Harvard moving ahead with new set of plays

Harvard Management Co. President and CEO Stephen Blyth has mapped out a detailed investment plan for the company overseeing Harvard University's $37.6 billion endowment, aiming to improve long-term investment performance and revitalize lagging returns.

The result is a new approach deemed the flexible indeterminate factor-based asset allocation, incorporating elements from modern portfolio theory, factor-based investing, the reference portfolio approach and best-ideas investing.

Mr. Blyth and his team outlined the FIFAA approach in a four-step process: selecting appropriate factors; measuring asset class exposure to selected factors; choosing desired factor exposures; and determining asset class targets and ranges to match desired factor exposures.

The approach is referenced in a letter addressed to Harvard alumni and friends announcing the results for the fiscal year ended June 30. In the letter, Mr. Blyth outlined three investment objectives: to achieve a real return of 5% or more on a rolling 10-year annualized basis; to outperform appropriate benchmarks by 1 percentage point or more on a rolling five-year annualized basis; and to perform in the top quartile among the next 10 largest university endowments on a rolling five-year annualized basis. Harvard's is the nation's largest academic endowment.

“Our objectives are to be achieved while maintaining a portfolio whose risk profile is in line with the university's risk tolerance,” Mr. Blyth wrote. “Thus, in addition to these investment objectives, we have established an appropriate set of risk guidelines that provide suitable flexibility for a long-term endowment portfolio, yet maintain a prudent set of risk parameters within the portfolio.”

For the 12 months ended June 30, Harvard's endowment posted a return of 5.8%, surpassing the 3.9% return of the Cambridge, Mass.-based university's benchmark policy portfolio. It reported an average annual return of 10.5% for the five-year period, surpassing its benchmark return of 9.1%.

Mr. Blyth, previously HMC's managing director and head of public markets, assumed his new role Jan. 1 after then-CEO Jane Mendillo retired. Mr. Blyth did not respond to requests for an interview.

In the letter, Mr. Blyth stressed the importance of endowment distributions to the university's operating budget. With distributions averaging 4.4% over the past 20 years, a real return of 5% “will be necessary to maintain the real value of the endowment for future generations,” he wrote.

But delivering a real return of 5% will be more challenging in the current environment than in the past, he noted.

The endowment's real returns have declined steadily over time, he wrote, citing a decline in the risk-free real interest rate; reduced risk premiums across asset classes due to “significant liquidity injections;” and fewer opportunities for generating alpha.

Upon taking the helm, Mr. Blyth and his staff conducted a review of existing asset allocation approaches.

The FIFAA approach is presented in detail in an upcoming report, to be published in the Journal of Portfolio Management. In that article, Mr. Blyth and fellow authors reviewed various asset allocation frameworks, including modern portfolio theory, targeted risk-objective approaches (e.g. risk parity), the “best ideas” framework, the endowment model, factor-based investing and the reference portfolio approach (as implemented by Canada Pension Plan Investment Board).

Finding the pros and cons of these approaches, Mr. Blyth and the authors determined that cherry-picking elements from various frameworks might “represent a meaningful improvement over our current process,” one that that is highly quantitative but also combines qualitative inputs.

The report indentifies the five tradable factors (global equities, U.S. Treasuries, high-yield credit, inflation and currency), which they think “account for 85% to 95% of a typical domestic institutional investor's risk, are low to moderately correlated, and are amendable to relatively confident forecasting.”

After steps two and three, Mr. Blyth and his team decided on 12 asset classes for 2016 that “satisfy the optimal five-factor exposures.” They are (with ranges):

•U.S. equity, 6%-16%;

•Foreign equity, 6%-11%;

•Emerging market equity, 4%-17%;

•Private equity, 13%-23%;

•Absolute return, 11%-21%;

•High yield, zero-3%;

•Natural resources and commodities, 6%-16%;

•Real estate, 10%-17%;

•Domestic bonds, 5%-9%;

•Foreign bonds, zero-4%; and

•Inflation-linked bonds, zero-6%

The endowment's policy portfolio for the fiscal year 2015 was: domestic equity (11%), foreign equity (11%), emerging markets equity (11%), private equity (18%), natural resources (11%), real estate (12%), absolute return (16%) and fixed income (10%).

In his letter, Mr. Blyth also noted that he has charged HMC's portfolio managers to engage in more cross-asset class discussion and collaboration; be creative in considering new partnerships, vehicles and platforms for investing that provide the maximum benefit for Harvard; develop the conviction to invest in scale; and to engage more fully both with HMC's investment partners and with peer institutional investors globally.

Mr. Blyth added: “HMC will maintain portfolio liquidity so that at least 5% of the endowment ... can be realized in liquid form within 30 days.”

That liquidity target impressed William Jarvis, managing director, head of research at the Commonfund Institute, Wilton, Conn., who described it as “a specific quantitative goal ... and I don't know if I've seen anyone from an endowment be so specific.”

Charles A. Skorina, founder of San Francisco-based executive search firm Charles A. Skorina & Co., which specializes in the hiring of chief investment officers, commended Mr. Blyth for the investment strategy.

“I like the fact that he actually laid down something. It was always muddy before. In any case, Mr. Blyth tried to be clear and I applaud him for it,” Mr. Skorina said, adding “the goals are not spectacular, (but) they're reasonable.”

Before Mr. Blyth took over, Harvard's endowment was facing challenges after years of being known as the biggest and strongest kid on the block — not only for being the largest endowment but also for typically generating the highest returns.

When Ms. Mendillo became president on July 1, 2008, the endowment was valued at $34.9 billion. Then just 2½ months later, Lehman Brothers Holdings Inc. filed for bankruptcy.

The portfolio dropped to $26 billion at the end of its 2009 fiscal year.

For the five years ended June 30, 2013, the endowment posted an annualized return of 1.7%, well below the median 4.6% annualized return among foundations and endowments for the period, according to the Wilshire Trust Universe Comparison Service.

However, the endowment managed to shake off the effects of the global financial crisis and pick itself up. It posted an average annual return of 11.6% for the five years ended June 30, 2014.

Mr. Skorina noted the endowment's returns this year can be attributed primarily to Ms. Mendillo's leadership. “It takes about two years minimum before you can turn a giant tanker like this in a new direction,” he said.

Not all U.S. university endowments have released their fiscal year figures. For the 12 months ended June 30, Harvard's return of 5.8% is below that of Massachusetts Institute of Technology's 13.2%, Yale University's 11.5%, University of Pennsylvania's 7.4% and the Stanford University merged pool's 7% return. It was, however, higher than UTIMCO's 3.5% over the same period.

Mr. Blyth's letter to alumni and friends can be found on Harvard Management Co.'s website.