Hanging onto Harvard's $25.9 billion stash
Emerging-markets whiz Mohamed El-Erian takes over the world's biggest endowment fund -- can he match the performance of near-legendary, now-ousted Jack Meyer?
NEW YORK (FORTUNE) - There's nothing ordinary about Harvard University's endowment. At $25.9 billion, it's the biggest such fund in the world, with an outstanding performance record, at the most prestigious of universities.
Its near-legendary longtime chief, Jack Meyer, bolted last year, along with dozens of colleagues, after faculty critics groused that he and his men were overpaid. (Their compensation was mostly in the form of bonuses for outsized returns.) Harvard's president, Larry Summers, is also on his way out after a few controversies of his own.
So while running the Harvard Management Co. (HMC) - the entity that oversees the endowment - is certainly a plum job, these days it's also a hand grenade with the pin pulled out.
The far-from-ordinary man who finds himself in this predicament is Mohamed A. El-Erian, who began as CEO of HMC on Feb. 15. El- Erian, 47, is French and Egyptian, and was educated at Cambridge and Oxford. He worked at the International Monetary Fund for 15 years before a stint at Salomon Smith Barney/Citibank.
A specialist in emerging-market debt, El-Erian then headed to bond house Pimco, where he worked for almost seven years managing a variety of portfolios and established himself as a superstar in the field.
Says Robert Rubin, former Treasury Secretary and member of the Harvard Corp. (the university's governing board), who participated in the search process: "We wanted somebody who had a very good investment sense and had the intellect not only to be effective in this job but also to win the respect of the Harvard community, which Mohamed obviously does."
Along with smarts, El-Erian has a courtly manner and a well-developed sense of humor. Even with all that, a few observers wonder if he's the right man for the job. After all, how is it that an emerging-markets expert has the breadth of experience to run something as singular and high profile as Harvard's endowment?
Seeking nothing less than veritas itself, I recently dropped by El-Erian's office for his first extensive interview since he took the job. Perched high atop the Federal Reserve Bank building in downtown Boston, with a panoramic view of the harbor, El-Erian is well aware that he's sitting in the office previously occupied by Jack Meyer. You would be too if you were replacing a guy who racked up 16 percent annual returns over the past decade.
I ask El-Erian if he's sat down with Meyer.
"I've met him a few times," says El-Erian. "He has been and continues to be available to me whenever we have questions, and he's very supportive. We also have $500 million with Convexity Capital [Meyer's new $6 billion hedge fund]."
Right now, though, El-Erian is mostly focused on beefing up HMC, since Meyer took 33 of HMC's 150 employees with him, including its entire bond desk.
"We're rebuilding, and HMC toned down risk-taking consistent with the resources that were in place," says El-Erian, telegraphing potentially lower returns for now.
I ask El-Erian if he's planning to change how HMC is run. His answer is decidedly no.
"The wonderful thing about Harvard Management is that it has a very deep tradition of doing things in a certain way that works very well," he says. "There are a lot of similarities with Pimco. Because it has performed consistently well for so long, the clients understand that Pimco should have a long-term vision. If you have one month of underperformance, it's not going to do you in. Also, Pimco is known to be a place that drives people hard, that attracts smart people. Harvard is the same way. So the philosophy, the culture, the infrastructure feel very similar. That's what attracted me to the job."
El-Erian doesn't see his emerging-market expertise as any sort of handicap or bias. He notes that he oversaw half of Pimco's trading operations and managed funds that invested in a wide range of markets, including Treasuries, agency bonds, mortgages, corporates, foreign exchange, and municipals.
He also points out that HMC has a long history of playing in emerging markets. Ultimately El-Erian sees himself as the organization's primary asset allocator, as well as a portfolio manager/analyst.
"Every Monday at 4:15 we meet and ask, What are people seeing from a bottom-up perspective? We have someone who will talk about emerging equities; we have someone who will talk about domestic equities; we have someone who will talk about timber," he says. [Partly because of peculiarities in the tax code, financial players like HMC and Yale's endowment have been big buyers of timber.]
"We then go to those who manage our external managers, so they talk about private equity, they talk about venture capital, and they'll talk about hedge funds. And then we collectively look at all that, and we try to get some common themes out of that."
So what is El-Erian's global investing view right now? It is an uncertain time, he believes. Nearly every single market in the world is producing healthy returns at the moment, but the resulting higher prices for stocks and bonds suggest a puzzling complacency.
El-Erian calls the present scenario "stable disequilibrium." Says he: "There's no doubt that the world is in disequilibrium. You look at the U.S. household sector in terms of its negative savings. You look at how the real estate market has allowed people to sustain consumption by monetizing their equity. You look at the U.S. current-account deficit at 7 percent of GDP. You look at the fact that the poor countries are running surpluses and financing the rich countries. The surprising thing is that this disequilibrium is very stable, so risk premiums have shrunk and volatility has almost disappeared. What makes it stable is a sort of vendor financing relationship where the surplus countries - like China - find it in their interest to continue to invest in the U.S."
El-Erian says this stable disequilibrium may end in a crisis soon, or it may persist for a decade. Here's his strategy regardless of how it plays out: "Rather than speculate on two uncertain and extreme outcomes, we want to supplement the appropriate asset allocation with things that we know. We know that the Fed is nearing the end of the hiking cycle, so there's value at the short end of the yield curve - that if you can lock in at 5 percent two-year returns, that is a good deal with inflation running at 2 percent.
We know that certain emerging economies have a tail wind behind them of high commodity prices and better fundamentals, that as long as one is willing to live through the hiccups, one is willing to take the volatility, they will continue to perform well. We're talking about countries such as Brazil and Russia, where you can see the international reserves going up.
And finally you look at certain industries on the equity side that benefit from the current configuration, such as natural resources. Focus on what you have confidence in and insure against the extreme - for example, through deep out-of-the-money put options on the S&P. That's not what most people are doing. Most people tend to flip-flop."
Long time horizon
Of course El-Erian and HMC have certain advantages that most investors, institutional or otherwise, don't. El-Erian is well aware of the bows in his quiver.
"First we have a stable pool of capital - we don't have to worry about redemptions. So we can provide liquidity at times when others cannot. Second, the endowment has a very long time horizon, so one can invest accordingly. You're not subject to the week-by-week fluctuations, etc. We can actually get paid for other people's impatience. The third thing is we're backed by a triple-A balance sheet. The fourth thing is that Harvard has been a magnet for ideas."
With all of this bounty comes the not-so-small matter of El-Erian's compensation, which ended up being such a bugbear for his predecessor. When I ask El-Erian about this, he notes that since HMC is a nonprofit institution it will continue to publish once a year the salaries of the five highest-paid executives, plus the CEO.
"I suspect there will always be those who believe that the pay is too high, there are those who will believe that the pay is too low," he says diplomatically.
Will he still have incentives à la Jack Meyer?
"Yes, we have a comp system that pays a relatively low salary, that links the bonus to performance, subject to a clawback. So if you outperform your index, you earn a certain amount of money. But you don't get all that money immediately. Some of it is clawed back, and you only get it if you continue to perform well. The reason is that we are looking for long-term performance."
Ah, yes, the long term. It's certainly how Mohamed El-Erian hopes he is judged, because what he needs most right now is time. Time to rebuild the HMC team. Time to settle into the job. Time to establish a track record. And if he does prove himself over time, let him get paid handsomely for it, I say.
If Harvard has found what amounts to the next Jack Meyer, it could do a lot worse. This time the university would be wise to appreciate him and keep him.