Essay About Harvard Management Co. And Treasury Bonds

Harvard Management Company Business Analysis
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Case 1 – Harvard Management Co. BY : GROUP – 8  Q1: Why does Harvard spend so many resources in managing its endowment?  Why not simply invest it in Treasury bonds and be done?Harvard has a long-term goal to distribute annually between 4% and 5% of the endowment to the schools within the university, while still preserving the real value of the endowment and allowing for some real growth in the income distributions.  With Harvards current assumptions of 3% expenditure growth annually, gifts to the endowment of 1% and its expected distribution to the school,Harvard needs an investment real return of at least 6-7%. If Harvard were only to invest in US treasury bonds, they would only recognize a return of about 5.2% each year, which would not align with its investment goals. Harvard spends many resources managing its endowment – “In fiscal year 1999, the expenses generated by this active strategy (including performance fees) had been $93.1 million, or about 49 basis points of total assets under management.” Its active strategy performs significantly better than bonds, and achieves a real return of 11.3% per year after expenses.Q2: Take the HMC management’s views of expected returns, standard deviation and covariance of real returns as correct.  Also, for this entire case, assume that cash is riskless (e.g., zero variance and covariance).  If the Board allowed HMC to invest in only one asset class, which asset classes would you advise HMC to discard right away based on risk‐return considerations?   How would you advise them to choose among the rest? If the board allowed HMC to invest in only one asset class, the asset classes that would be discarded right away through risk-return considerations are listed below:Foreign Equity – Although foreign equity and domestic equity have the same expected return, foreign equity has a higher standard deviation and is therefore the riskier of the two.Commodities – Commodities falls into the category of investments that have the same risk characteristic (i.e. they have the same standard deviation). When compared to Absolute Return, High Yield and Real Estate securities, commodities have the lowest expected return.Foreign Bonds – As in the first case mentioned above, although foreign bonds and domestic bonds have the same expected return, foreign bonds have a higher standard deviation and is therefore the riskier of the two.Among the rest, the risk aversion of the investor should be considered before investment.[pic 1]Q3:  If the Board allowed HMC to invest in cash (riskless) and one other asset class, which asset class would you advise them to invest in?  Why? To answer this problem, we ran Solver in Excel to get the optimum portfolio that minimizes variance or conversely in our case, maximizes the Sharpe ratio. The Sharpe ratio gives us an indication of the risk adjusted return of the portfolio. We found that a combination of Private Equity investments and cash gives us the highest Sharpe ratio of 0.27. Although it doesn’t guarantee the highest expected return, it gives us the best risk-return reward. The amount to be invested in the two asset classes doesn’t matter since the Sharpe ratio doesn’t change in any case. It all depends on the investor’s risk aversion.[pic 2] Q4:  What would you do if the Board asks you to consider only domestic equity and bonds for the endowment (no cash), arguing that they are “safe choices” in the sense that these assets are well‐known to investors and they have deep, liquid markets?  Which combination of domestic bonds and equities would you pick? We ran Solver on excel to find the Global Minimum Variance portfolio by minimizing standard deviation and the optimum portfolio by maximizing the Sharpe ratio. The Global minimum variance portfolio resulted in an investment of 1.95% in domestic equity and 98.5% in domestic bonds. The excess return of the portfolio was 0.84% with a standard deviation of 6.99% giving us a Sharpe ratio of 0.121. This is perfectly understandable since bonds are a very safe investment and are almost considered riskless. This strategy will be preferred if the Board is relatively risk averse.