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Adam Keller: Now The Sins of Omission

Keller2.jpgWe’ve spent some time looking at the money that Adam Keller lost for Dartmouth through unwise (read: butthead) investments of the College’s working capital and a disastrous fling with interest rate swaps, and we’ve also looked at Keller’s beyond-belief severance package, but what about the opportunities that Keller was offered that he passed up?

As we’ve seen, Keller was advised in 2006 by David Russ, Dartmouth’s Chief Investment Officer (CIO), to move the College’s swaps away from Lehman Brothers about two years before that firm’s bankruptcy — advice that he ignored. But that was not his biggest mistake, not by a longshot.

In 2007, Russ drafted a paper proposing that the College purchase insurance on the value of the endowment in the form of “put options” on the Standard and Poor’s 500 index. At that point in time Dartmouth’s endowment had experienced a spectacular four-year run, going from $2.12 billion in the summer of 2003 to close to $4.0 billion by the late fall of 2007. The total return on Dartmouth’s money in each of the four fiscal years had been between 11-22%, with 2007 being the best year since 2000. Heady stuff. Too heady for an experienced money manager like Russ. And so, while the markets continued to soar, wiser minds sensed the shakiness of a boom, even though the options market continued to sell S&P puts at an extremely reasonable cost.

Using S&P puts to protect the value of an investment against a market decline - a form of insurance, if you will - is neither arcane nor unusual. For instance, Texas’ public university endowment, the second-largest U.S. college endowment fund, recently described its efforts to use derivatives to safeguard past gains in the currently unstable markets. And renowned fund manager Alice Handy, whose Investure LLC firm manages the endowments of Smith, Barnard, Middlebury and other mid-size institutions, used the same technique over the last few last years to earn returns higher than Harvard, Yale and a certain small college in Hanover, NH.

Russ.jpgAt the time of Russ’ proposal, the cost of insuring the value of College’s endowment against a market decline was very low — as demonstrated by the “VIX”, a measure of stock market volatility often known as the fear index. The “VIX” was then at 10; in 2008 it rose to 88. Insuring the entire endowment against loss in 2007 would have cost approximately $70 million — about 2% of the endowment’s value — a cost that could be have been carried fairly easily given the endowment’s 20+% growth during that year.

However, during the time frame leading up to Russ’ proposal, President Jim Wright and the Trustees were not only increasing the College’s spending, they were doing so by increasing the draw on the College’s growing endowment. Their pressure on the endowment jumped from the traditional, sustainable rate of 4-5% to 6-7%. When extrapolated over a decade or two, such a change can have a massive impact on the size of the endowment and the funds that it can provide to Dartmouth. To boot, this decision was made even though the College was in the midst of a lucrative $1.3 billion capital campaign.

Dartblog has obtained the text of an internal document in which CIO Russ wrote:

“The pattern is very clear in the May-June 2006 period. As the market rises, complacency sets in and volatility settles down. The period leading up to and following September 11, 2001 also exhibits this pattern…

As of 12/31/2006 the Total Investment Assets portion of the endowment was valued at $3.365 Billion. If we were implementing a hedging strategy we would recommend using a portion … to protect [the endowment against] the potential for downside surprise…

In this same memo, Russ also objected to Dartmouth’s out-of-control spending under Wright/Keller. He pointed out that the cumulative effect on the College’s longterm financial projections of drawing too heavily on the endowment would be substantial:

“The combined impact of the increased [level of current] spending affects both the future value of the endowment in 2036 ($1.5 Billion less that the base case) and the cumulative decrease in spending for the period 2016 to 2036 (cumulative impact of $959 Million due to the reduced endowment value). In effect, creating a nearly $2.5 Billion reduction in endowment value and spending over the last twenty years of the projection.”

With the prescience for which experienced financial professionals are paid, Russ summed up his position in this paragraph from his 2007 memo:

“The role of the investment office is to protect and enhance the value of the College’s endowment. An increase in spending from 5% to 7% [of the endowment each year] has the potential risk of eroding the long term value of the endowment. The other key risk factor that could affect the value of the endowment is a period of adverse market conditions. A concurrent increase in spending AND a period of adverse market conditions could be detrimental to the long term value of the endowment. [Emphasis added]

But Keller — undoubtedly informed in his financial market analysis by the teachings of his 1981 University of Minnesota masters degree in public health, his only post-graduate training — would not be persuaded. Acting alone, he overruled the recommendations of CIO Russ and the Investment Office. He changed their document in one way; he added the word not to their recommendation:

“To protect the entire endowment using S&P 500 put options beyond a 10% loss for one year, or below 90% level of the current value, would cost nearly $72 million… If the market remains flat or rises the options expire worthless. Considering that $72 million equals about 2% of the current market value of the portfolio, a fully covered hedging strategy costing 2% acts as an additional drag on the portfolio on top of the 7% proposed spending rate.

After careful consideration of option based hedging strategies, we would not recommend hedging at this time. However, we believe that it would be a natural question for the Trustees to consider.”[Emphasis added]

The Trustees chose not enter into the hedge proposed by Russ, nor did any of them suggest doing so on their own, either.

Had the College entered into the hedge that Russ had suggested, the S&P puts insurance program would have generated a PROFIT for the endowment of up to $400 million in 2008; the trade would have safeguarded the endowment’s value against a large part of the losses that it ultimately suffered. Phrased another way, the CIO’s hedge would have turned the College’s negative -19% return in 2009 into an Ivy-leading -11% return.

So why did Keller not choose to act prudently in 2007 to safeguard the endowment’s spectacular gains of the previous years? There’s an easy answer to that question that goes beyond Keller’s stumblebum approach to these highly technical questions. According to Dartblog’s sources, Jim Wright had given Keller an incentive interest in the endowment’s growth, even though Keller did not have a direct hand in the Investment Office’s management of the endowment. An out-of-pocket insurance plan in the form of S&P puts would have eaten into Keller’s year-end bonus — or so he thought. Keller’s short term financial interest was not aligned with incentives for the endowment’s longterm health. Too bad for us.

Addendum: Adam Keller is no longer the College’s CFO; he left that job with his severance package in November, 2009 — about six months after Dartmouth lost its AAA credit rating. He now occupies an ill-defined position as Director of Education at the Dartmouth Institute for Health Policy and Clinical Research, and he has no financial management responsibilities. David Russ is no longer the College’s CIO; he left that job in June, 2009. He is now the Chief Investment Strategist and Managing Director at Credit Suisse Asset Management, LLC in New York, which is part of Credit Suisse Group, the world’s sixth largest bank.

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