Ec 1723 Problem Set 3

Tarun Singh Worked with: Clifford Beltzer Ronald Kamdem Ec 1723 Problem Set 3 1. A) The role and importance of the Harvard endowment is to provide the various schools within Harvard with funding to support education, research, faculty salaries, paying for financial aid initiatives and to rebuild and maintain campus buildings. Different schools within Harvard get a proportion of the endowment to spend on the aforementioned projects based on the share of ‘units’ of endowment the particular school holds. This amount allows each school to continue to attract high quality professors and students and can range from 16% of the total spending (HBS) to 56% of total spending (Divinity School) for a particular school.

B) A policy portfolio is a portfolio that Harvard should hold under ‘neutral’ conditions since it is hard to determine short-term fluctuations. Thus, the policy portfolio was intended for the long run, and was evaluated each year to determine what proportion of the portfolio should fall into each asset class. Although the policy portfolio specified a ‘neutral weighting’ for each asset class, HMC sometimes adjusted asset allocation based on short-term market expectations. However, such freedom was constrained, as HMC set out to create range for how much of the endowment to invest in a particular asset class.

C) Jack Meyer and the HMC staff decided to constrain portfolio weights in their mean-variance analysis to plus or minus 10 percentage points compared to the policy portfolio because they wanted to see if the computer optimizer would still tilt towards the same set of assets as the unconstrained optimization. In particular, the unconstrained optimization had recommended investing in untraditional asset classes, and HMC realized that the input of assumptions into the model heavily influenced the optimization. By constraining the optimization, HMC was be able to determine which way the portfolio should be tilted relative to peer institutions.

D) HMC was given a minimum and maximum range for each asset class because the Policy Portfolio was designed to allocate the endowment to asset classes tactically while still allowing HMC to identify any mispricing in each asset class. By allowing some flexibility to the allocation HMC fund managers

can make changes to the asset allocation based on the market without getting approval from the HMC board.

E) HMC used active management and not passive allocation in indices because it believed its fund managers were good at finding relative mispricings within asset classes and would be able to outperform the market. This combined with a strong incentive strategy for fund managers made the incentives of the fund managers and the endowment aligned.

F)HMC has managed money internally as opposed to outsourcing because the size of Harvard’s endowment allows HMC to take positions that may not be possible with outsourcing, as many top venture firms who are oversubscribed offer the same dollar amount to each client. Further, HMC managed money internally if it thought it could add value to that specific market sector.

G) The portfolio should not employ leverage as this would add further risk. Leverage is generally used to move large amounts of assets with a small amount of cash, but this is generally not a problem for HMC as they have large amounts of cash and can easily move large amounts of assets. Instead, HMC should continue with the current policy of having the portfolio geared towards long-term returns.

H) The ideal risk/return tradeoff for Harvard is making sure that Harvard takes enough risk to keep the endowment growing in order to expand on University programs while minimizing risk so a market crash or widening of arbitrage spreads wouldn’t cause extensive losses to the endowment. Harvard should continue spending about 4.6% (the average over the last several decades) of the endowment each year, allowing for minor fluctuations. This proportion should stay relatively constant over time so that the endowment doesn’t lose value over time.

I) I would advise Jane Mendillo to continue to use constrained optimization in deciding asset weights for the policy portfolio in order to minimize the risk from a possible economic slowdown. The attractive compensation scheme ought to be continued as it ensures that HMC fund managers and the portfolio have aligned incentives. I would, however, recommend that Mendillo pursue a fundraising campaign, as the current economic crisis may make it

more difficult for HMC to increase the size of the endowment without fundraising.

2.

A) 7/1926- 12/1963 Small Low

Small High

Big Low

Big High

Average Excess Return

.993

1.409

.843

1.203

Α

-.058

.120

.041

.011

Β

1.226

1.505

.936

1.391

Note: all values rounded to 3 decimal places

1/1964- 12/2007 Small Low

Small High

Big Low

Big High

Average Excess Return

.462

1.043

.418

.699

Α

-.180

.573

-.062

.300

Β

1.381

1.013

1.033

.859

Note: all values rounded to 3 decimal places

As shown by the small values for α, CAPM works well in the first sample, and CAPM doesn’t work as well in the second sample where values for α are larger. Thus, explaining why the data points are closer to SML line in the first sample compared with the second. In both samples, the small-high and the big-high have positive values for α. Whereas the small-low has negative values for α in both samples and big-low has a positive α in the first sample and a negative α in the second alpha.

B) Small 7/1926-12/1983

Small 1/1984-12/2007

Average Excess Return

1.084

.650

Α

0.208

-.057

Β

1.35

1.11

In recent years, small firms have not performed as well as in the pre-1984 time period. This is seen with the negative α in recent years which suggests that small firms are overpriced, whereas pre-1984 the α was positive suggesting that small firms were underpriced.

C) The sample period in part a) was probably selected because the CAPM model was developed in the mid 1960’s so the difference in time periods shows how investors may have changed their investment patterns based on the CAPM. The sample period in part b) was probably chosen because in the early 1980’s economists found that small stocks provided higher returns than large stocks. Thus, the two time periods were chosen to show how investors took advantage of both money making opportunities.