I went to a very worthwhile talk last night at the Harvard Club by Mohamed A. El-Erian, President and CEO, Harvard Management Company, which manages the $29 billion Harvard endowment (as of 6/30/06). The endowment has had consistently impressive performance. As background, I've posted on the blog below an article I wrote for the Harbus, the HBS school newspaper, back in 1998, profiling Jack Meyer (Dr. El-Erian's predecessor).

One of the marks of a sophisticated thinker is that he can make complex subjects seem simple. The global economy is certainly complex (especially now) but this talk boils it down to just a few key issues and tensions.

My notes:

                                                                                "Navigating a Fluid World"

Presentation to the Harvard Club of New York

Mohamed A. El-Erian, President and CEO, Harvard Management Company

and Faculty Member at Harvard Business School

Oct. 17, 2006

You're obviously not Mets fans or else you wouldn't be here.

Will discuss impact of global economy on investing. Internally, we've gone back to 1^st principles as we rebuild HMC.

Signals from the market are increasingly inconsistent (i.e., confusing). We've come across issues that are systemic in nature, uncertain in impact. And we have lots of questions. Some will think we don’t know the answers. Some will think we know but aren't telling. And you're both right.

Market signals which used to appear sequentially inconsistent now appear simultaneously so. So very tempting to dismiss them as noise. Don't dismiss them as noise---they're consequential in terms of info content.

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1. What are the markets trying to tell us?

Signals have gone from being sequentially inconsistent to being simultaneously inconsistent. 3 examples:

A) In the world's most liquid markets, are US equities or US bonds correct? Equity market is doing well. Suggests vibrant economy. But bond market suggests economy is slowing down very quickly. Last week, both shape & level of interest rates suggest something more sinister than a soft landing.

B) What to make of the unusual dispersion in interest rate forecasts in the context of subdued volatility? Some suggest by Dec. 07, Fed will cut rates to 4%. Some suggest Fed will raise rates to 6%. I've never seen such a range in terns of magnitude and sign. Reason: we're at an inflection point in the economy.

o       Market volatility has declined (VIX index). Intra-market differentiation in developed markets has also declined (graph: FTSE All-europe valuation dispersion). EM Credit spreads have tightened in a quasi-linear fashion (graph: EM Sovereign spread over USTs). FX market volatility has collapsed (graph: avg. GX implied volatility).

C) Michael Cullen, New Zealand finance minister, says investors in NZ are "irrational". "Just how badly do we have to do on the current account before investors notice? … I have to think someone would have to be slightly strange to take a bet on the NZ dollar right now."

I can explain each of these inconsistencies, but not in a self-consistent way. Harvard prof told me about this: "This is complex. But in academe, we can just go to something less complex."

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2. What are the underlying drivers?

3.5 major structural changes ongoing:

1) Global productivity shock. Secular, long-term in nature.

Communications costs plummeting. Internet users spiking. Less and less capital controls. Transport costs down. More and more regional trade agreements. Greater involvement of new segments of the labor market.

2) Global terms of trade shock. Secular, long-term in nature.

Significant increase in demand (from China, India, etc.) which won't go away.

3) A financial innovation shock. Secular, long-term in nature.

Proliferation of derivative-based instruments that lower entry/exit barriers and facilitate many permutations of risk securitization, tranching, and bundling.

3.5) New marginal price setters. Possibly short-term.

New set of marginal price setters have emerged: central banks, hedge funds, private equity, etc. (Graph: Notional amounts outstanding of credit default swaps have swelled enormously) This is 'half a change' because it's not as yet clear whether it is cyclical or secular

Seemingly different objective functions, time horizons, and guidelines now have an important marginal influence. I'm particularly talking about central banks in emerging countries who have huge influence---China has $1trillian in reserves.

Compare playing the game of Risk. It's a purely probability-driven game. You'll win if you can calculate probabilities. When someone joins the game and behaves irrationally, all the others have to adjust accordingly. In the financial markets, these are the non-commercial players who have entered the marketplace.

Results:

A. Convergence in real economy indicators.

Standard deviation of global growth rate has converged to US growth rates. Global interest rates have also converged to US. US is the global locomotive of growth. It's the Goldilocks economy.

B. Portfolio diversification and reduction in home biases.

 Both assets & liabilities are becoming globalized. Countries own more and more of one another; so does the corporate sector in each country. Over 50% of US treasuries are held outside the US. This is a good thing---it's international risk sharing.

C. Unprecedented global payment imbalances.

US current account balance is at -$800B. Largest deficit any country has ever run in terms of global GDP. In 1995, many countries ran a deficit. Now, the US runs a huge deficit and relatively few other countries do. We've never seen this imbalance. (Shows powerful slide from IMF.)

