Even the serene towers of academia, it seems, have been rattled by the shifting landscape of global markets, and André Perold, the George Gund Professor of Finance and Banking at Harvard Business School, is as taken aback as anybody.
This may be because Perold is no mere professor but an investor of some stature as well. He is chief investment officer at $1.8 billion Boston-based HighVista Strategies, an endowment-style fund he helped launch in 2005 with $630 million in assets under management and whose holdings include hedge funds. Perold, 56, has long been an ardent student of the markets and a prolific researcher. In his 29-year tenure at Harvard, he has published scores of papers and case studies on topics as varied as derivative instruments, currency hedging, quantitative investment modeling and portfolio asset allocation.
Never has he seen anything quite like this year’s credit meltdown, the collapse of U.S. investment banks and the extent of massive government intervention.
“The world is a scary place,” Perold says in discussing the turmoil. However, the professor is not one to let a teachable moment go by. “We learn a lot, fast, when things are volatile. There will always be cycles of fear and greed — human behavior never changes — but who would have thought after the tech bubble collapsed that we would get another bubble in only five years?”
Certainly not Perold, who three years ago co-founded HighVista, which seeks to emulate the multistrategy, global investment approach first used by pioneering college endowment funds like those of Harvard University and Yale University. The success of those endowments has been widely attributed to their decision early on to invest in alternatives, particularly hedge funds and private equity.
To some of his associates, Perold seemed like an obvious choice to help start an investment firm.
“We called André and asked why this hadn’t been done: a simple fund that delivered an endowment strategy,” explains Daniel Jick, one of Perold’s two partners at HighVista. Jick, a Harvard Business School alum, ran Goldman, Sachs & Co.’s Boston office for 11 years. The other partner is Brian Chu, a former managing director at Vulcan Capital, the investment office of Microsoft Corp. co-founder Paul Allen.
The concept of an endowment-style fund was largely but not completely untried at the time. Mark Yusko in 2004 became the first CIO to leave a university endowment, the University of North Carolina’s, to start such a fund, Chapel Hill, North Carolina–based Morgan Creek Capital Management, which has $12 billion in assets. From the outset Jick believed the HighVista partners’ combined investment skills and their network of relationships with Boston-based investment stars like hedge fund managers Seth Klarman of Baupost Group and Jonathon Jacobson of Highfields Capital Management would make such a fund a success.
When he isn’t doing research or working at HighVista, Perold teaches finance to first- and second-year MBA students as well as to the businesspeople who attend Harvard’s executive education programs. Teaching material abounds these days.
“When you have capital to invest, you experience market phenomena in ways that would not be possible otherwise,” Perold says. “It’s exciting to examine those experiences through bigger-picture conceptual lenses and bring them into the classroom.”
It’s an upbeat point of view emblematic of Perold’s long career. Fellow Harvard professor Robert Merton, the 1997 Nobel Prize winner in economic sciences and a former partner at Long-Term Capital Management, which had its dramatic demise in 1998, admires the breadth of Perold’s research. “He’s deeply engaged in problems that are interesting,” Merton says. “André brings a clarity of thought and rigor to the analysis.”
Perold’s dual presence in academia and the day-to-day markets is crucial, says William Spitz, a former CIO at Vanderbilt University in Nashville who taught alongside Perold in executive education programs at Harvard for many years. “André is one of the few people I know who has very strong academic credentials but is also very plugged into the real world,” notes Spitz, who co-authored two Harvard market case studies with Perold and served with him on the board of Wilton, Connecticut–based Commonfund — a nonprofit investment manager serving the endowment and foundation community — for a decade, until 2001.
According to an investor in the firm, HighVista’s return for the latest endowment year, ended June 30, was 7.7 percent after fees. Its gross return of 9.6 percent for the same period topped the 8.6 percent performance of Harvard’s endowment fund as well as Yale’s 4.5 percent. HighVista reported a 6.2 percent annualized return for the three-year period ended September 30.
Perold’s eight-page bibliography includes research collaborations with such luminaries of finance as Nobel Prize–winning economists William Sharpe, the creator of the Sharpe ratio, and Harry Markowitz, the father of modern portfolio theory. In addition to his many research papers, Perold co-authored two books, The Global Financial System: A Functional Perspective and Cases in Financial Engineering: Applied Studies of Financial Innovation, both published in 1995.
After graduating from the University of Witwatersrand in his native Johannesburg in 1974 with a degree in applied mathematics and statistics, Perold earned a Ph.D. at Stanford University. After a postdoctoral year at IBM Corp.’s T.J. Watson Research Center in Yorktown Heights, New York, he took a professorship at Harvard.
In early October, Alpha Senior Writer Frances Denmark spoke with Perold about his investment approach at HighVista and how the hedge fund industry may look in the future. Alpha: What scares you most about the unfolding financial drama?
Perold: First, the staggering loss in wealth. World equity market capitalizations alone have fallen nearly $30 trillion, and the effects of this wealth loss will be significant and lasting. Second, the domino effects and systemic failure we have seen in just about every corner of the financial system. We are clearly in desperate need of infrastructural innovation.
Are you worried about how this financial crisis will affect hedge funds?
