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 .993 1.409 .843 1.203

Excess Return

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 .462 1.043 .418 .699

Excess Return

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.