Asset Allocation in China: Crafting the Optimal Allocation Strategy, Episode III

SECTION 2: Best practices of sophisticated U.S. institutions and individuals: the case of Harvard Management Company

2.1 Overview

This section presents a model for developing a global portfolio, taking as a basis the assumptions and approach employed by Harvard Management Company (HMC), the institution that manages the endowment of Harvard University, as seen in Stafford (2010). In order to illustrate the benefits of diversification on all dimensions -- across securities, across asset classes, and across countries -- we will build up the portfolio in stages.

2.2 Asset Classes and Model Assumptions

Below we list the relevant asset classes HMC used in the portfolio analysis as shown in the case study. For each we show what HMC estimated for its expected return and volatility forecast by HMC's staff. HMC has traditionally revisited its policy portfolio assumptions every five years, but of course since markets move every day, anyone creating a portfolio should take account of the most up-to-date available information in developing such assumptions.

All the figures used here and in the rest of this paper are "real" returns -- that is, they represent returns over and above inflation. So if an asset class is expected to return 4.5% real and inflation is expected to be 2%, then the total return of the asset class is expected to be 6.5%. Thus real returns like those shown below reflect increases in purchasing power.


- U.S. Equities:

· Publicly traded U.S. stocks listed on the NYSE and NASDAQ/AMEX exchanges.

· 5.75% expected return, 15.5% volatility.

- Foreign Equities:

· Stocks listed in developed markets other than the United States; primarily Western Europe (including the U.K.). Canada, and Japan.

· 6.25% expected return, 16.0% volatility.

- Emerging Market Equities:

· Publicly traded stocks outside of developed markets.

· 7.0% expected return, 19.0% volatility.

- Private Equity:

· Includes direct investment in privately held businesses and also investments in private equity funds, primarily leveraged buyout funds that borrow heavily in order to purchase companies and venture capital funds that invest in innovative young private companies.

· 6.75% expected return, 20.0% volatility.

All the equities are heavily correlated. Correlation to Domestic Equity is 0.8 for Foreign Equity, 0.75 for Emerging Markets and 0.8 for Private Equity.

Fixed Income:

- US Domestic Bonds:

· Includes government and corporate bonds issued in the United States.

· 1.75% expected return, 5.5% volatility.

- Foreign Bonds:

· Government and Corporate bonds issued in non-U.S. developed markets.

· 2.25% expected return, 5.8% volatility.

- Inflation-indexed:

· Also known as Inflation-Protected Bonds (TIPS). Bonds issued by the U.S. Government that offer interest that rises and falls with U.S. inflation. So a 1.5% inflation-protected bond would pay 4% interest if inflation is 2.5%, but only 3% interest if inflation is 1.5%. These bonds can be attractive risk reducers if inflation uncertainty is high and one's spending is going to be in U.S. dollars.

· 2.25% expected return, 5.1% volatility.

- Cash:

· Includes very safe short-term securities such as bank deposits and treasury bills.

· 1.00% expected return, 3.5% volatility.

Fixed Income generally has low or no correlation to Equities. For example, Domestic Bonds have no correlation to Equities in general and slight negative correlation (-0.1) with Emerging Markets.


- Absolute Return:

· Includes hedge funds that use complex strategies involving buying and shorting stocks, bonds, currencies, and other liquid instruments, as well as derivatives and other trading strategies.

· 5.00% expected return, 11.0% volatility.

- High-Yield:

· Risky bonds that offer high promised returns but with high likelihood of default.

· 4.75% expected return, 14.0% volatility.

- Commodities:

· The dominant component of the commodities basket is energy, especially oil but also including natural gas, coal, etc. Commodities also include metals, both precious metals like gold and industrial metals, and additionally covers agricultural commodities like coffee and wheat.

· 4.5% return with 21% of standard deviation.

- Natural Resources:

· Harvard was a pioneer in investing in timber through direct ownership of, and management of, forests. This category also includes ownership in farms and other forms of agricultural land.

· 5.00% return with 10.0% standard deviation.

- Real Estate:

· Includes investment in real-estate funds such as Real Estate Investment Trusts as well as direct ownership of large buildings.

· 6.00% expected return, 15.0% volatility.

Absolute Return and High-Yield are assumed to have a 0.6 correlation to Equities. Commodities have moderate correlation to traded equities (0.3 to 0.4) while low correlation (0.15) to Private Equity. Natural Resources have low correlation to Equities as well (0.1-0.2). Real Estate has a 0.4 correlation to traded equities and a 0.2 correlation to Private Equity.

HMC considers Private Equity a form of Equity and High Yield Bonds as an Alternative asset; as mentioned above many investors categorize Private Equity with Alternatives, and many would place High Yield Bonds with Fixed Income.

In generating the assumptions listed above, HMC took many factors into account, including:

1) the long- and short- term historical records of each asset class in terms of risk, return, and correlation;

2) inputs from a number of consultants and investment management firms that specialize in this type of analysis; and

3) adjustments to correspond to recent market conditions and to attempt to ensure that the inter-asset comparisons made intuitive sense.