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Alternatively Speaking

Looking ahead to an inflated economy, campus finance executives downplay stocks and bonds in favor of alternatives.

If investor sentiment could be correlated to movie choices, As Good As It Gets would probably be the big hit among ordinary investors this year: a recovering stock market, climbing home values, low interest rates--what's not to like?

But among many of the leading college endowment professionals and advisors, the mood is very different. Talk to more than a few of them and you get a sense that they'd be more in the mood for The Lord of the Rings--or any story where little guys face long odds against big and scary monsters.

Dale Kindregan is a relationship manager for Endowments and Foundations at Russell Investment Group (, a global investment advisory firm that manages $95 billion in assets and provides advice for $1.8 trillion more. Kindregan says this year she's noticed a distinct difference in the outlook of large endowment managers compared to managers of small endowments. "Large universities are far more pessimistic than smaller universities, period," she says. "That's very, very, very clear."

It would be tempting to dismiss the big investors' negativity as some kind of collective cultural quirk, except for one thing: These folks apparently have a better track record for understanding the market than do the smaller endowment managers. Kindregan notes that most studies have shown that endowments worth more than $1 billion have outperformed smaller endowments for many years. According to 2003 NACUBO statistics (, the billion-plus club's returns have outpaced the returns of endowments under $25 million for the past one, three, five, and 10 years--reflecting the expertise of the big funds' larger money management staffs and the broad diversification of their holdings, say the experts.

"THERE'S A MAJOR DEBACLE COMING," says Norman Nabhan, national
director of the Smith Barney Consulting Group. But some IHEs
may even be in for a "double whammy" if in moving away from
stocks, they're now too heavily invested in bonds.

Although Wake Forest University's (NC) endowment is not quite a billion, Louis Morrell's view typifies the bearish outlook. Vice president and treasurer of the university since 1995, Morrell oversees an $825 million endowment invested in everything from timberland and apartment buildings to Asian stocks and emerging market debt. In fact, right now the university's portfolio is less than 10 percent invested in U.S. stocks. Morrell's take: The growth of the money supply by the Federal Reserve, the federal government's rising deficit, the Bush administration's tax cuts, and the falling dollar are all setting the stage for a return of high inflation, probably in the first part of 2005. "From a pure supply and demand point of view, prices are going to have to go up," he says. "There are more dollars chasing fewer goods; that's inflationary in nature."

And if mortgage refinancing, tax cuts, deficit spending, and low-interest borrowing don't kindle a real recovery, bad times could be on the way, say many. Higher interest rates discourage corporate investment and expansion and keep consumers away from the stores. For investors, that could mean a return to the markets of the 1970s, when commodities (like oil, most memorably) went up, but almost everything else lost ground.

Dennis Hammond is president of Hammond Associates (, an endowment investment advisory firm that advises 30 public and private colleges with assets ranging from under $100 million to over $1 billion. Hammond shares Morrell's view that returns from most traditional investments are likely to prove anemic in the coming years.

"Consultants like us are advising clients that over the next decade, returns from traditional long-only portfolios will be significantly truncated not just relative to the recent past--the last 10 years or so--but relative to the historic past," he says. His Exhibit A: Price-to-earnings ratios of stocks are currently at about 27, compared to their historic average of 16. That means that stocks are nearly twice as expensive as their historic average. Finance experts also say that the value of most kinds of bonds would suffer if inflation returned. The reason is that as interest rates rise, the value of a bond's promised future payments declines.

"The most a bond is going to give you is a fixed sum of money," explains Rangarajan Sundaram, an assistant professor of Finance at New York University's Stern School of Business. "When interest rates go up, people will pay less for that fixed sum of money." And since bond payments are made over a long period of time, even a slight rise in interest rates has huge repercussions for bondholders. "I've heard some very well-respected bond managers say, "If you think what happened in the summer when rates picked up a bit was bad, watch out. There's a train wreck coming."

Performing the complex
due diligence required
for alternative investments
can be a complex and
time-consuming task.

According to Norman Nabhan, national director of the Smith Barney Consulting Group (, and until recently a leading institutional financial advisor, "That was a car accident. There's a major debacle coming." Smith Barney (a division of CitiGroup,) manages over $900 billion in investment assets for individuals and institutions, and some of those institutions, says Nabhan, may be in for what he calls "a double whammy" if they have allocated funds to money bonds at the end of the last down market but haven't changed their allocation since then. "If they lost money in stocks, and then got scared and didn't bring the ratio of stocks in the portfolio back up and now have a higher ratio of bonds, [they're] going to be in trouble," he says.

