth. These assumptions imply a U. S. equity premium of 3% (6. 5%- 3. 5%) and a foreign equity premium of 3% (6. 5%-3. 5%), 3. 5% being the return of cash. However cash is not considered as risk-free (1% volatility). Hence both equity risk premiums are a little higher than 3%. Using the data from Exhibit 11, discuss how you would obtain Exhibit 12. Exhibit 11 summarizes the return, the risk and the correlation of each asset class. Exhibit 12 defines the weights invested in each class of assets in order to get the highest return for a given risk or the smallest risk for a given return. It represents the efficient border and can be made using Excel and Solver. The efficient portfolios suggest not invest in any equity. Moreover, the expected return of the portfolio is increasing in the emerging market/private equity/commodities’ weight. As we mentioned above, the optimal asset allocation includes non-traditional position and this is why HMC imposed some constraints on the asset classes. According to Exhibit 12 and given that the required return should be around 4. 5% 7. 5% per year to cover the endowment distribution need [historical endowment spending shown in Exhibit 1 (3. 5% 4. 5%) + the inflation rate (1% 3%) + real growth of the fund], HMC knows its investment optimal policy. Exhibit 13 gives more traditional weights by imposing some constraints on the optimizer, in order to make Harvard look alike its competitors (the others universities). Discuss the pros and cons of constraining portfolio weights. Adding constraints to the portfolio makes the model more realistic in one hand, because it suits better with the firm’s benchmark and the firm’s possibilities; but in the other hand, achieving the same return will imply more risk-taking as well. The efficient frontier moves to the right. Asset class may indeed have different transaction costs and, as long as the model does not take transaction costs into account, HMC has to constraint the model to minimize these costs. Another reason to constraint the model is the difference in the taxation of the money invested in different classes of assets. Finally, constraining the portfolio may lead to miss some opportunities: a first investment in private equity might require further investments in order to make the firm extend and become profitable. The absence of investment may on the contrary lead to the decline of the high-tech firm. Finally, HMC has to figure out that some asset classes might be less liquid than others. Do you agree that TIPS should be considered as an additional asset class in Harvard’s policy portfolio? Because of the long-term oriented investment strategy of HMC, inflation risk has to be taken into account. Hence TIPS will have to be considered as an asset class, since inflation may have a significant impact on the value of the fund when long-term investment is considered. The Treasury Inflation-Protected Securities provide protection against inflation risk, since TIPS value is correlated to the inflation rate. Moreover, TIPS have interesting properties in terms of diversification. They are very lowly correlated with other classes of asset (see Exhibit 11 showing zero correlation with equity market). Thus, creating a new asset class might very well be benefit to improve the portfolio diversification. TIPS return has a relatively low rate of 3. 6%, but it suffers a very small risk (3%). The Sharpe ratio ((3. 6% 3%) / 3% = 0. 2) is quite good compared to other bonds. TIPS are nevertheless relatively new asset class (introduced in 1997) and HMC should therefore be careful of the reliability of the asset class, given the low volume of historical information available. TIPS might be a good investment solution in this context, according to the HMC forecast stating that inflation will be high in the US economy. Comment: TIPS gives rotection against inflation based on the CPI. HMC should be aware that Harvard has not the same exposure to inflation as the one for which TIPS offers hedging solution. Additional comment: HMC strategy is focused on providing important and predictable cash distribution to the different schools. This fact implies a long-term view of the investment strategy and safe positions in order to yield predictable performance. However, managers seem to be paid according to short-term performance (500,000$ per 1% above the benchmark). HMC could change the remuneration system so that managers would be more involved in the long-term performance of the fund. In this regard, HMC could set a remuneration based on performance achieved over the 5 previous years. Changing the remuneration system would possibly solve the conflicts within the Harvard community as well. Nevertheless, during the course of the last nine years the performance has been above both the benchmark and the median value of large funds calculated by TUCS (Exhibit 9). We can then really wonder whether the benchmark was not underestimated. Additional comment: The retribution strategy is to allocate an endowment each year according to the portion owned by each school. HMC assumes that all schools have the same needs for their budget. Yet the case does not provide enough information about the individual budget of each school, it could be that one school happens to have an extraordinary expense. HMC could therefore manage differently the part of the endowment of that specified school in order to avoid pressure on its operating budget.