This is our "vendor-financing relationship" with Asia, aka "Bretton Woods 2". Asia supplies goods (and India supplies services), and Asia also supplies credit for us to buy it. It's like Ford financing your car. It makes great sense for the US consumer, using his house as an ATM---consuming above his income.

Why is Asia doing this? They don’t think about bits of paper. They think about the benefits of being massive export machine: creates jobs, which attracts foreign investors. Easier to import FDI (foreign direct investment). Lastly, once you acquire market share, it's hard to lose it.

This all turbo-charges int'l reserve growth among oil exporters. They're accumulating even more reserves than Asia.

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3. What are the implications?

This is a "stable disequilibrium" (quoting PIMCO)

No agreement on lifespan of this. How long will Asia take bits of paper for their goods---when the bits of paper will lose value?

3 views:

A. Optimists ("new paradigm school") looks at: US productivity gains, demographics, entrepreneurship. Maturation of key emerging economies. Gradual resurgence of Japan/Europe.

B. Cynics. Others believe we're on verge of large disruption: size of huge current account deficit, leverage in financial sector, bubble in housing market, risk of a change in the asset preferences of holders of US financial assets.

C. All the views in the 'muddled middle': those noting 'dark matter' (measurement error), enhanced policy credibility, system self-insurance.

This is a frightening slide. Endowments and foundations have to focus on long term, and there are question marks about what the long term is.

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Future is function of four factors:

-         Developments in the US in private consumption. Will consumption soft- or hard-land?

-         Developments in surplus countries, including relative asset preferences and 'managing success' (suddenly being in surplus). Finance minister told him: "Managing success is more difficult than managing a crisis."

-         Interactions between the two. They're two sides of an income statement.

-         Prospects for orderly re-alignment of exogenous and endogenous liquidity.

The challenges for policy reaction functions in advanced economies:

- navigate payment imbalances

- understand and adjust to structural changes

- counter protectionist tendencies

The challenges for emerging economies:

They're used to running a deficit---that's what the textbooks suggest. How do they handle this?

Theoretical orderly global solution exists, and is discussed at every G7

+ Rebalance of US economy—US must consume less.

+ Structural reform in Euroland and Japan to grow faster.

+ Asia has to consume more.

+ Oil exporters provide cheap financing in the interim.

BUT: if any one of these parties moves first, they're hurt. This is a classic game theory dilemma/prisoner's dilemma. So without coordination, it's best not to move.

G7 can't act as a coordinating body because it excludes the countries in massive surplus. So we rely on IMF and other multilateral institutions.

At a time when int'l coordination is essential, legitimacy of multilateral institutions is being questioned due to: lack of representation, governance, resources etc.

Business models have to adopt: new two-way flows between advanced & emerging economies. Regional and local product development.

Just 5 years ago we thought emerging economies were a destination for capital; now they're the major source of capital.

Most companies have outperformed lately because growth outside US has been stronger than envisioned.

Investment management is about 3 things: asset allocation, investment vehicles, and risk management. Not very complex.

Key questions for investors:

-         striking the right balance between forces of economic synchronization and de-coupling.

-         Portfolio positioning in the context of binary medium-term outcomes

-         Appropriately handle the internationalization of investment management

-         Dealing with asset class fluidity and correlation changes

-         Ensuring value for money in accessing investment vehicles

-         Navigating organizational challenges.

Buying real estate in Mexico is very different than buying bonds there.

Traditional classifications no longer make sense.

How to ensure value? Fees get very high when everyone wants a certain asset.

Risk management is going to be increasingly important. We're rebuilding and reinventing the institution of HMC.

CONCLUSION

These signals are meaningful. Global economic convergence has continued while fluidity of int'l monetary system is increasing.

At public sector level, we need to test and retest robustness of nat'l policy reaction functions and global governance.

Q&A

Q: As you know there are 8,000 hedge funds. Is this a problem?

Hedge funds are not asset classes; they are a means of managing investments. They do 2 things different from tradition: a) they leverage, b) they can go short and long. Like everything else, if taken to extreme, these actions can cause problems.

3 distinctions:

- Are they a threat to stability? Amaranth at least was not, despite losing more money than LTCM.

- Are they a threat to the small uninformed investor? Those investors shouldn't be in them.

- Do they potentially contaminate economic relationships? Are they a level playing field?

Q: Insights on Africa, Egypt? On carry trades?

Most crowded carry trades in April were in NZ, Turkey—all funded by yen. You could borrow at 1%, get 10-17% returns in NZ, Turkey. Then certain markets dropped by 20-30%---and nothing blew up. Carry trades have tendency to become more crowded.

