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Hedging Your Endowment Bets

Does playing the hedge fund investment game reduce risk, or add to it?
University Business, Nov 2005

Star quarterbacks? Nobel laureates? Once upon a time, these people were the big deals on campuses. Now they have to make room for the new star, the endowment's hedge fund manager.

By reputation, hedge funds entice dollars with suggestions of reduced risk and enhanced returns, and they've helped many of the largest and highest-profile university endowments post outstanding returns. The business media have awarded accolades to Harvard and Yale for their investment prowess; both institutions invest heavily in private investment partnerships and alternative asset classes, including hedge funds.

Institutions are hardly the only ones looking to this investment class. Hedge funds attracted more than $1 trillion in assets by the end of 2004, an increase of 27 percent during the year, according to the Hennessee Group, a consultancy specializing in this investment area. Most of that growth, 17 percent, came from new capital inflows, while the remaining 10 percent came from investment performance.

For the same period, the S&P 500 had a total return of 10.88 percent. Because hedge funds don't make detailed performance information available to the public, it's unclear if the aggregate risk was more or less than that of the U.S. stock market.

As with any investing strategy, not every institution with an endowment consisting of hedge funds has had national championship performance. In 2001, trustees at the Art Institute of Chicago reported that Integral Investment Management, a hedge fund, lost $39 million of the then-$667 million endowment that supports the museum and its college. The National Futures Association investigation of the case found that Integral made performance claims for which it had no substantiation and that the firm's method of calculating profits in futures trades did not match industry norms.

Of course, that's little comfort to the school, which reportedly wound up having to make 3 percent budget cuts across the board to make up for the endowment losses.

In the early 21st century, the economy has experienced both a weak stock market and low interest rates, making it difficult for endowments to grow through investment performance. Some endowments have shown great success with hedge funds during that time, and many others have watched that and want a piece of the action. While hedge funds can enhance long-term performance and reduce portfolio risk, not all funds are alike. Also, there's not much public information about them. That lack of performance and other data may contribute to campus controversy--and poor returns--for an institution.

Those asking this question are not alone. And the answer isn't a simple one-liner.

Consider the general rule of investment returns: The riskier the investment, the greater the potential for a large return. The potential return should be great enough to offset the risk of losing the investment.

Federally insured passbook savings accounts at a neighborhood bank have really low returns because they have really low risk; savers will almost definitely get that promised half-percent return.

Venture capital returns, on the other hand, can be huge, especially for those who provided early funding to Intel, America Online, and Yahoo. These high returns offset losses on whatever risky investments may fail to pay off. (Imagine the losses suffered by those who thought they saw potential in and Webvan, for example.)

A hedge fund works differently from a traditional investment. In its purest form, a hedge fund invests in otherwise risky assets--stocks, bonds, etc.--but they do so in such a way as to reduce the relative risk. A truly "market neutral" hedge fund performs in its own realm, canceling out the ups and downs of the underlying market. This means less risk for a given level of return than traditional market-exposed investments such as mutual funds.

The earliest hedge funds reached this state by short selling: borrowing securities that they did not own, selling them, and then buying back the securities to pay off the loan, ideally after the security has fallen in price. (To own a security is also known as having a "long position" in it.) Modern market-neutral funds use options, futures, and borrowing in addition to shorting to achieve their target positions. Because funds borrow in order to increase certain positions, they may have market exposure (long positions less short positions) greater than the amount of investable assets. In 2004, the Hennessee Group reports that the average hedge fund's nominal market exposure stood at 102 percent.

What does all of this mean for institutional endowments? Take Wake Forest University as an example. The Winston-Salem, N.C.-based school has increased the hedge fund allocation since 2001 to reduce volatility of its endowment's total return in difficult investment environments. Now 18 percent of the endowment is invested in hedge funds, says treasurer Louis Morrell. The hedge fund portion of Wake Forest's endowment is an overlay, so that its investments match the pre-determined strategic asset allocation between equity, fixed income, and alternative investment classes.

"The biggest mistake people make is that they look for hedge funds to add returns rather than to reduce risk," Morrell says. "Hedge funds, to us, are not an asset class. They are too different from one another."

The biggest mistake people make is to
look for hedge funds to add returns
rather than reduce risk. -Louis Morrell, Wake Forest University

Many funds referred to as hedge funds are simply unregistered investment partnerships that buy and sell many different types of securities and that are not necessarily market neutral. Hedge fund managers do not have to register as investment advisors with the Securities and Exchange Commission (SEC), but some register anyway. In fact, the Hennessee Group reports that 61 percent of hedge funds are already registered with a regulatory agency, be it the SEC, National Association of Securities Dealers, or Commodity Futures Trading Commission.

Some hedge fund managers will be required to register with the SEC by February 1, 2006, but that may not make a difference to endowments. "I don't think registration will create meaningful investor protection," says Stephanie Breslow, a partner at the law firm of Schulte Roth Zabel LLP who works on hedge fund issues. "It's never been my experience that large, reputable managers are ignoring the rules anyway." She also points out that funds can avoid registration by preventing redemptions for a period of two years plus one day from the time of the initial investment.

With registration, "it will be slightly easier to get some data, but the bottom line is that it won't speed up our due diligence process, or make it easier to identify those that will be the likely best performers going forward," says Christopher L. Bittman, chief investment officer at the University of Colorado Foundation, where 20 percent of the assets are allocated to hedge funds. "I don't rely on the SEC for risk management, so for us, it will have little impact," he says.

Morrell of Wake Forest sees the value in registration, though. The requirement "will help weed out the crooks," he says, "but if you've done your research, you won't be doing business with them in the first place."

