Q: You've had a great run over the past decade, earning a 15.9% annual return. But recently you've been warning Harvard that you don't expect the good times to persist. Why not?
A: Because when you look at the various asset classes in which we invest, they're all pretty expensive. The U.S. market is expensive by any valuation. The emerging markets were cheap for a while, but they have had a tremendous run over the past two years. In private equity, there's too much money chasing those deals, so they are less attractive than they were 10 years ago. And in bonds, you have Treasuries at 5%, so it's hard to get excited about that.
Q: What can you get excited about?
A: Timber. As an asset class, it is mispriced. If you are patient and have a little skill, you can buy timber today to return 7.5% to 8% a year in real terms, assuming flat real-log prices.
Q: You've got about 10% of your assets, or over $2 billion, in timber. How do you buy it?
A: We have three professional lumberjacks on staff. They go and look at the trees. And this is the one asset class where our size is an advantage. There are very few people who show up to buy a $600 million piece of timber in New Zealand with cash [like we did].
Q: A lot of money is pouring into hedge funds. What do you make of that?
A: The opportunity set in the hedge-fund world is way down from what it was two to two-and-a-half years ago. There is too much money in there. So all of the fun stuff that we did in the 1990s -- like the merger arb and convertible arb -- doesn't really exist anymore.
Q: So what does that mean for hedge-fund returns?
A A lot of new funds have promised their investors double-digit returns. But I don't think [they'll deliver]. So I suspect thousands of these funds will go out of business. I don't think the large funds will [disappear], because they were quite disciplined. But their returns will keep going down. So it's hard to get real optimistic.
Q: What kind of returns do you think you can produce for Harvard going forward?
A: Our policy portfolio [the mix of assets recommended by Harvard] has returned 12% over the past decade. But over the next 10 years, 7% to 8% a year would be more like it.
Q: That's your forecast for how much money invested in the basket of assets you recommend would return. But won't your managers be able to add a lot of value to that?
A: In the past, we've been able to add about 400 basis points of value [or about 4 full percentage points over industry benchmarks]. But it is much harder to add value now than it was a couple of years back. The billions of dollars that have gone into these hedge funds are diminishing the opportunity set. So I've been telling our board that I'll take 1% to 2% value-added [100 to 200 basis points]. I'd take it in a second.
Q: How do some of your managers achieve such stellar returns? In U.S. bonds, for instance, David Mittelman has earned 17.1% a year over the past five years, more than twice the industry benchmark of 7.6%. And in foreign bonds, Maurice Samuels has earned 23.1% a year over the same period, more than three times the industry average.
A: These two gentlemen are the two best fixed-income managers in the world. And they've been able to crank out this value-added year after year.
How? I'll tell you how it is not achieved. We don't make bets that interest rates are going up or down, and we don't take credit risks, by buying a bunch of junk bonds. What these managers are really good at is finding mispricings in the fixed-income market.
Q: How can individuals find managers who can beat the street?
A: Most people think they can find managers who can outperform, but most people are wrong. I will say that 85% to 90% of managers fail to match their benchmarks, if you properly specify their benchmarks.
Q: That's pretty pessimistic.
A: Yes. But because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value. The investment business is a giant scam. It deletes billions of dollars every year in transaction costs and fees.
Q: So what should individuals do?
A: Most people should simply have index funds to keep their fees low and their tax down. No doubt about it.
Q: To what extent do you time the market -- by shifting your asset allocation in anticipation of a big move in stocks, for instance?
A: As a practical matter, we don't do much of that. It's the romantic thing to do, and it's what people like to talk about at cocktail parties. But frankly, we don't think anyone is very good at it. It's a difficult way to make money.
Q: What have been your biggest disappointments?
A: There have been plenty of investments that didn't work out. I was a fan of emerging-market equities early on, but I was wrong for a long time. And a lot of the trades we make each day are bad. But we try to structure them in a way so that if things go wrong, we don't lose a lot of money. And if they go right, we make a lot of money. I call that long volatility.
Q: Critics argue that your managers are grossly overpaid. In fiscal 2004, your two top managers were paid $25 million each. Yet no one else at Harvard comes close. Even [Harvard] President Larry Summers makes less than $1 million.
A: I'm confident the design of our compensation system is sound. In fact, it's superior to any I've seen in the investment world. It's based on value-added. So if you simply match the benchmark, you get no incentive bonus. Even if you were a commodities manager in fiscal 2000, and earned 59.6%, your bonus is zero, because that is what the benchmark was.
Q: Of course, you could get around this debate by simply farming out your money to outside firms to manage, as other universities do.
A: The problem in doing that is that our fees would go up, our returns will go down, and we will likely underperform our peers because of our size. So I'm very confident that this has been a good deal for Harvard. If Harvard had acheived the same results we have [internally] using external managers, it would have cost more than twice as much.
Q: Given all the debate, do you think you'll be forced to change your compensation system?
A: What deserves serious debate is whether you can maintain world-class portfolio managers in an academic setting. It is increasingly difficult to do with all this focus on compensation. And people don't see how much portfolio managers make [on Wall Street]. The numbers are enormous.