In a sit-down interview at The Crimson, the new chief executive of the Harvard Management Company (HMC), Mohamed A. El-Erian, squelched speculation that the University would follow the path of peer institutions—including Yale—that hire outside firms to steer their endowments.
While most schools entrust their endowments to external portfolio managers, HMC has roughly 150 employees who invest much of the University’s money themselves.
The choice between internal and external management is critical from the perspective of University finances and campus politics. On the one hand, HMC’s internal management structure has proved fabulously successful, generating a 19.2 percent return last fiscal year and annualized returns of 16.1 percent over the past decade. On the other hand, HMC can be a lightning rod for criticism. Since it must disclose its employees’ compensation each year, it annually draws fire from alumni who say that managers’ multimillion-dollar pay packages are excessive.
This past fall, some believed that Harvard might change its ways.
Former HMC chief Jack R. Meyer took more than 30 employees with him when he left in September after 15 years at the helm to start hedge fund Convexity Capital Management LP.
High-flying bond managers David R. Mittelman and Maurice Samuels departed alongside the outgoing chief. The dynamic duo had consistently ranked among HMC’s top earners, garnering $18 million and $16.9 million for fiscal year 2005.
At the time, it was not clear whether Harvard would seek to replace those stars, or whether it would shift away from internal management entirely.
“At some point, it simply won’t make sense to maintain the existing format,” Meyer said a year before he left Harvard. “There is a point where we would simply move to an external model.”
But that point has not been reached.
El-Erian told The Crimson that Harvard will “rebuild and reinvent” HMC rather than move to an external management structure.
STARTING FROM SCRATCH
The formation of Convexity last fall came after a number of similar attempts by HMC managers. Jeffrey B. Larson, a foreign equities manager, left with 14 members of his team in July 2004 to start a hedge fund that received $700 million from Harvard. And David W. Scudder ’57 left last May to form a similar fund.
But Convexity made a splash far beyond its predecessors. In addition to a $500 million pledge from Harvard, it garnered $6 billion from other investors—the largest start-up in hedge fund history.
The departure of so many key players—and Harvard’s move to put more than $1 billion in their hands—brought HMC to a crossroads. With HMC’s top stars now gone, was the internal management structure worth saving?
Meyer told The Crimson in an interview last year that any decision on whether to change the current internal management model would be up to the HMC Board and the incoming CEO.
And James F. Rothenberg, the University treasurer, said in an interview with The Crimson in January 2005 that he would not rule out a move to external management.
But El-Erian says the consensus fell in favor of the current system, noting that by his numbers, external management would be two to three times as expensive as an internal approach.
“We went back and questioned everything from first principles because we had the obligation to do so,” says El-Erian. “We would rebuild it with the same hybrid model”—a mix of internal and external management—”because it is so potent in terms of delivering returns.”
“The right thing for Harvard is to maximize the return on the endowment using its attributes—there is no reason why we should outsource a triple-A balance sheet,” says El-Erian. “And we have the best operations in place, the best risk management in place, the best technology in place. It’s just waiting for the portfolio managers to come in.”
PAYING THE BIG BUCKS
Payouts to top HMC managers hit a peak in 2003 when Mittelman earned $36.8 million and Samuels garnered $35.6 million. Meyer announced in early 2004 that the company would cap payouts to managers—and Mittelman and Samuels both earned about half as much in their last year here as they did in 2003. Meyer earned $6 million in the fiscal year ending last June 30.
El-Erian says HMC’s compensation structure will not change.
“The compensation system will be always a function of performance. We will not pay if performance is not delivered,” says El-Erian. He points out that a certain portion of a manager’s performance-based pay is deferred for a year under the current system, ensuring that “people are incentivized to perform over time and consistently rather than go out.”
The University is not required to report how much it pays to external managers.
“It is not common in the financial industry to have your compensation in the front page of The Crimson and the front page of the Boston Globe,” says El-Erian. “But the attraction of being part of the mission of Harvard Management is so strong that people are willing to be humiliated in public.”
At HMC, Mittelman managed domestic bonds—which account for 11 percent of the company’s policy portfolio—and Samuels steered the five percent of the portfolio invested in foreign bonds.
“The analogy I use is that in the past Harvard Management was a V-12 that was driven very rapidly, and the bulk of those cylinders were on the fixed income side,” says El-Erian. “In the future, once we finish the transition period, we will look like a V-12 but those cylinders will be much more diversified. That is because the sort of experience that went with David and Maurice doesn’t get recreated overnight.”
El-Erian wants to expand Harvard’s presence in foreign currency management. Since the University already has extensive overseas holdings, he says, HMC should manage its foreign currency exposure so as to soften the potential blow from exchange-rate fluctuations.
He also says that, with poorer countries invested heavily in the U.S., HMC “wants to be in a position to navigate through what is likely to occur at some point, which is the adjustment in these global imbalances, because they are unprecedented and unsustainable at some point.”
And El-Erian wants to capitalize on the resources of Harvard’s own scholars to expand HMC’s expertise. “Every single faculty member would like to see the endowment do well,” he says. “It’s a wonderful alignment of incentives.”
With top economists at the Business School, the Faculty of Arts and Sciences, and the Kennedy School, “we’re going to be drawing upon this brainpower to help us maximize the return on the endowment,” he says.
El-Erian himself adds to Harvard’s stock of brainpower. With a doctorate in economics from Oxford University, he has served as a senior official at the International Monetary Fund, the head of the emerging market research team at the predecessor to Citigroup, and as the chief of the Pacific Investment Management Company’s $28 billion emerging market portfolio.
—Staff writer Cyrus M. Mossavar-Rahmani can be reached at email@example.com.