Q: How do you handle risk management?

     1)      Buy cheap insurance on fat tails

2)      Analyze correlation of exposures across and within asset classes.

Q: What is optimal compensation scheme for outside funds and for your own employees?

Several new hedge funds have overly generous comp schemes, and we tend to avoid them.

For our own employees, we have clawback provision. If they don't consistently outrperform, the carry they earn is clawed back.

Q: Aren't US markets much more sophisticated? US markets providing a service to global economy.

There's a view that Asians don't trust their own markets. So they delegate capital allocation to the West. I think that's an outcome, and not a bad outcome, but it wasn't by design.

Part of the orderly solution is for emerging markets to develop more sophisticated capital markets.

At some point Asian populations will ask for bridges, schools, etc.

Q: Opinion on china?

HMC has increased the emerging markets allocation by $1b+.

One of the reasons managing success is tough is that the typical emerging market is not used to deal with large capital inflow.

How do you get out of overinvestment? Because China is mostly a closed economy, you can work off overinvestment over years, unlike the typical boom/bust of Thailand, Argentina, etc.

Q: Hedge funds account for ½ of NYSE volume. Doesn’t that call for regulation?

Have not thought about this.

Q: Where are you investing?

We think US fixed income market is near a secular top.

We think US economy will soft-land, either for endogenous reasons (housing market corrects but corporate investment picks up) or will soft-land because of enormous monetary market flexibility (Fed could cut rates). It's hard to imagine foreign markets doing better than US when US goes into recession. So there's no safe refuge.

If world goes into recession, you want a liquid market. We think of recession as a risk under our 'fat-tail' insurance.

As background for my next blog post about Dr. Mohamed El-Erian (current President and CEO of Harvard Management Company), I've attached below an article I wrote for the Harvard Business School newspaper (the Harbus) back on July 7, 1997.

The Financial Future of Harvard is in HBS Hands

"Harvard Management Company is the only first-class investment institution owned by a nonprofit." Bold words from Jack Meyer, MBA 1969, President of Harvard Management Company, but perhaps justified by impressive investment performance.

Harvard has the largest endowment of any private university in the USA: $9.4 billion. Harvard Management Company (HMC) is a wholly owned subsidiary of Harvard University, founded in 1974 to manage the University’s endowment, pension assets, working capital, and deferred giving accounts. A Board of Directors, appointed by the President and Fellows of the University, governs HMC and its 160-person staff. The Board is comprised of professional financiers, including HBS Finance Professor Jay Light and Goldman Sachs partner Eric Mindich. HMC manages a total of $11.7 billion, including Harvard’s pension accounts, gift annuities, and other non-endowment funds.

A Day in the Life of Jack Meyer

Mr. Meyer, 52, graduated from HBS in 1969 as the youngest member of his class. His was the first HBS class to stop wearing a coat and tie. After graduation, he spent three years with Brown Brother Harriman. Since 1979, Mr. Meyer has specialized in managing money for nonprofits. Prior to HMC, he was Treasurer and Chief Investment Officer of the Rockefeller Foundation ($2B endowment). Before Rockefeller he was Deputy Controller of New York City, where he managed $20B. He lives in Cambridge with his wife and two children.

In a wide-ranging interview, Meyer said that the most important parts of his job are "to find the right people, motivate them properly, and maintain the HMC culture." Less important than the people tasks, he is responsible for tactical asset allocation, which generally does not fluctuate widely.

Meyer commented that, every year, it becomes harder to attract and retain top investment talent, both portfolio managers and back office staff. In a competitive marketplace, many employees are attracted to HMC’s Boston location. Many of his team are also attracted to the strictly defined HMC compensation system. According to Meyer, employees at many money management firms are compensated based in part on ambiguous criteria, such as how much the President likes the employee. At HMC, Meyer says that the compensation system is unambiguously pay-for-performance.

Meyer observed that HMC is not large enough to train people, so he focuses on recruiting people with significant asset management experience. HMC does not typically hire new MBAs.

Controversial Issue: Compensation

By far the most controversial issue involving HMC is management compensation. HMC’s compensation data is available in its federal tax filing. Fiscal 1996 compensation for the 160-person HMC staff tripled to $57 million, up from $16 million in 1995. The top ten highest paid people at Harvard are all HMC employees. Jonathan S. Jacobson, a domestic equity manager, earned $4.7 million in 1996. Meyer earned $897,523, a 25% drop from $1.2 million in 1995.

