Monday, March 02, 2009

No Smarter Than Anyone Else?

Perhaps those Harvard endownment managers were not smarter than any other set of investors after all. Year after year, Harvard managed to report returns on their endowment investments that exceeded the Standard and Poor's index by a wide margin. What explained such fabulous returns (which led to handsome rewards for the Harvard money managers)? One explanation focused on the remarkably astute investing skills of the team at Harvard Management Co. - presumably a function of the amazingly talented and intelligent professionals that HMC hired and then compensated so well. Another explanation suggested that Harvard had better access to certain non-traditional investment opportunities than other institutions.

Perhaps, though, a simpler explanation suffices... Harvard took a ton of risk - far more risk than we find in the S&P 500 index. With high risk comes high reward - lesson #1 from any introductory finance course taught at Harvard Business School. Now, the Harvard endowment managers have learned that there is indeed no free lunch. With all that risk comes the potential for huge losses and a liquidity crunch. This article from abcnews.com explains that Harvard now faces a severe budget crunch because of a liquidity crunch at the endowment. The school does not face a problem simply because they had become dependent on the endowment for one third of the annual operating budget. In fact, the problem is more severe. High-risk investments now put Harvard in the position of having to dump assets at rock-bottom prices, raise money through pricey debt, and inject additional cash into certain private equity investment vehicles.