Hedging Their Bets

Big foundations and universities turn to non-traditional investments

When the stock market plunged in August, the John S. and James L. Knight Foundation had a cushion to break the fall. One-fifth of the foundation’s $1.2-billion endowment was invested in “hedge funds.” The funds — which place bets on the movement of market prices around the world — collectively fell by less than half the rate at which Standard & Poor’s index of big U.S. stocks declined. One of Knight’s hedge funds even made money.

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Hedge funds are not the only unconventional asset that Knight holds. An additional 20 per cent of the foundation’s endowment is in funds that invest in new or recently sold businesses, in securities of financially ailing companies, and in enterprises located in rapidly developing foreign countries — so-called emerging-markets stock.

Investments in such strategies can be risky — as evidenced by the losses sustained by several universities in the Everest Capital Fund Ltd., which recently confirmed that it had lost $1.3-billion. Knight’s investment strategy is not unique among large non-profit institutions. Indeed, more and more non-profit groups are diversifying into such non-traditional investments as leveraged-buyout funds, oil partnerships, and real estate — both to increase returns and to provide a buffer against declines in the stock market.

The shift has been dramatic for some of the largest institutions. In 1995, 14 big foundations, museums, and hospitals had $455-million, on average, in alternative investments, according to a survey by Goldman, Sachs & Company and Frank Russell Capital. In a sample of comparable institutions conducted last year, the average commitment was $1.02-billion. As a share of the institutions’ total assets, alternative investments rose from 11 per cent to 16.6 per cent.

Another survey, by Greenwich Associates, a financial-services company in Connecticut, found last year that half of 261 endowments already used hedge funds or were considering using them, and more than a fourth were using, or thinking about using, oil and gas investments.

Some alternative investments have already turned out to be extremely lucrative. Wake Forest University, for example, saw its $25-million stake in the Jaguar Fund, a big global hedge fund, expand to $43-million from August 1997 to June 30, before falling back to $39-million at the end of September. That represents a 56-per-cent gain in 13 months.

But the university was not so lucky in some of its other alternative investments.

Wake Forest’s stake in emerging-markets stock — $30-million in 1996 — grew to $39-million before shrinking this past summer to $16-million, then inching back to $16.8-million by the end of September, according to Louis R. Morrell, vice-president for investments at Wake Forest. “We took a very big hit,” he says.

Other non-profit organizations have experienced similar downturns. Harvard University’s $13-billion endowment recently incurred losses, on paper at least, of $1.3-billion because of souring emerging-market stocks and other investments. The loss erased much of the money the university collected in four years of a record-breaking fund-raising campaign.

Despite such losses, many endowment managers say they are sticking with their alternative-investment strategies for the long haul.

“We’re not risk-averse,” says Mr. Morrell of Wake Forest. “We’re opportunistic.” He adds: “If we have enough diversity in our portfolio, risk will take care of itself.”

Others caution that alternative investments are exceedingly complex and that only the savviest non-profit institutions should get involved in them.

“This is pretty sophisticated stuff,” says Michael Sullivan, treasurer of the University of St. Thomas, in St. Paul. The university’s trustees studied such deals but decided to avoid them, he says.

“How do I know if the latest alternative asset is the right thing?” Mr. Sullivan asks. “How do I know I’m not going to get snowed?”

Although alternative investments can be problematic for all kinds of institutions, they raise special problems for non-profit groups. Not only must trustees learn to evaluate such deals carefully — or pay for outside advice — but those investments often take years to produce solid returns. Non-profit boards, which are prone to frequent turnover, may not have the patience to see such deals through to a profitable end.

Another challenge that charities face is how to explain unusual investments to donors who may not be comfortable with anything but plain-vanilla stock-and-bond investing.

Says Larry D. Carr, chief executive of the Presbyterian Church (U.S.A.) Foundation, “If you were playing in the oil and gas fields of western Australia and had to explain to Mike Wallace why you’re willing to take these unreasonable risks with money that’s going to feed widows and orphans, you’re not going to get 15 minutes to explain diversification. You’re going to stand there and stutter for the 15 seconds that you have a chance to answer.”

Despite such concerns, proponents argue that betting too much of an endowment into conventional investments is far riskier than diversifying into alternative categories.

Indeed, many non-profit organizations say they have moved into alternative investing to protect their portfolios against the roller-coaster effects of the conventional markets.

“It’s simple — higher returns and lower volatility,” says Jay Yoder, director of investments at Vassar College, in explaining why nearly a fourth of the school’s $500-million endowment is invested in hedge funds, venture-capital and leveraged-buyout funds, real estate, and energy partnerships.

