The Harvard Management Company and Inflation-Protected Bonds

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Case Questions

 

  1. What are the goals of the Harvard Management Company (HMC)? What are its investment horizon, sources of income/revenue, spending, and growth goals?

The goal of Harvard Management Company (HMC) is to provide active strategic management to the Harvard university endowment funds. Its investment strategy aims at adding value by engaging investment professionals who actively seek superior returns across a diverse array of asset classes. In the fiscal year 2000, the company oversaw the management of $19 billion, of which $15 billion was from the endowment funds. The primary sources of income for HMC was the endowment funds (25%), tuition fees (30%), gifts, and grants.

Moreover, as of 2000, the company’s active management strategy had produced a real return of 11.3% per year for the previous ten years. However, the expenses generated by this proactive strategy had been $93.1 billion; 49 basis points of total assets under management. The long term goal for the endowment was to distribute between 4% and 5% of the endowment to the schools within Harvard University, while at the same time preserving the real value of the endowment and allowing for real growth. Harvard spending had been growing at 3% after inflation. Therefore, it would require a real return between 6% and 7%.

  1. What are the differences between real and nominal returns? Why is HMC focusing on real returns? What other return/risk characteristics does HMC consider?

Nominal returns are what an investment generates before taxes, fees, and inflation. It is the net change in price over time. However, real yields are the actual value of returns after adjusting for inflation, income tax, and fees. The historical average rate of endowment gifts is 1%. Therefore, the goal of 4% and 5% distribution among the schools, and the continued spending of Harvard at 3% after inflation would require an investment real return goals between 6% and 7%.

To determine the relevance of an asset class for its portfolio, the HMC considered three characteristics: expected future real returns, the volatility of real returns, and the correlation of the real return on each asset class with the real return on all other asset classes. To estimate these characteristics, HMC historical data on real returns and the assessment of experts.

  1. What are TIPS? Describe its features. How are they different from regular Treasuries? How do they protect against inflation? When do TIPS underperform Treasuries; when do they outperform?

The U.S. Treasury Inflation-Protected Bonds (TIPS) are bonds whose principal and coupons grow with the general level of prices as measured by the consumer price index (CPI). Therefore, protecting investors from the decline in the value of money contemplated by inflation.

The Inflation-Indexed Notes are issued with maturities of at least one year, but not more than ten years. However, Inflation-Indexed Bonds have maturities of more than ten years. These securities are auctioned in terms of real yield. TIPS are structured in a manner that requires changes in the coupon of the based to change the monthly level of inflation. So technically, the principal value of the security on any date equals the value at the time of issuance.

TIPS pay interest every six months based on a fixed rate determined at the bond’s auction. However, the interest payment amounts can vary since the rate is applied to the adjusted principal or value of the bond. If the principal amount is adjusted higher over time due to rising prices, the interest rate will be multiplied by the increased principal amount. As a result, investors receive higher interest or coupon payments as inflation increases. Conversely, investors will receive lower interest payments if deflation occurs. TIPS have generated higher real returns than the U.S Treasury Bills (T-Bills). TIPS are designed to protect investors from the adverse effects of rising prices over the life of the bond. The par value—principal—increases with inflation and decreases with deflation, as measured by the CPI. When TIPS mature, bondholders are paid the inflation-adjusted principal or original principal, whichever is greater. T-Bills are not inflation-adjusted, so they outperform TIPS whenever inflation goes down, and underperform when inflation goes up.

  1. Why is HMC considering TIPS to add to their portfolio? How are TIPS returns correlated with other assets in HMC portfolio?

TIPS had offered real yield between 3.2% and 4.25%. By contrast, the real yields on T-Bills had been historically around 2%, while that on Treasury nominal bonds was about 3%. HMC believed that TIPS could be a good asset to hold in its portfolio. They thought that the real yield by TIPS suggested that a 2% real return was too low and that a better estimate was 3.5%. To study the volatility and correlation of real return on TIPS with other class of assets, HMC performed a mean-variance-analysis. The highest positive correlation witnessed was between TIPS and domestic bonds – accounted for 50% or 0.5. TIPS did not correlate with emerging markets. However, TIPS had a negative correlation with cash and foreign equity. The expected real return was 4% with a standard deviation of 3%.

