Playing his chips

Few money managers can touch the performance record of Laurie Hoagland, CIO of the William and Flora Hewlett Foundation. He’s made a big bet on alternative assets but sees a bleak future for U.S equities.

It’s a rainy Sunday afternoon in late February, and Laurance Hoagland Jr. and the investment committee of the $6.5 billion William and Flora Hewlett Foundation are sitting around an oval cherry-wood table in a second-floor conference room that overlooks the neatly trimmed lawn and shrubbery in the backyard of the residence of Stanford University’s provost. The foundation staffers are here for a quarterly investment meeting. In his characteristic Socratic style, Hoagland, Hewlett’s chief investment officer, peppers his ten colleagues with questions about whether the U.S. economy’s status in the global marketplace has eroded. It’s a crucial issue for the foundation, which keeps about one third of its assets in nondollar investments, about twice the average of its peers among foundations with more than $1 billion in assets.

“Does it still make sense to be that much out of the mainstream?” asked Hoagland, 68.

Although the dollar was rallying against the euro and the yen, Hoagland and his colleagues believed that long term the U.S. economy was vulnerable. Determined to exploit opportunities outside the U.S, the committee decided to shift 4 percent of portfolio assets from domestic to foreign equities.

“We’re losing ground to the rest of the world, but it’s not all bad news,” Hoagland remarked. “There’s a lot of good news in that for leveling the global playing field.”

Throughout his 42-year career in finance, Hoagland, known universally as Laurie, has been asking tough questions and never blinking at the answers. Intellectually rigorous and terminally industrious -- Sunday meetings are the norm for the investment committee -- the soft-spoken, circumspect Hoagland took the reins at Hewlett in January 2001, after serving as the founding CEO of Stanford Management Co., where he delivered a splendid 18.4 percent average annual return in the endowment portfolio over nine years. It was an extraordinarily charged time for the Menlo Park, Californiabased foundation. Like most technology stocks, Hewlett-Packard Co. and Agilent shares, which made up 15 percent of the $3.7 billion portfolio, were in free fall. Ten days into Hoagland’s tenure, Hewlett-Packard co-founder William Hewlett died, swelling foundation assets by some $4.6 billion in gifted HP and Agilent shares. Then, just eight months later, the new CIO was yanked center stage in the dramatic merger of Hewlett-Packard and Compaq Computer Corp., which the Hewlett family opposed.

A natural consensus builder, the lanky 6-foot-3 Hoagland needed the forensic skills of an investment pro and the aplomb of a diplomat to succeed at his task: diversifying Hewlett’s portfolio while avoiding political pratfalls.

“Any foundation that remains a single-stock foundation is likely at some time to pay a very, very high price,” Hoagland says. “My main objective was to get the diversification done and get the risks off the table.”

And that’s just what he did. Methodically, Hoagland overhauled the portfolio. He dramatically reduced the HP and Agilent holdings from more than 60 percent to 5 percent of total assets, reduced exposure to U.S. equities and, notably, boosted the foundation’s targeted allocation to hedge funds from 5 percent to 20 percent.

Apart from reducing risk, Hoagland’s moves reflected an extremely dour outlook for U.S. stocks. “There’s a significant probability that the U.S. market will have another downward leg,” he says. While reducing his targeted U.S. equity exposure from 50 percent to 21 percent of assets, Hoagland upped the target allocations for international equities from 15 percent to 27 percent; boosted U.S. and foreign bonds from 15 percent to 25 percent; real estate from 5 percent to 12 percent; and high-yield bonds from 0 percent to 5 percent. He left private equity steady at 10 percent.

“The volatility in absolute-return funds has been dramatically less than in the stock market. We’re hoping that the combination of mediocre equity returns plus absolute-return-fund alpha will add up to at least a decent return,” the CIO explains. “We’ve lowered the level of risk in the portfolio.” He adds that the fund’s return expectation is 8.8 percent, down from 9.7 percent last year.

The moves appear to be paying off. Finalized in October 2001, the new allocation strategy was put in place beginning early the following year. After a laggard 2001, when Hewlett’s returns fell 12 percent, versus an 8.7 percent decline for its internal benchmark, the portfolio in 2002 declined 7.6 percent, just 30 basis points below its benchmark and 10 basis points below the Commonfund benchmark for foundations with more than $1 billion in assets. In 2003, Hewlett gained 23 percent -- 2.9 percentage points better than its benchmark and 2.5 percentage points better than the Commonfund index -- aided by a big bet on distressed debt made in 2002, when Hoagland doubled his exposure to that sector to about 7 percent of the portfolio. In 2004 the portfolio climbed 15.4 percent, handily besting its benchmark’s 13.7 percent.