Instead, money managers look to others for information. Morningstar, an investment research firm based in Chicago, uses 15 different categories to evaluate hedge fund performance. However, it can only evaluate performance if the fund managers submit data to Morningstar for review. (To date, almost 1,600 funds out of the 8,000 some experts believe are out there have done so.) Then the information is made available only to accredited investors who subscribe to the service. This is unlike mutual fund data; these funds must send performance information to the SEC. Morningstar makes some of its evaluations available for free to the public on its website; the rest is available to anyone paying $12.95 per month.

Because hedge funds are not registered, they do not have to report their results publicly. In fact, many hedge funds ask their investors to sign non-disclosure agreements that limit how much they can discuss performance and investment strategies--and that may limit how much the investor is allowed to know in the first place. Furthermore, Morningstar notes that media reports of outstanding investment performance are skewed by a survivor bias. Those funds that disband because of poor performance drop out of the numbers entirely, leaving only those that posted acceptable returns.

Just because an institutional investor wants to invest the school's endowment in a particular hedge fund doesn't mean it can be. Many funds take on investors only when they are being formed. The investor is relying on the track record of the money manager in another setting because there is no past performance for the fund in question.

In some cases, endowments get on a waiting list to buy into existing funds when other shareholders cash out. Hedge fund managers often want to control the amount of money put in because they want to ensure there are enough investments that fit their strategy. Otherwise, it will be impossible to generate the expected returns. This also means that investors may not be able to take their money out readily. Lockups of two years are not uncommon.

Morrell says that Wake Forest has had the best experience with hedge fund companies that have been in business for a while. Some portfolio managers may have developed a great performance record for someone else, then left to start their own firm. Unfortunately, these people often are not skilled at office operations, hiring and managing employees, and customer communications. "The key to all of this is research and knowing the manager," he says.

University investors answer to numerous
constituents-from donors to faculty,
staff, and students.

Institutions can get assistance with hedge fund investing. Some companies, like Morningstar, provide data; others, like the Hennessee Group, will help clients determine their hedge fund allocation and then find managers who can meet the institution's investment policy. Some endowment managers feel that consultants add costs that reduce total returns. Others appreciate their research, especially at institutions with small staffs.

The key is getting one's money's worth. "Whether paying a consultant or doing the analysis and due diligence in-house, there is certainly a cost to do the work that impacts the net results," says University of Colorado's Bittman.

Besides often not being registered, hedge funds may have investment strategies that are proprietary, or holdings that aren't disclosed. Those who invest in them are sometimes forbidden from discussing the investments. (The investment manager at one school refused to be quoted for this story, saying that all it would do was help competing institutions.)

Many private investors are happy to put up with these shortcomings as long as the returns are good. However, university investors answer to numerous constituents. Many in the higher education community believe that investment holdings and strategies should be open, and many institutions have investment restrictions that cannot be adequately enforced when hedge funds enter the picture.

At Yale, several student and faculty activists have formed Unfarallon, an organization that protests the university's participation in a fund operated by Farallon Capital Management in particular and hedge fund investments in general. Student and faculty activism for responsible endowment investing has spread to other campuses, too, with Stanford University and Mills College in California, as well as the University of Texas starting Unfarallon chapters themselves.

Phoebe Rounds, a junior at Yale who serves as spokesperson for Unfarallon, says that the problem isn't the hedge funds themselves so much as the veils around them that prevent students and donors from knowing whether the investments are responsible. "What we're focusing on is the issue of transparency. Hedge funds are in conflict with the mission of an open institution of higher learning," she says. "We'd like to see a discussion in an academic setting about what they mean for the university as a public citizen." Donors are also concerned about transparency; 75 percent of those surveyed by the Goldman Sachs Global Market Institute in January 2005 agreed that "university endowments should only invest in funds that disclose which companies they invest in, because endowment donors deserve to know how their donations are invested." When asked specifically about socially responsible investments, 47 percent thought that returns were more important, but almost as many, 43 percent, favored slightly lower returns in exchange for investments that fit social objectives.

At the same time, though, most donors are satisfied overall with the funds that they support. Almost three-quarters of those who responded had a positive impression of endowments, and 68 percent thought that the endowment should primarily serve the university.

While many endowment managers will accept restrictions on disclosure, they need to know a hedge fund's strategies and holdings for internal risk management. "Position-level transparency might be one of the best ways for an endowment or foundation to monitor risk," says Bittman. That way, managers won't be blindsided.

Given how varied both hedge funds and higher ed institutions are, there is only one hard and fast rule about hedge fund investing by endowment managers: Do your homework. Only with careful research can an institution make the best decision.

Ryan Tagal, product manager of Hedge Funds Analytical Services at Morningstar, advises those considering hedge funds to first consider the benefits and risks of investing in funds that are not correlated with traditional investments. They also need to understand how leverage affects the risk of the portfolio and how the lack of liquidity can help returns while affecting total portfolio management. More importantly, he says, hedge funds "should not be an investment just because it is the new hot thing." Endowment managers need to understand partnership agreements, illiquidity, and strategies that may not have come into play before.

Despite concerns and the occasional headline-grabbing bad experience, most endowment managers with a thoughtful approach to hedge funds have been rewarded with steady performance and a reduction in expected risk.

"Hedge funds are intended to smooth out the dips and keep the upward line moving," says Morrell. It's not as glamorous as a Business Week cover story, but it's enough to keep most educational endowments growing to meet long-term institutional needs.

Ann C. Logue is a freelance investment services writer based in Chicago. She can be reached at

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