  1. Examine the mean-variance analysis in Exhibits 5 and 6. What are the assumptions? How did HMC come up with these assumptions? What do the results of this analysis indicate about the inclusion of TIPS in HMC’s portfolio?

The HMC team performed several optimization tests to find the ‘efficient frontier.” Exhibit 5 showed allocation when portfolio weights for all the included asset classes, except Cash, were bound to lie between 0% and 100%; the constraint for Cash was set between negative 50% and positive 100%. Exhibit 6 shows allocation for all asset classes, except inflation-indexed bonds, were constrained to lie between 10% points above and below the weights of the HMC portfolio that was et before the inclusion of TIPS. In this exercise, the constraint for inflation-indexed bonds was set to 0% and 100%.

Overall, the mean-variance optimizations suggested that inflation-indexed bonds were an attractive asset to hold in a portfolio. Additionally, private equity, real estate, emerging markets, and commodities were also suggested to for long positions (expected to rise).

  1. Compare HMC’s asset allocation with other institutions’ (Exhibit 7). What are the similarities and differences?

From the mean-variance analysis, it was suggested that inflation-indexed bonds were an attractive asset to hold in a diverse portfolio. However, the results were not very conclusive. Therefore, HCM performed an analysis of other institutes and how they allocate their portfolios. From the study, it was suggested that HMC, in comparison to other institutes, had been short on cash and had higher holdings in foreign equities. HMC also had more considerable holdings in emerging markets. HMC had limited allocation in absolute returns, as compared to other institutes. Also, a long position in commodities was witnessed.

However, HMC had a high holding of domestic equities, so did other institutes. Additionally, allocation in private equities was as high as the average of other institutes.

  1. Evaluate HMC’s decision to add TIPS to its portfolio. Do you agree with this decision? Explain. What are the advantages and disadvantages of adding TIPS? Is 7% allocation appropriate? Explain.

After careful consideration of the mean-variance optimization results, and the portfolio of peer institutes, a new Portfolio Policy was recommended that would include a unique position of TIPS of 7%, and no shorting of cash, at the expense of smaller domestic equities and domestic bonds. In the new HMC portfolio, domestic equities will constitute 22%, down from 32% a year ago, and the U.S. bonds would add up to 7%, down from 11% last year. A 1% change was made to absolute returns, commodities, and high yield. TIPS were newly added at the expense of U.S. equities, which performed well in the past.

Nonetheless, it is thought that the new portfolio was a proper formation. Although U.S. equities performed well, they were open to risk and not adjusted to inflation. The standard deviation was very high for U.S. equities as well as for domestic bonds. Even though the inflation rate in the U.S. from 1997 to 1999 was not very high, TIPS still generated a decent return. After 1999 the inflation rate was expected to rise, hence making TIPS an even better option to hold in a diverse portfolio. The inflation factor was terrible for other domestic bonds that were not inflation-protected therefore it was suggested to limit its holdings in the portfolio.

  1. How has HMC asset class allocation changed from 1999 to 2019?

For the fiscal year ended on June 30, 2019, the return on the Harvard endowment fund was 6.5%, and the total value of assets was $40.9 billion. The allocation to public equities has increased (1999-2019) to 26%. A new asset class has been added, accounting for 33% of the total allocation, Hedge Funds. TIPS adds up to 6%, still a sustainable percentage. Allocation to private equity has been increased to 20%, which has generated a 16% return. Moreover, Natural resources have been added as a new asset class that adds up to 4%, which gave a negative 12.4% return. Cash holdings have been increased to 1% to 2%.

Nonetheless, HMC endowment allocation is relatively small to Venture Capitals (a high risk, high reward asset class), which would have generated significantly higher returns in 2018-2019.

 

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