Harvard Management Company Investment Analysis

Case Study 2

The Harvard Management Company and Inflation Linked Bonds (2001)

HMC's Mission Statement

Case Study 2: The Harvard Management Company and Inflation Linked Bonds (2001)

HMC Background

• The organisation that actively manages the assets of Harvard University.

• HMC manages 68% of endowment assets internally• Employs 180 with 38 as investment professionals • Endowment, pension assets, working capital,

other: total $19 billion • Last 10 years HMC provided real return of 11.3% • Over same period U.S treasury bills: 2.2%, U.S equities:

15.8%


Policy Portfolio (goals)

• Determined by board, but management allowed to make short run tactical adjustments

• Designed to fulfill growth goals of the endowment.

• Estimated, to achieve these goals, they need an average real return on the endowment of between 6% & 7%


Policy Portfolio (components)• Consists of 11 wide asset classes

Type of Asset Policy

Domestic Equity 32

Foreign Equity 15

Emerging Markets 9

Private Equity 15

Absolute Return 4

High Yield 2

Commodities 5

Real Estate 7

Domestic Bonds 11

Foreign Bonds 5

Cash -5


Policy portfolio (analysis)

• HMC determined relevance of each asset by considering: expected future returns, volatilty of real return, correlation of real returns on each asset class with the real returns on all other asset classes.

• Used historical data to estimate this.

• Determined portfolio implications using mean-variance analyses: which combinations of assets lower risk & increase return (ie, are on the efficient frontier)


TIPS performanceSee exhibit 3: (from handout)• HMC used data based on the last 3 years and also

compared TIPS to similar assets like commodities (which also offer protection against inflation)

Since 1997:o Real return rate of between 3.2% and 4.25%o Real yields on treasury bills have only been around

2%Treasury nominal bills around 3%


HMC’s final Recommendations

•HMC evaluated TIPS using mean-variance analyses based on estimated data.•Also reviewed how other Universities were allocating their portfolios•HMC recommended a new Policy Portfolio with a new

position of TIPS 7%


Recommended Policy PortfolioType of Asset Old Policy Portfolio New Policy Portfolio

Domestic Equity 32 22

Foreign Equity 15 15

Emerging Markets 9 9

Private Euqity 15 15

Absolute Return 4 5

High Yield 2 3

Commodities 5 6

Real Estate 7 7

Domestic Bonds 11 7

Foreign Bonds 5 4

Inflation-Indexed 0 7

Cash -5 0


What are TIPS?

• Inflation linked bonds issued by the US treasury • First issued in 1997 • Around US$500 billion on issue• Offered on 5, 10 and 20, year terms • Are marketable securities• Principal is marked to CPI• Pay coupons semi-annually


What are Inflation Linked Bonds?

• Total of US$1.5 trillion on issue • Mainly issued by governments• Principal is indexed to inflation• Removes exposure to inflation• Fairly low correlation with other asset classes


Associated Risks


• Perform poorly with sharp interest rates rises • Potential difference with CPI and actual inflation• Return declines in deflationary environment• Possible, but highly unlikely default risk

How do TIPS work?


• Yields are linked to inflationary expectation • If the yield on treasuries is 2.5%, and the yield on

TIPS is 2%, inflation the TIPS duration is expected to be 0.5%.

• Coupon payment changes with principal value • i.e. CP = Principal x Coupon Rate• At maturity the higher of original or adjusted face

value is returned to investor

How do TIPS work?

Lets say a:• Principal value is $1,000• The coupon rate is 2% • Thus the coupon payment would be $20 • However, if the CPI increased by 5% the principal

value would increase to $1,050 • The coupon rate remains at 2%, however the

interest payment is inflated to $21 ($1,050 * 2%)


How do TIPS work? - Principal


How do TIPS work? - Coupon Payment


When would TIPS OUTperform/ UNDERperform regular Treasuries?

what is a regular US treasury security?

• Govt Debt• Provides a Fixed interest payment until maturity • Carry different maturities based on T-Bills, T-Notes, T-

Bonds • Very Liquid• No Credit or Default risk- (backed by the Govt.)• Subject to high Inflation and Interest Rate risk • Avoid long-term maturity unless you trust that the inflation

rates and the interest in the market will be lower.

Regular Treasuries vs. TIPS

• If inflation is lower than expected, regular Treasuries will be a better investment than TIPS.

• If inflation is higher than expected, TIPS will be better.• Inflation can erode the value of regular Treasuries • if inflation remains low, TIPS holders receive lower returns

than what they could receive with regular Treasury notes and bonds for the same maturity period.

• TIPS principal is adjusted strictly- with CPI changes, the value of the principal can go down from a peak it's already reached but never will go below original face value

SO..What happens to TIPS if deflation occurs?

The principal is adjusted downward, and your interest payments are less than they would be if inflation occurred or if the Consumer Price Index remained the same. You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal.

In a period of substantial inflation uncertainty (e.g., now), TIPS are an attractive bet. You get inflation protection if prices rise, but you get your full nominal principal back at maturity if prices fall.

example

You have a Billion Bucks (BB) and you are thinking about buying either regular treasuries or TIPS Today? Treasury yields are 3% and TIPS is 3.5%? where do you want to put your BB is you expect a expect CPI inflation at 3%, .5%, or -2%?

There are 4 criteria for determining an asset class:• The asset class should be relatively independent of other

asset classes already in the portfolio • An asset class should be comprised of homogeneous

investments• An asset class should have the capitalization capacity to

absorb a meaningful fraction of the investor’s portfolio • An asset class should be expected to raise the utility of the

investor's portfolio without selection skill on the part of the investor

Correlation between TIPS and the other securities in the portfolio

But why doesn't TIPS satisfy the 4th criterion of asset class categorization?

Sharpe Ratio = Rp - Rf

σ

Asset class effect on Sharpe ratio

New portfolio

1.Foreign Equity2.Commodities3.Foreign Bonds4.TIPS • In this new portfolio, when TIPS is removed, the

Standard Deviation (Volatility) increases and the Sharpe ratio falls from .21 to .17

>>> A decrease of 23.5%

Harvard Management Company Investment Analysis

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