Investment Policy at the Hewlett Foundation

Purpose of the case

To provide students with the opportunity to discuss the design of asset allocation policies for long-term investors, the design and implementation of return overlay (or “alpha transport”) strategies, evaluation of performance and risk exposure of hedge fund strategies, portfolio diversification, and investments in non-liquid assets.

Objectives After completing this case students will understand:

1. Asset allocation design2. Design of overlay portfolios, also known as “alpha transport” or

“portable alpha” strategies, to separate search from alpha from risk exposure.

3. The role of hedge funds in investors’ portfolios4. Portfolio undiversification5. The benefits of specialization versus the benefits of portfolio

diversification.6. The use of geometric mean returns and arithmetic means returns

as forecasts of expected returns al long horizons.

Case Synopsis

This case examines the asset allocation decisions that the William and Flora Hewlett Foundation (HP) is considering in early 2005. After careful analysis of the financial challenges and investment opportunities the foundation is currently facing, the chief investment officer and his team are about to make three asset allocations proposals to the foundation committee which, if approved will substantially change the foundation’s investment portfolio.

First Proposal Adopt a new allocation policy to reduce considerably the foundation’s portfolio of domestic equities and instead increase the allocation to absolute return (or hedge fund) strategies and US TIPS (Treasury Inflation Protected Securities). This

recommendation is based on a detailed asset allocation study that includes a re-valuation of HF’s long-term projections of capital market conditions.

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Second Proposal . Implement a return overlay program for the absolute return portfolio. This recommendation is based on a study of the historical performance and risk exposure of the foundation’s long-standing absolute return portfolio. This study has concluded that returns on this portfolio have consistently exceeded the returns on a passive investment in Treasury bills, with a risk exposure that is largely market neutral with respect to the equity market and the fixed income market. The investment team at HF is asking the investment committee to consider enhancing the expected return on the foundation’s portfolio by transforming this exposure into equities, nominal bonds, and TIPS using return overlay strategies. These strategies will allow HF to capture the excess return, or “alpha”, in the absolute return portfolio and superimpose it on the expected return on a balanced portfolio of equities and long-term bonds.

Third Proposal .

To commit up to 5% of assets to a global distressed real state investment fund with which the foundation has invested in the past. This represents an unusually large commitment to single investment manager for a non-profit institutional investor.

Study Questions for the Oral and Written Presentations

1. Provide a brief summary of the case

2. Was HF’s donor stock sale program a good idea? In your discussion you need to provide arguments in favor and arguments against the program

3. What are the financial issues facing the Hewlett Foundation (HF)?

4. Describe how HF manages its assets.

5. Is the proposed allocation adequate to meet the HF’s long term spending pay out of 5% (inflation adjusted) while preserving

capital in real terms and avoiding short term fluctuations in spending?

6. As a member of HF’s Investment Committee, would you agree with the proposal to double to 20% the allocation to absolute return strategies? To support your decision, in your discussion you must provide arguments in favor and arguments against the proposal .

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7. As a member of HF’s Investment Committee would you agree with the proposal to implement the bondization and equitization overlay program (alpha transport)? You need to discuss the effect of these programs on the expected return of the absolute return portfolio and what contracts will be most effective for HF to utilize. To support your decision you must provide arguments in favor and against the proposal.

8. As a member of the HF’s Investment Committee would you make the 5% commitment to Sirius V? You must provide arguments in favor and arguments against the proposal to support your decision

9. Give a summary of your recommendation for the three proposals

Team Meetings

Meeting of March 18 2014: Issues to be discussed by the teams

1. What are HF’s objectives as a foundation (Exhibits 1a and Exhibit 2)? What is the role of HF’s Laurie Hoagland and his investment team?

2. How HF’s philanthropic objectives translate into specific objectives for the endowment (Exhibit 3a)?

3. What investment policy could HF adopt to achieve simultaneously its two objectives of maintaining its asset based in real terms and avoid fluctuations in spending (Exhibits 3a and 4?

4. Is the volatility of the proposed portfolio too high or too low? What alternatives can you offer?

5. Should HF adopt highly levered mean-variance portfolios instead of the proposed portfolio?

6. Review of HF’s capital market assumptions. Does HF think that returns are predictable?

7. Given HF’s views on capital markets, is 5% real spending rate compatible with the proposed investment policy?

8. If you were a member of HF’s investment committee would you approve the proposal to double the allocation to absolute return strategies (hedge funds) from 10% of assets (or about $600 million) to 20% of assets (or about $1.2 billion (Exhibits 6, 8a, 8b, 9a and 9c)?

9. What additional questions would you ask Laurie Hoagland before approving (or rejecting) the absolute return strategy?

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Meeting of March 25, 2014: Issues to be discussed by the teams

1. How a return overlay strategy (also known as “alpha transport” or “portable alpha” strategy) works in a simple setting, for example, one in which HF transports the expected alpha in the absolute return portfolio into the S&P 500?

2. What is the impact on the expected return on the absolute portfolio of the proposed overlay portfolio, which involves exposure not only to domestic equities but also to bonds and inflation indexed-bonds? What are the risks?

3. How can HF implement the return overlay program (“bondize” and “equitize” its absolute return portfolio)? Should HF “bondize and equitize” the absolute return portfolio?

4. What are the advantages and disadvantages of investing in Sirius V, the global distressed investment fund (Exhibits 10, 11, 12a and 12b)? Should HF pledge up to 5% of the endowment to Sirius V?

Meeting of April 1, 2014: Teams’ Oral Presentations; Written Presentations are due