“He has done a brilliant job,” says foundation trustee James Gaither, a venture capitalist at Sutter Hill Ventures in Palo Alto, California, and former chairman of the Stanford University board. “He diversified a single asset into a multiasset portfolio without getting killed in the process.”

Most important, given the nature of its mission -- “to address the most serious social and environmental problems facing society” -- Hewlett has been one of the few major foundations able to increase its philanthropic gifts over the past few years. As of December 31, 2004, its assets were valued at $6.5 billion, making it the seventh-biggest foundation in the U.S. Last year it made gifts and grants totaling more than $265 million to some 570 organizations.

“The foundation’s ability to sustain its grant making through a very tough period in the market is fantastic,” says D. Ellen Shuman, CIO of $1.9 billion Carnegie Corp. “And Laurie has done a tremendous job of lowering the foundation’s overall risk by diversifying.”

From the start Hoagland never hesitated to shake up systems that had been in place for many years. That has been especially true in his use of hedge funds. The Hewlett Foundation had managed hedge funds in-house since it first dipped into the asset class back in 1995, but Hoagland determined to move the entire allocation, then representing 5 percent of total assets, to a fund-of-hedge-funds manager, Aetos Capital. Anne Casscells, a managing director working in the Menlo Park office of New Yorkbased Aetos and co-president and CIO of its absolute-return strategies, had been Hoagland’s CIO at Stanford Management.

Aetos recommended that Hewlett keep in its new roster the eight hedge funds that the foundation had already invested in, and Hoagland agreed. In its current investment strategy, which targets a 20 percent allocation to hedge funds, Hewlett now invests in all its hedge funds through a separately managed Aetos fund of funds, paying the double layer of fees. Hoagland felt confident that the expertise of a fund-of-funds manager would more than make up for the additional cost. “It’s a decision between the full mind-share of a new, separate team of two or three people or a partial mind-share of Aetos’s fully fleshed-out investment team,” he says.

Hewlett’s hedge fund lineup, all absolute-return portfolios, includes such industry leaders as AQR Capital Management, Davidson Kempner International Advisors, Farallon Capital Management and Perry Capital Management. The overall hedge fund portfolio has returned an average annual 11 percent since its inception in 1996. In 2004 the portfolio gained 13.2 percent, more than double its internal benchmark target of Treasury bills, which averaged 1.4 percent for the year, plus 5 percentage points.

“It was a very difficult year for hedge funds to make money,” Hoagland says. Many hedge funds that profess to be market neutral in fact carry a small beta exposure, he notes, and that tends to depress returns.

Despite the strong returns, Hoagland worries about the “absolute wall” of money flowing into hedge funds, making market inefficiencies much harder to exploit and squeezing returns. “We’re fighting on every front,” he says. “There’s so much liquidity that it’s like the Grand Canyon is filling up and backing into rivers. So you have to run to the creek bed to stay ahead of the liquidity. What’s already a pretty unattractive investing environment might actually get worse.”

FOR HOAGLAND, WORKING AT STANFORD AND the Hewlett Foundation has been both a homecoming and a dream come true.

On December 18, 1936, Hoagland was born at Palo Alto Hospital on the Stanford University campus, where his father, Laurance Sr., was in his second year of business school. The following spring the family, including Laurie’s mother, Naomi, and his older sister and younger brother, moved to Omaha, Nebraska, home of Carpenter Paper Co., the family business of Hoagland’s mother. Laurance Sr. rose through the ranks to become president.

As a boy during World War II, Hoagland rang neighborhood doorbells and took orders for 25-cent stamps that filled booklets that could be exchanged for $25 war bonds. “My mother would take me to the drugstore and buy the stamps, which I delivered,” he recalls. “There was no markup.” Hoagland says he was a “grind” in high school. But when he followed his parents’ lead and enrolled at Stanford in 1954, “I found I was better prepared than anyone but the prep school kids,” he says.

Like his father, Hoagland met his wife, Gay, at Stanford, where he earned an AB in economics in 1958. Then, on a prestigious Marshall Scholarship, he attended Oxford University, earning an MA in philosophy, politics and economics. He received an MBA from Harvard Business School in 1962.