John Griswold Jr., executive director of the Commonfund Institute (, which monitors institutional money management trends, says he is already seeing investors moving away from fixed income entirely, in favor of the equity market or alternatives.

But what about Alan Greenspan? Hasn't he more or less promised he won't raise rates? Yes, say the bears, but the Federal Reserve chairman may have no choice in the matter. While the media always makes it sound as though the Fed is the absolute arbiter of U.S. interest rates, the Federal Reserve actually controls only short-term rates--essentially by deciding how quickly to print dollars and the terms upon which it will make short-term loans to banks. Long-term interest rates, on the other hand, are determined to a large extent by global bond managers, say Morrell and others. Those decisions are based mostly on the bond managers' assessments of the risk that inflation will erode the value of their long-term investments.

At the same time, campus pressure to keep distributions flowing is highly unlikely to go away. Susan Fitzgerald, a senior vice president at Moody's Investors Service, (, says that although this year the financial situation has improved somewhat for most institutions of higher education, her agency is forecasting continued revenue and expense pressure for colleges and universities. Rising health care costs for university employees, as well as expensive capital investments to renovate buildings and compete for new students, are among the factors she cites as likely to add pressure to the balance sheet in the coming years. That, and the memory of the huge, punishing swings in the S&P 500, are no doubt behind the growing interest in alternative investments among universities. Over the last five years--the same period that saw the S&P suffer--the typical fund of funds (a kind of hedge fund that invests in other hedge funds) grew an average of 8.7 percent, and with less volatility, according to Hammond Associates analysts. It's no surprise then that many endowment managers are now attracted to a category that appears to deliver more gain with less pain than conventional investments: The most recent Commonfund Benchmark Study noted that one-third of all institutions intend to increase their alternatives allocation in 2004.

WAKE FOREST VP AND TREASURER Louis Morrell oversees an
$825 million endowment invested in everything from timberland
to apartment buildings. "Prices are going up," he says, so
only 10 percent of the school's endowment is now in stocks.

In making this shift, endowments across the board are following the lead of the larger college funds over the last 10 years. Mimi Lord, director of Product Development for TIAA-CREF Institutional Asset Management (, affirms that the bigger endowments have indeed been reducing their plain vanilla stock allocations since 1997, in favor of hedge funds and other alternatives. Now, it seems, the managers of smaller endowments have caught on.

At Hampden-Sydney College (VA), for instance, Norm Krueger is one satisfied "small" endowment customer. As vice president for Business Affairs and treasurer of the institution, Krueger manages a $98 million endowment that began moving into alternatives in 1999. And though a 5.3 percent return for the fiscal year ending June 30 might not seem like much to write home about, it was almost double the 2.7 average for endowments of Hampden-Sydney's size, according to recent NACUBO figures. The good news: Beating the average is not an impossible task for a smaller investment office, Krueger insists.

"Anyone who is willing to take some more risk and wants to take the time to educate him- or herself about alternatives, can do it," he says. "It's just a matter of how much time and education you want to spend on it, and how much risk you're willing to take." Krueger has been willing to step out on that limb: Hampden-Sydney's portfolio is currently 21.6 percent alternatives. (Fifty-nine percent is now in equities, 19 percent in bonds.)

Still, Krueger and other alternatives aficionados caution that becoming a good alternatives investor is a long-term process. Investing in such vehicles isn't simply a matter of adding another wedge to the pie chart. That's because "alternative" is an asset class in the same way that "none-of-the-above" is a candidate. It's really a term that encompasses a variety of different strategies that are not readily apparent--from hedge funds and private equity investments, to investments in everything from office buildings to oil wells. What's more, performing the complex due diligence required for these types of lightly regulated, specialized investments can be a complex and time-consuming task: Yale University and other schools with massive endowments have whole staffs of investment professionals just ready and waiting to do the work.

But delving into alternatives also means a real bump-up in ongoing management. George Benson, executive director of the Michigan State University Foundation, says that investing in hedge funds, for instance, is very different from conventional investments. Unlike traditional investment vehicles--where you can remain invested over time and trust that eventually, a particular asset class will come back into favor--some strategies can stop working more or less forever.

Take market inefficiencies, for example. A market inefficiency might not sound like a good idea for an investment, but it's the kind of opportunity some hedge fund managers live for. (By "inefficiency," investment pros mean a pricing anomaly that the rest of the market somehow doesn't see or can't exploit. For instance, some funds in the late 1990s specialized in borrowing money at low interest in Japan, and then investing the proceeds in higher-rate bonds in the U.S.--easy money as long as the exchange rate or each country's interest rates didn't change.) By their very nature, such inefficiencies lose their power (and their appeal) when the inefficiency-related relationships change, or more investors simply catch on to the game.

