Lessons from Harvard’s Endowment Fund

A new article in Vanity Fair, “Rich Harvard, Poor Harvard” chronicles how Harvard is reeling from massive losses in its once mighty endowment fund. Financial journalist Edward Jay Epstein of the Huffington Post estimates that in the second half of 2008, the endowment declined as much as 50%, which would equate to an $18 billion loss. If memory serves, there was a time not so long ago when alumni were clamoring to gain access to the endowment’s fund managers. Now, Harvard is facing large operating deficits and hard choices about where to make cuts.

The situation at Harvard is once again a reminder of some important financial lessons. It is amazing that we need to keep learning these same lessons over and over.

1. (Very) Smart people are capable of doing dumb things. This speaks for itself and is reminiscent of Long Term Capital Management, whose founders included two Nobel Prize winning economists.

2. Don’t risk what you need for what you want (and don’t need). Harvard’s $39.6 billion endowment was the envy of academia, and there was every reason to believe, given Harvard’s uber-successful alumni, that large gifts would continue. Why then did the University take on this kind of risk?

3. Don’t invest by looking in the rear-view mirror. Between 1990 and 2008, Harvard’s endowment “boasted an average annual growth rate of 14.3%”. It appears that Harvard’s leadership came to think that these past returns were a kind of guarantee of similar returns in the future.

4. Don’t spend beyond your means. Harvard used its gains to ratchet up spending in the form of a huge expansion program, big pay raises, and a program that made tuition free for large numbers of students. These decisions now seem high on hubris and low on prudence.

5. Stay within your circle of competence. It is very hard to believe that Harvard’s fund managers really understood all the investments they put on. In my judgment, anytime you invest in something you don’t understand, you are speculating.

6. Think about risk first – and then rewards. Value investing is about taking risk seriously, not the kind of risk that academicians measure with Beta, but the risk of losing most or all of your capital. That type of risk management was not on display at Harvard.

7. Beware of the danger of an asymmetric incentive system for investment managers. “Heads I make tens of millions of dollars in bonuses, tails I walk away (and leave Harvard holding the bag.)” You generally can expect to get the type of behavior that your incentive system encourages.

8. Beware of the dangers of leverage. The article documents that over time Harvard’s fund managers added considerable leverage in order to jack up returns. As I wrote about yesterday regarding John Griffin, you have to build your ark on sunny days to withstand periods of great distress.


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