Innovative Investing

Walter M. Cabot '55 has been trading securities for more than 25 years, and today, he says, the business is more complicated than ever. "In the old days, all you did was buy a stock or a bond," explains the president of the Harvard Management Company. "Now you can buy 49 different things."

The proliferation of investment fields since the 1960s has multiplied the tasks of Cabot and his colleagues, who work full time in downtown Boston overseeing the University's $2.44 billion endowment fund. Because many of the highest earning investments are also the newest and riskiest, the company in the last six years has hired now experts, turned increasingly to outside consultants, and delved into at least a dozen new areas of money management.

With encouraging--even lucrative--results from investment sectors like venture capital, real estate, and the options market, Harvard has begun to raise the ceiling on these "special investments." This year, nearly $150 million will go into fields which Harvard (and nearly all other universities) shied away from only a decade ago.

Most college endowments are invested with far more caution than abandon--"prudence" is Cabot's favorite description--because the institutions will depend on them for money for generations into the future. But Harvard has received steady praise for its strategies of centralization and investing heavily in common stocks since the tenure of Treasurer George Putnam '49 began in 1973. With many universities searching for higher-yield investments after the inflationary years of the late '70s, Harvard has emerged as one of the heaviest and most diverse experimenters in the hunt for "modern" sources of funds.

At Home

The Management Company itself represents an unconventional form of administration. Most universities "farm out" their endowments to trusted expert brokers, retaining only moderate input on strategy. Harvard also followed this route for several centuries, with State Street Management handling the University's holdings during the terms of Treasurers Paul M. Cabot '21 and George Bennett '33.

But Putnam's appointment in 1973 spurred a major financial reorganization, and Harvard decided to move its investments in-house. The Management Company was formed the next year to oversee what was then a $1.15 billion endowment, with Walter Cabot and ten "partners" retained to work full time on multiplying the University's holdings.

Implicit in Harvard's forming the Management Company was a confidence that it could manage its money better and more cheaply than an outside staff of experts. For his partners Cabot drew from a group of traders, most of whom had two things in common: many years of experience in the Boston financial district, and a Harvard degree.

The expertise of this group became apparent in the late '70s, when Harvard was able to keep its endowment increasing while many other dropped sharply. Critics of in-house money management say it carries a risk of being stuck with poor traders for many years, but this has not been a problem at Harvard. The Management Company's leaders have been rewarded with salaries that approach $200,000.

Around 1977, the Management Company made a conscious decision to become more aggressive in exploring newer, unconventional investment fields. Putnam, Cabot, and Financial Vice President Thomas O'Brien--who had just arrived on the scene--are all vague when asked who originated and promoted the idea, but the Corporation quickly endorsed the push for diversification.

O'Brien says he saw the search for new sources of profit as almost a necessity. "A few years ago, it seemed [the Management Company's] strategy might not give us the revenue we needed," he recalls, but adds, "It's not a problem anymore. I think we're innovative."

Harvard's first forays into unconventional investments--real estate and venture capital--have proven to be the largest and most successful, although the Management Company has changed its strategy by relying on outside experts for guidance, "with a lot of massaging from us," Cabot says.

"It takes a very different kind of expertise than we have," says the Management Company's real estate expert, Michael Thonis. Cabot describes these fields as "very specialized, labor intensive" areas that require more manpower than Harvard can afford.

Partners

Harvard has gone into real estate and venture capital in trading partnerships with as many as 50 other investors, a handful of them other universities such as MIT, Dartmouth and Stanford. Through the Property Capital Trust (real estate) and a handful of venture capital holding companies (one of them, Satirev, is "Veritas" spelled backwards), the University has essentially handed over several million dollars to professionals and waited for the returns. They have been quite impressive.

Over the last five years, Property Capital Trust has earned its backers a 35.4 percent annual compounded return; measured since 1974, the figure is still an admirable 19.2 percent. Such returns far outstrip the 10 to 12 percent Harvard could expect to receive from the most attractive bonds, and, excepting the recent take off, dwarf all stock market indices.

So why isn't Harvard into them even more heavily? Thonis says that few real estate projects turn out so successfully, and that Harvard has confidence to turn its money over to only a very small number of them.