By comparison, Harvard’s top professors can earn $176,000 (excluding outside income, such as consulting fees). Because HMC managers earn so much more than President Rudenstine, or even HBS professors, they receive some uncomfortable publicity every fiscal year. Mr. Meyer commented that this publicity is by far the least enjoyable aspect of his job. The Boston Globe’s observation was that the high salaries "have created considerable angst within the Harvard community."

The HMC Board compensates Meyer and his staff based on their performance against the Policy Portfolio. As Meyer observed, other universities are also paying large salaries to money managers. The key difference is that high-paid people like Mr. Jacobson work directly for Harvard, so their salaries are public knowledge. A million-dollar-a-year manager at Fidelity may be managing money for Princeton, but her salary does not appear in Princeton filings because that endowment is primarily externally managed.

Meyer must balance a fundamental tension between the University’s very long-term perspective and the short-term perspective of most money managers. In order to align the interests of the managers and the University, compensation is split into a small base salary and an incentive bonus, based on performance relative to benchmark. This bonus can be either positive or negative.

When a manager earns a significant bonus, the bonus is held in escrow for up to 3 years and subject to "clawback". When returns are below benchmark, the manager’s bonus is docked from the money held in escrow. Certain managers have earned negative compensation in some years, as a result of this structure. Meyer’s primary goal: to prevent a manager from earning excess return by taking excessive short-term risk.

Whether it is the compensation system or Meyer’s management skills, the performance numbers indicate that HMC is doing very well.

Impressive Performance

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*Extensive use of futures causes cash to appear as a negative percentage of total asset value.

The HMC portfolio is diversified across both asset class and industry. HMC’s target portfolio includes a higher allocation to foreign securities and commodities and a lower allocation to domestic fixed-income assets than the typical institutional fund. The fund holds roughly 5,000 different securities.

For Fiscal 1996 (which ended June 30), the Endowment outperformed the Policy Portfolio by 3.7%. Approximately 0.3% of that 3.7% was due to successful tactical asset allocation decisions (under or over weighting asset classes). The remaining 3.4% was due to outperformance within asset classes.

Harvard is unique among major universities in managing 88% of its endowment internally. Most major universities externally manage close to 90-100% of their endowment. According to Harvard President Neil Rudenstine, HMC manages money for substantially less than Harvard would have to pay outside managers.

Meyer’s goal is to keep pace with or outperform the growth in university expenses each year. HMC disburses 4.5%-5.0% of the fund’s capital value each year. Those disbursements accounted for 24% of the University’s 1996 revenues.

When HBS or any other Harvard department receives an alumni donation, it has two options: either it can invest in a money market fund for working capital purposes, or it can invest with HMC. The primary rationale for this aggregation of funds is that HMC achieves economies of scale by working with the funds of all the Harvard departments combined. As of June 30, 1996, HBS had an endowment of $571 M, ranking it third among all Harvard departments, after the Faculty of Arts and Sciences ($3.8 B) and the Medical School ($1.0B).

Investment Philosophy

In maximizing returns, Meyer takes full advantage of Harvard’s unique position. The University’s credit is rated AAA, because of its highly liquid endowment and well-diversified sources of income (grants, tuition, endowment, and business operations such as the HBS Publishing Corporation.)

The endowment’s large size facilitates hedged transactions. As a nonprofit, HMC only has to pay trading fees, not capital gains taxes. In most cases, HMC can reclaim any withholding tax deducted on dividend payments. Whether the school receives money as a capital gain or as income is irrelevant.

Unlike many institutional investors, Harvard’s long-term perspective allows it to invest in illiquid, volatile investments, such as venture capital funds and emerging market shares and bonds. Many private equity investors enjoy having Harvard as part of a syndicate, because of the school’s prestige.

Lastly, HMC can put money into an extremely broad range of deals, because of its flexibility in both capital type and size. One limitation: HMC generally does not pursue transactions that are subject to high start-up, technology, or exploration risk.

Meyer focuses on finding market anomalies and taking large, hedged, leveraged bets on them. A comparable for-profit fund could not trade as frequently as does HMC, because it would have to pay capital gains taxes on every profitable transaction.

A classic arbitrage maneuver typical for HMC: it buys a Japanese bond that looks undervalued relative to the bond’s futures, and simultaneously sells the futures. HMC’s expectation is that the two securities will converge in value; the bond will rise and the future will drop. T

heoretically, this arrangement allows for zero market risk. Although HMC’s percentage profit may equal only one basis point, its dollar profit will be significant because HMC can invest such a large sum in the trade.

HMC is a highly sophisticated user of leverage and of the derivatives market. As of June 30, 1996, HMC was long $16.2 billion and short $14.5 billion in total fixed-income market exposure. By comparison, its fixed income balance sheet position in cash was long $7.5 billion and short only $0.6 billion.