Proponents contend that alternative investments often zig when Wall Street zags, allowing an endowment or foundation to insulate itself from the worst effects of a downturn in stocks. Hedge funds can produce good returns no matter which way the markets move, they argue.

Michael Horst, manager of financial services at Denison University, in Granville, Ohio, says the institution has put money into alternative assets for a decade. Denison now has more than a third of its $300-million endowment in such investments, including 30 per cent in five hedge funds that invest in markets as diverse as biotechnology and retailing.

In August, when prices of big U.S. stocks tumbled, Denison’s hedge funds rose in value by a fraction of a percentage point. Mr. Horst says the gain proved the soundness of using hedge funds to insulate against a sharp stock decline.

A defensive posture also shapes the investment strategy at Memorial Sloan-Kettering Cancer Center, in New York. The non-profit hospital and research institution has put $175-million of its $2-billion in assets into alternative investments, including hedge funds.

“We’ve picked those to fit together as part of a puzzle,” says Michael P. Gutnick, senior vice-president for finance. “We wanted to reduce our exposure to a major market correction and thus achieve good returns with lower levels of risk.”

Other non-profit executives, such as Mr. Carr, of the Presbyterian Church (U.S.A.) Foundation, say they do not believe that they are sacrificing good returns on their endowments by staying out of alternative investments. The history of hedge funds and other avant-garde investments is simply too short to make any long-term predictions about their usefulness, skeptics say.

Only a decade or so ago, few foundations and endowments agonized over whether to diversify into alternative investments. Most small and mid-size foundations and endowments tended to shun all but the safest places to put their money. For many groups, high-quality bonds and cash accounts were de rigueur.

But several forces have changed the dynamics of endowment investing in recent years.

Fearing that inflation was eating away at their endowments, a handful of big foundations and universities began in the 1960s and 1970s to diversify away from cash and bonds into stocks and alternative investments in order to seek higher returns. Many other non-profit groups followed their lead, despite the difficulties that befell some organizations that diversified.

While the influence of the wealthiest non-profit organizations was important in changing investment habits, so too were legal and cultural changes in the concept of what constitutes a “prudent investor.”

The advent of modern investment-portfolio theory and the recasting of government standards on investment diversification over the past two decades have led non-profit groups to manage their money in a way that seeks maximum total return, not simply income from cash accounts and other conservative investments. That shift has led groups to put a portion of their money into investments that may not be easily sold in the open market but that, over time, may produce better returns than assets like blue-chip stocks and high-grade bonds that can easily be converted to cash.

As non-profit groups have become more willing to diversify their portfolios, an entire industry of financial consultants has arisen. Those consultants, especially a handful of major ones, have wielded enormous influence over the investment decisions of endowments and foundations — including decisions to buy alternative investments.

Many foundation officials say the consultants are doing the responsible thing by exposing their clients to the latest innovations in portfolio management. Others, however, worry that gung-ho advisers can steer volunteer investment committees into financial shoals that may wind up costing an endowment big money.

To avoid getting into trouble, says Mr. Yoder, of Vassar, endowments and foundations that are new to alternative investing should consider putting their money in a pooled arrangement called a “fund of funds” that spreads risk among several managers or types of investments.

Also at issue is whether so much money from big institutions, including government and private pension plans, is flooding the market for alternative investments that it’s difficult to find top-quality deals to be part of.

That’s a concern for the Ford Foundation, which has largely stayed out of the alternative-investment game, says Linda Strumpf, Ford’s chief investment officer. With huge sums to invest and a desire to be in only the “best funds,” Ms. Strumpf says, the question becomes, “Can you find opportunities on the scale you have to?”

Ford’s size and visibility would make it an easy target for critics if it failed at a high-wire investment act, she says.

“I don’t want to be hauled to Washington to find out why I lost money speculating with the foundation’s assets,” she says.

The foundation keeps 90 per cent of its $9.6-billion in assets in conventional stocks, cash, and fixed-income securities and only 10 per cent in alternative investments — none of it in hedge funds.

Whether other foundations and non-profit groups will do well by using alternative investments remains to be seen. Some observers question whether there is enough history of alternative investments to know for sure that they will perform differently from the stock market. What’s more, some people wonder whether tying up money in hedge funds and buyout deals, which usually can’t be dumped on short notice, really will beat the well-documented average performance for bread-and-butter stocks.

Ms. Strumpf, for one, says she is not convinced that alternative funds will do sufficiently better than stocks and therefore be worth the loss of flexibility. But she is willing to acknowledge that her colleagues who tout alternative investments might be correct. “Time will tell,” she says, “who turns out to be right.”