Crowded

The success of Harvard and other colleges in real estate and venture capital has prompted many other endowment funds to seek them out, a situation which may eventually overcrowd the investing market and drive down the rates of return. This happened in the field of "stock lending," one of the University's earliest ventures into unconventional investing, which has since been widely emulated and hence fallen in value.

Stock lending involves giving control of the fund's stocks or bonds to a brokerage house, which may need them to manipulate the market for a certain issue. In return, the broker lends the fund's owner a sum of cash, which the owner invests and profits from while the broker uses the stocks. Because it involves almost no risk, no research, and no manpower, stock lending is the closest one can come to a sure thing in the fiduciary world.

Harvard and Yale got into stock lending early, more than 10 years ago, but word soon got out. "It used to be a very good business," says Cabot, but now, with scores of endowment funds willing to lend out their stocks, brokerage houses are paying less. In the past Harvard made as much as $4 million a year in the program; this year, Cabot says it will be less than $500,000. "There may well be a time when a lot of institutions get out of it, and the margins will return," he adds, explaining why the University is keeping its hand in.

In the meantime, the Management Company has experimented with two riskier types of stocks, growth-oriented and "contrary." The Icarus Fund, with $75 million behind it, searches for smaller sized issues with growth potential. Most of these are from young, technology-based companies which are too small to be traded on a major exchange. Thus, more research and manpower is devoted to finding them than for normal stocks.

Against the Grain

The field of contrary investing, where Harvard buys stocks that it believes are undervalued, represents one of the Management Company's newest ventures. Charles T. Haydock '74 joined the company 15 months ago, and last winter he and Cabot agreed to put some $25 million into buying stocks which were "out of favor, overlooked or undervalued," Haydock says. Because the field is new and somewhat radical, there are no experts, and Haydock is reluctant to cite it as his specialty. The program is useful, according to Cabot, if only for providing useful information about the market.

Harvard has also applied the concept of searching for wealth among the ruins to bankrupt companies. Paying cut-rate prices, the Management Company's Phoenix Fund acquires bonds issued by now-bankrupt firms "where capable people can see value," Cabot explains. After buying a foundering company's issues at, say, 30 cents on the dollar, its eventual recovery can prove to be quite lucrative.

Beyond the traditional stock, bond, and futures markets. Harvard has made a major effort in one other field: options. In the options market, one purchases the right to buy or sell a stock at a certain price on some later date. It is one of the riskiest and most exciting investment fields, and Harvard has assembled a four-man staff to oversee the company's options trading.

In 1979 the Management Company brought in Bing Sung '66 at the fourth-highest salary in the firm and installed him as its head options broker. For Sung, the responsibilities were especially complicated, not only does Harvard speculate in the market, but it also acquires buying and selling rights as insurance against plunges in the prices of some stock and bond holdings. It, for example, the Management Company were concerned that IBM was about to take a dive, it would protect itself by buying the right [rather cheaply] to sell the stock at its current value 30 days from now. It does not: however, have to exercise that option.

Sure Things

There are even more esoteric branches of the options market, such as "covered calls." Here, through distortions in the market, an investor can occasionally own the rights to buy a security at one price and sell it at a higher one--a guaranteed profit which Cabot calls "premium stripping." Harvard makes some efforts to find covered calls, but relies mostly on an outside consultant, Princeton/Newport. This firm uses computers and other sophisticated techniques to isolate covered calls and other premium stripping opportunities. The Management finds even more of these through its own program, called "Cash and Carry."

"Harvard leverages its balance sheet," explains Cabot of these obscure but low-risk strategies. But he insists that the Management Company's array of unconventional investments will always represent only a minor portion of the endowment. Harvard's search for new fiduciary outlets is done, he says, in the hope that one or two will develop into lucrative but prudent resources. This appears to be the case with real estate, venture capital, and to an extent, the options program. Other ventures, like stock lending, have bottomed out, and Harvard has ignored some areas--oil rights, foreign stocks, commodities--altogether.

With the economy immersed in an era of change, preserving Harvard's billions will become an even more complex task in the future. But for the experts who can engineer, and even invent, new ways of doing it, the rewards come both financially and through the sheer excitement of beating the market. "There's no free lunch," smiles Cabot, "but there are opportunities."