Given the light regulation and the high degree of specialized knowledge that's sometimes required to understand alternative strategies, how can schools without a staff of money managers take on such challenges? The answer is, they can't--at least not directly. Says TIAA-CREF's Lord, "At a small college with an endowment of $20 million, the person in charge of the endowment might also be in charge of properties, the budget, and just all kinds of things. He or she couldn't possibly take on complicated investment undertakings that are a real specialty in and of themselves."

TIAA-CREF'S MIMI LORD HAS SEEN managers of big endowments do
a whole lot of hedging-that is, investing in hedge funds. As product
development director for Institutional Asset Management, she's says
that she now sees managers of smaller endowments catching on.

However, what a smaller school like Hampden-Sydney can do, endowment experts say, is invest in a fund of fund product. Funds of funds come in many varieties. Some are general, and follow global macro-economic trends. Others specialize in a particular kind of investment strategy, such as investing in timberland--an unusual commodity play popularized in part by Yale's chief investment officer, David Swenson. The upside of investing in a fund of funds is that it provides more diversity with less administrative wear and tear, according to experts. On the downside, hiring a fund of funds manager adds another layer of fees on top of the enormous 20 percent cut in profits that's taken by the underlying hedge funds that a fund of funds is invested in. (Got that?)

Krueger, who invests in funds of funds, recommends meeting prospective managers face-to-face before entrusting a fund with any money. "You often find things in the in-person presentations that you don't find in the material that they send you," he explains. For example, he says, while interviewing to find a fund of funds that invested in timberland, he found that the manager was actually just selling timberland directly. "It was a direct equity investment, and that wasn't at all apparent in the materials that they presented to us," he says. What's more, a visit can yield more recent performance information than is available in the fund's sales materials, he adds.

"Another thing you find out," says Krueger, "is: Is this firm interested in us? That distinctly comes out in speaking with managers." He adds that he's also learned something else over time: Managers will negotiate many of their terms, including minimum investment levels and lock-up periods (the amount of time in which money is locked up in a hedge fund or other limited partnership such as a venture capital fund or a private equity investment. Such investments are illiquid and profits can take years to materialize).

Endowment pros with experience in alternatives say typically they use a consultant to lead them through the process. Vetting hedge funds, for example, can be very time-consuming, and endowment officers of mid-size endowments who have been through the process almost always say they rely on consultants to help them make those choices.

But using a consultant carries its own set of risks, for instance: How to guard the guardian? Richard Ennis, a fee-only consultant and principal of Ennis-Knupp Associates (, a Chicago-based institutional investment advisory firm, estimates that at least half of all the consulting advice endowment officers receive on any topic is somehow compromised by their consultants' other business interests. He says that "hard, naked conflicts" are "very powerful, very real, and very prevalent." And even that, he says, isn't the whole story.

"A lot of the conflicts are insidious. It isn't necessarily that some consultants are on the take, but they may have so many different business interests that they simply aren't in a position to offer clients unvarnished advice. The advice that they give clients has to be watered down," Ennis advises.

The bigger endowments
have been reducing
their plain vanilla
stock allocations in favor
of hedge funds
and other alternatives.
Now the managers of
smaller endowments
have caught on.

What makes the consulting relationship even more problematic with alternatives, say some experts, is that it's more lucrative than conventional money management advising. While those fees may be justified by the complexity that alternative due diligence presents, the heftier fees can also create an incentive for financial consultants to steer clients to the highest-paying side of their practice.

Morrell at Wake Forest is more sanguine about the whole issue of consulting conflicts. "Just make up a disclosure statement," he says. "If you think that your consultant may have a conflict, first define what you mean by a conflict, and then, as a condition of employment, have him sign a statement that he doesn't have a conflict."

Are the managers of smaller endowments too late to get in on alternatives? No, endowment experts say. Alternatives should remain an important source of diversification in the coming years. However, the enthusiasm may be somewhat overblown, they admit. "It has many of the earmarks of a bubble or a herd mentality. At the same time, though, I do think alternatives are here to stay," says Hammond.

But there is also speculation that the days of big returns in alternatives may indeed be over. Benson, who now invests 40 percent of the $300 million Michigan State University Foundation endowment in alternatives, believes that the huge returns generated by some non-traditional investments won't be repeated in the years ahead. He feels that though alternatives pay off by exploiting market inefficiencies, the large infusions of new capital into these strategies chase away the inefficiencies. Timing, apparently, is everything. Says Benson: "It's all about recognizing the ebb and flow of opportunity."

Bennett Voyles is a New York-based business and finance writer.

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