HMC Portfolio Case

How is the policy portfolio of Harvard determined? What are the three major asset classes in the portfolio as of May 1999? Internally, by the HMC. The Board of the corp determined the Pol Port, but the mgmt. was permitted to make short-run decisions within certain constraints. HMC, considered 3 things when looking at asset classes: expected future rel returns, volatility of real returns, and the correlation of the real return on each asset class w/ the real return on all other asset classes. Of the current HMC portfolio, Domestic equities make up 32%, Foreign equity accounts for 15%, & Private Equity investments make up another 15%. The next closest asset class is domestic bonds at 11%. 2. How does HMC form its capital market assumptions? Historical data & advice from historical data on real returns. Conducts mean-variance analysis & looks to invest on the efficient frontier based on HMC’s risk tolerance. 3. What do HMC’s capital market assumptions imply about the forward looking domestic equity premium? How does it compare to the historical equity premium?

Since HMC is considering lowering their allocation of domestic equities, and growing their TIPS allocation, it can be inferred that HMC is either becoming more risk averse, or they believe the risk premium for domestic equities is too high & that domestic equities will not live up to their historical high rates of returns. 4. Take the HMC management’s views of expected returns, standard deviation, and covariance of real returns as correct. Also, assume that cash is riskless (i.e. zero variance and covariance). If the board allows HMC to invest in only one asset class, which asset classes would you advise HMC to discard right away? Why? HMC seeks at least 3-4% just to preserve its current endowment size, but in order to support spending growth, it seeks a real return closer to 6 or 7%.

If the board were to invest in only one asset class, and still wanted to meet this 6-7% real annual return growth goal, it would not want to invest in anything that had a historical return below 6-7%. So, investments in emg mkts,commodities, real estate, foreign bonds & cash could all be immediately discarded. 5. Suppose the board allows HMC to invest in cash and one other asset class, which asset class would you advise them to invest in? Why? I’d advise PE because it has the highest annual real return of 17.9%, but the std dev of 15.2% is the 3rd highest of their current asset classes. Even if real returns for the following yr were 1 std dev below their expected return, HMC would still bring in a positive return. Advanced:

1. Suppose the board allows HMC to invest only in domestic equities and domestic bonds, arguing that they are “safe choices” in the sense that these assets are well-known to investors and they have deep, liquid markets? What combination of domestic bonds and equities would you pick? Rp=WdRd + WeRe 2. Would you advise them to add commodities to the mix? If so, what would that asset mix look like? If not, why? 3. How do regular Treasury bonds work? How does inflation impact the coupons of a T-bond? How do TIPS work? Will TIPS always outperform regular Treasuries?

4. What effect do you think an increase in real yields has on the price of TIPS? What about expected inflation? Are these effects different for a regular Treasury bond? 5. How can you form a portfolio that has exposure to expected inflation risk but not to real interest yields risk? 6. Should TIPS be considered an additional asset class in Harvard’s Policy Portfolio? 7. What are the assumptions about the expected real returns on TIPS, its volatility, and its correlation with the other asset classes? 8. What do HMC’s capital market assumptions imply about the optimal allocation to TIPS in a mean-variance framework? What are Harvard’s target real returns? Should Harvard invest in TIPS?