The generic hedge fund model has been severely challenged — as has the infrastructure that supports hedge funds. Take the notion of leverage, for example. When leveraged, you may be forced to sell simply to maintain your leverage ratio after suffering a loss, or you may be forced to sell because the terms and availability of your financing have changed, or you may be forced to unwind positions because the costs and risks of maintaining short positions have increased. At the same time you may have to reduce your exposures to meet client redemptions, and you may face the added hardship of frozen or nonrecoverable positions held at a prime broker that went bankrupt. It is not a good business model when you can’t depend on financing, client capital or the underlying infrastructure.
Describe the hedge fund of the future.
The funds with the best chance of survival will be those that structure their businesses to be compatible with their investment approaches. Longer lock-ups, akin to a private equity model, will reduce the potential universe of investors but will address the issue of capital stability. At a fundamental level managers who can no longer rely as much on leverage or short-selling will have to reaffirm their value proposition. They may need to run lower-leverage, longer-biased funds, which might affect their ability to earn returns. They may still be able to outperform but might need more equity to do so. There will be less alpha per dollar of investor equity, and clients may walk or demand lower fees. Long-short funds that become essentially long-only will have to change the benchmarks relative to which they receive their carry. Investors will say, “I’ll pay you for returns in excess of the S&P 500 but not over zero.” Clients have long been concerned about paying a carry on beta, and these changes will only accentuate those concerns.
What if hedge funds were required to publicly disclose their short positions?
For many the investment world would become quite inhospitable. The capital markets are extremely competitive, and protecting your proprietary insights is crucial to your ability to outperform. It’s also much riskier to sell short when others know your positions and might try to effect a squeeze. On the positive side, those risks will be mitigated for funds less sensitive to disclosure, such as strategies that involve holding numerous but small short positions. Those managers may now find they have less competition.
What has been the impact on the industry of the volatility of the past few months?
It is punishing because it is the combination of extremely volatile prices, great uncertainty about fundamentals and unparalleled opaqueness in the system, including a lack of assurance that counterparties and others will be able to deliver on their contractual obligations. How can funds with short-term financing and an uncertain investor base survive periods where the equity market fluctuates up or down by more than 5 percent many times during the same day — where a short squeeze within hours gives Volkswagen a higher market capitalization than Toyota? Hedge fund capital, in theory, can and should play a crucial role in helping to stabilize the financial system. The problem is that the risks today may be too great for even the best investors to want to step up to the plate.
What does the hedge fund allocation usually look like at HighVista?
We are presently 50 to 60 percent invested in alternatives, of which about two thirds is in hedge funds. The remainder of the portfolio is invested in various indexes representing broad market asset classes such as global equities, sovereign bonds and inflation bonds, commodities, real estate and various categories of credit exposure. We invest in alternatives managers purely for their alpha, and we do so opportunistically. Therefore we don’t have set allocations to long-short, distressed, event-driven and multistrategy.
How do you usually approach risk?
We think there are basically two kinds of risk: broad asset-class risk — beta — and the risks managers take in pursuit of alpha. An important part of our process is to quantify both types of risk, based on an analysis of recent historical relationships. For example, the correlation between equities and Treasury bonds in the past few years has been significantly negative, making Treasury bonds an excellent hedge for equities. By contrast, the correlation between developed and emerging equity markets has been very high, meaning that there have been only limited diversification benefits to investing in emerging markets. We also assess how the present may be different from the past, particularly when factoring in the opportunities our managers are currently pursuing. Quantifying risk is a difficult and error-prone process, but it is an essential aspect of any investment.
How do you plan to adjust the HighVista portfolio in light of recent market events?
Our investment process is designed to be cognizant of changing risks. Broad asset-class risks and correlations generally do not oscillate back and forth in rapid fashion, but rather tend to be persistent, meaning that we usually experience lengthy periods of high or low volatility and correlation. Because we manage to a stable risk budget, we reduce our exposures when broad asset-class risks are high. For example, global equity market volatility increased significantly in mid-2007, and it has remained high ever since. We reacted by commensurately reducing our equity market exposure, a posture we have continued to maintain. Obviously, these actions greatly aided our investment performance. At the same time, we are faced today with attractively priced opportunities in many areas of the capital markets, particularly in the credit markets. Distressed valuations seem to be occurring on an unprecedented breadth and scale, but so are the risks. The challenge is how to avail ourselves of these opportunities and yet remain within our overall risk parameters.
What’s the summary lesson, then?
The risks of all asset classes are very high today, be they equities, bonds, inflation-protected bonds, currencies, commodities or emerging-markets securities. The correlations among these asset classes have increased significantly — such as the correlation between equities and commodities — or have become much more negative, such as the correlation between equities and Treasury bonds or between equities and currencies like the yen. At the same time, alternatives managers not only need to navigate the current environment from an investment point of view, they also need to confront challenges to their basic business model. We continue to hold modest equity exposures, but through alternatives managers primarily. We are cautiously investing capital in situations where the pricing is extremely attractive. Some segments of the municipal debt, bank debt and mortgage markets seem priced assuming Armageddon scenarios. In part that’s because a vast amount of paper that was considered high quality when issued has now become risky. The owners no longer have the know-how or wherewithal to hold that paper. Instead, more knowledgeable, sophisticated buyers need to step in, but they have limited capital relative to the total supply. The real edge today resides with those who do not have to sell, those who have dry powder to invest. If you are lucky enough to be one of those, you may not have to be a genius over the next five years.