That year Hoagland began his career in finance as an analyst at Irwin Management Co. in Columbus, Indiana, the family office of J. Irwin Miller, who ran Cummins Engine for four decades. In Hoagland’s first year he began managing money for several families and two Miller family foundations. He continued as a portfolio manager until 1974, when he moved to Cummins, where he spent the next five years running the company’s pension fund.

In 1980, Hoagland relocated to St. Louis, Missouri, to co-found an investment management firm, Anderson, Hoagland and Co. (His son Craig currently works there as a portfolio manager.) Between mid-1980 and mid-1991, when Hoagland left the firm, the value equity manager grew its assets from $11 million to some $300 million, producing a handsome average annual return of 21.5 percent, net of fees, in its stock portfolios, versus 15.1 percent for the Standard & Poor’s 500 index. (The firm’s assets peaked at $1 billion in the mid-1990s, but during the late 1990s the money manager’s value approach proved fatal, as returns fell and clients fled. Assets currently total $150 million.)

A loyal alumnus, Hoagland had entertained thoughts of one day working at Stanford ever since he began his career in the 1960s. His two brothers and four sons also graduated from Stanford. In 1986 he endowed a prize in undergraduate teaching at the university and in 1997 a professorship in the humanities and sciences. His gifts totaled more than $2 million.

“In the late ‘60s,” he recalls, “if you had asked me, ‘What are your fondest dreams and ambitions?’ I would have said, ‘One, to have my own money management business and two, to manage money for Stanford.’” Hoagland’s eyes lit up when a headhunter called in early 1991 and broached the prospect of a job at Stanford Management Co.

“It was clear he loved Stanford,” says Gaither, then the chairman of Stanford University’s board of trustees and the chief advocate of Hoagland’s candidacy.

Still, Gaither was surprised that Hoagland jumped as quickly as he did. At the time, Stanford was battling charges that it had defrauded the federal government by inflating its indirect research costs on defense and other government projects. But Hoagland thought the scandal would eventually blow over, and it did.

Since Stanford students first arrived on the Palo Alto campus in 1891, the university’s endowment had been handled by a university officer, usually the vice president of finance. His work was overseen by an investment committee of university trustees. But in 1991 the trustees decided to establish a quasi-independent organization to manage the growing endowment, which stood at just under $1.9 billion. In so doing, Stanford was following the lead of other elite educational institutions. Harvard University had been using a similar structure since 1974, Yale University since 1975 and Princeton University since 1987. Hoagland became the first head of Stanford’s new money management group.

Still, not everyone at the university was ready to embrace the new arrangement, Hoagland recalls. “The people who had been on the trustee investment committee were kind of like the kids pushing their noses up against the window,” he says. But he adds that they were good-spirited about the fact that under the new structure they had less control over investment decisions.

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Hoagland embarked on a systematic analysis of all asset categories. Compared to its peers at the time, the fund had a modest allocation to fixed income and was overweight in large-cap U.S. equity and real estate. During the 1990s, Hoagland reduced the U.S. stock exposure from 37.5 percent to about 25 percent, increased international stock holdings from about 15 percent to 23 percent, threw even more money into real estate and doubled the allocation to venture capital. Most critical, he picked top-performing money managers.

The new CIO also attracted renowned industry figures to the 11-member board. T. Robert Burke, a co-founder of the predecessor to AMB Property Corp., gave advice on real estate; Tully Friedman, co-founder of San Franciscobased private equity firm Hellman & Friedman, helped with venture capital investments. Nobel Prizewinning economist and Stanford luminary William Sharpe joined in 1993.

“Laurie works so well in a consensus mode,” says Sharpe. “He’s really a serious information gatherer. And he was spectacular in getting the right team.”

Among the team’s members was Hoagland’s deputy, Curtis Feeny. The former Trammell Crow Co. executive oversaw a number of very profitable direct real estate investments in the 1990s, including Stanford Research Park and the Sand Hill Road project, which included apartment developments and major local roadway improvements. “He was one of the best things that happened during my time,” says Hoagland.

Other key members included Casscells, whom Hoagland hired in 1996 after she had worked as a fixed-income salesperson and trader at Goldman, Sachs & Co. Recruited to handle asset allocation and risk management, Casscells quickly impressed Hoagland, who named her CIO in 1998. Together they set up Stanford Management’s absolute-return overlay strategy, which targeted hedge fund allocation of 15 percent of total assets by the end of the decade. Using a so-called portable alpha strategy, some of the hedge fund positions were categorized as part of equity and bond portfolios. Others were regarded as stand-alone investments. The absolute-return portfolio from inception in November 1990 through 1999 returned an annualized 17.3 percent.

Hoagland has never been afraid to step away from the crowd. In the early 1990s, when most U.S. institutional investors had only modest exposures to international markets, Hoagland moved deeply into non-U.S. stocks. He was mainly looking to diversify Stanford’s portfolio, but he also believed that European and emerging-markets equities were more attractively valued. Hoagland’s bet paid off. In the ten years through 1999, the portfolio returned an average annual 11.4 percent, versus the 7.3 percent annualized return of the Salomon Brothers broad market index ex-U.S.

The Stanford CIO made perhaps his shrewdest move right after he took the job in 1991, when he doubled the venture capital target, from 5 percent to 10 percent of assets. Through investments with venture capital firms Kleiner Perkins Caufield & Byers, Sequoia Capital and others in the late 1990s, the Stanford portfolio participated in many of the high-profile tech IPOs of the bull market, including those of, Cisco Systems, Netscape and Yahoo! Between its first venture capital investment in 1979 and year-end 1999, Stanford posted an average annual return on its venture capital portfolio of 28.2 percent.

THOUGH HOAGLAND HAS LONG SINCE DEPARTED Stanford for Hewlett, he left behind one especially memorable investment. Through Kleiner Perkins and Sequoia, the endowment participated in an investment in Google, which has soared since its IPO last August. Stanford University made its own fortune. In 1998 it had licensed the patent used in Google to the two Stanford graduate students who founded the company, receiving cash and stock in exchange. Stanford received about 1.8 million Google shares. It sold roughly 10 percent when Google went public, for about $15 million. Its remaining shares are worth approximately $290 million.

Under Hoagland’s leadership, assets of the Stanford endowment rose from $1.87 billion to $8.56 billion. The portfolio’s annualized 18.4 percent return over nine years ended July 2000 far surpassed the National Association of College and University Business Officers index’s 15.6 percent annualized return for the ten years ended July 2000. (A comparable nine-year Nacubo average is not available.) On Hoagland’s watch all but one asset class in Stanford’s portfolio, U.S. equities, outperformed their benchmarks.

The Hewlett Foundation board first became familiar with Hoagland in 1996, when, at the suggestion of trustee Gaither, he joined the foundation’s investment committee. He took over the seat formerly held by Arjay Miller, who had served as the president of Ford Motor Co. and dean of the Stanford Business School. In late 1999, Gaither suggested that Hoagland become the foundation’s CIO. “Along with Walter [Hewlett] and [foundation president] Paul Brest, we said, ‘Let’s be in the forefront of developing a new model for management of an endowment,’” says Gaither. Anticipating an inflow of HP stock after William Hewlett’s death, the trustees were also confident that Hoagland could skillfully diversify the portfolio.

Though he loved Stanford, Hoagland didn’t want to stay on the job more than ten years and was eager to try his hand at the foundation. He left Stanford in August 2000 and spent four months traveling in Peru, Iran, the Galapagos Islands, Uzbekistan and Tunisia, among other places, before reporting for work. Stanford’s trustees named Michael McCaffery, former CEO of investment bank Robertson Stephens and a Stanford graduate, as Hoagland’s successor.

Hoagland had been on the job just ten days when William Hewlett died -- and the problem of investing his trust became a reality. The new CIO and three associates -- treasurer Susan Ketcham, private equity chief Kelly Meldrum and Diana Lieberman, then head of research -- spent most of the first four months of 2001 discussing how to divest the massive infusion of HP and Agilent stock. “I put questions out there, got input, saw whether there was a consensus, got a decision and moved on to the next item,” Hoagland recalls.

Although diversification was the obvious move -- with the new HP and Agilent shares, the stock concentration was more than 60 percent -- Hoagland and his colleagues had to decide how long the process should take and whether to sell the holdings in big quick blocks or discreetly over time.

Separately, Hoagland and Brest had to deal with the emotions of the three Hewlett family members on the 11-person foundation board. All had powerful attachments to the company their father had co-founded.

Those feelings grew considerably more complicated on September 1, 2001, when thenHP CEO Carly Fiorina proposed a $19 billion merger with Compaq. Family members felt the combined company would destroy HP’s egalitarian ethos, if not the company itself. “For a family, and for the children, HP was not just an investment -- it was the life they lived,” says Brest, who had served as dean of Stanford Law School from 1987 to 1999.

Within weeks of the merger announcement, Hoagland was thrust into a high-profile proxy battle.

In early November 2001, Walter Hewlett, the founder’s eldest son and the foundation’s chairman, publicly vowed to fight the proposed merger. Hewlett personally controlled less than 0.5 percent of HP stock; the foundation owned an additional 5.1 percent, making it the second-largest shareholder after the David and Lucille Packard Foundation. Over the next several months, Fiorina and Walter Hewlett became embroiled in an increasingly nasty fight that eventually consumed $110 million. Hewlett repeatedly lambasted Fiorina’s leadership, and at one point Fiorina sent a letter to shareholders deriding Walter Hewlett as merely an “academic and musician.”

In accordance with the foundation’s 1998 bylaws, which aimed to avoid possible conflicts of interest, all investment issues relating to HP or Agilent shares first had to be analyzed by the investment committee, with no Hewlett family members present.

As he waded into the merger debate, Hoagland urged the investment committee to make the most dispassionate decision it could. Over a five-week stretch, his staff polled buy- and sell-side analysts and arbitrage specialists, among others, asking them if they endorsed or opposed the merger. “Our objective was to get a sample of sophisticated opinion from people who were not involved in the deal,” Hoagland explains. In the end, 80 percent of those surveyed opposed the merger; 20 percent were “lukewarm in their support.”

In early November 2001 the investment committee voted unanimously against the deal. On November 6 the full board, which had final authority (and no input from Hewlett family members), agreed and announced the foundation’s opposition. Although supporters of the merger criticized the foundation’s final judgment, its decision-making process was seen as fair. Fiorina, for one, never spoke out against the foundation.

“It was a tough situation, but Laurie Hoagland managed to not piss off too many people,” says Carnegie’s Shuman.

The proxy fight finally ended in March 2002 with 51 percent of the company’s shareholders voting in favor of the merger. Nearly three years later, on February 9, 2005, HP’s board, dismayed by Fiorina’s leadership, ousted the CEO.

With the Compaq merger a fait accompli, Hoagland was well into a three-year effort to sell off HP and Agilent stock to get the stake in the two companies down to 5 percent of foundation assets. By last August the HP and Agilent positions had been trimmed to their target level.

Of course, because HP and Agilent stock fell sharply in late 2001 and 2002, the foundation would have been better served by an early sale, but that’s only clear in hindsight. “We took a more measured approach,” Hoagland says.

His approach to hedge funds has been similarly measured. Like a growing number of pension plans, foundations and endowments, the Hewlett Foundation is investing in hedge funds as part of a portable alpha strategy designed to add oomph to asset classes and subsectors where it’s especially difficult to outperform the market. Hoagland has targeted large-cap equity, Treasury inflation-protected securities and investment-grade corporate bonds. Using a portable alpha strategy, 5 percent of the asset allocation is set aside for market, or beta, exposure, using swaps or derivatives to deliver exposure many times greater. The remaining 95 percent is devoted to alpha-generating strategies from any asset class. At Hewlett the vast majority of alpha comes from the 20 absolute-return funds managed by Aetos.

All are fighting to beat their benchmarks in a very tough environment. “Classic arb strategies now have extremely small spreads,” says Hoagland. “We’re a bit better off than the average absolute-return portfolio.”

Hoagland keeps close track of his hedge fund managers. At weekly meetings of the senior investment staff, Aetos’s Casscells often joins in. Periodically, Hoagland meets with the individual hedge fund managers, either in their offices or at Aetos. “We watch pretty closely to see whether what they’re doing matches how they describe their investment approach,” he says.

These days Hoagland is looking for more direct investments in private equity and real estate funds in Europe and Asia. In 2004 the foundation invested in another international real estate fund, and this year Hoagland expects to close an investment in a European real estate fund.

Looking ahead several years, Hoagland perceives several potentially serious threats to capital markets. He argues that the low U.S. savings rate and historically high current-account deficit must sooner or later be corrected, most likely through slower U.S. economic growth and a weaker dollar. As a result, Hoagland says, U.S. economic growth will slow and the dollar may weaken even more. “Valuations are likely to be flat or down from here,” he notes, suggesting that the U.S. stock market could possibly hit new post-9/11 lows. “It’s not a 100 percent certainty, but it’s a significant enough probability that one wants to have considered it.”

Over the course of a long career, Hoagland has learned when to push and when to pull back, when to reach for excess returns and when to worry about risk. At this juncture, he suggests, “the smartest thing to do may be to just live with lower returns and not do something stupid.”