Ford Foundation Official Warns About Dangers of Alternative Investments

As endowments increase their allocations to alternative assets, skeptics have generally focused on two risks of such investments: their high fees, which eat into returns, and their tendency to use lots of debt, which can spell disaster when investments drop sharply.

Now an investing expert at the Ford Foundation, in New York, has highlighted a third concern: liquidity risk. In a paper to be published this fall in The Journal of Portfolio Management, Laurence B. Siegel, director of research in the foundation’s investment division, argues that endowments may have a difficult time making their payouts if they are heavily invested in alternatives during a severe bear market.

“It’s a cautionary tale,” Mr. Siegel says. “Before we jump with both feet into alternative investing, let’s think about what can go wrong, not just what has gone right for other people in the past.”

His paper is likely to draw attention from endowment managers, given that the U.S. stock market entered bear territory — defined as a drop of 20 percent from the most recent high — this month.

Surprising Findings

Some endowment managers who are just beginning to move into alternative investments — which include categories such as hedge funds, private equity, real estate, and venture capital — may be surprised by Mr. Siegel’s findings, since many endowments decide to diversify into alternative investments to soften the blow from a declining stock market. Mr. Siegel acknowledges that alternatives can reduce the risk of losses during down markets. Hedge funds, for example, can short stocks, or bet that they will decline, and in some cases produce profits during bear markets.

But alternative investments differ from conventional stock investments — they’re not nearly as easy to move in and out of. Hedge funds, for example, often require a three-year “lock up” period during which investors cannot withdraw money. Private-equity funds, and real-estate and energy partnerships, also require investors to tie up their money for years, and in addition they use “capital calls,” meaning the fund manager can require existing investors to add new money to the fund.

Bear-Market Scenarios

Many endowments have cut back on their holdings in the most-liquid investments — cash and fixed income — believing that such assets don’t provide high-enough long-term returns. Among the 87 endowments in The Chronicle’s survey with more than $1-billion in assets, the median holding of cash and fixed income is just 13 percent. The same funds have 35 percent of assets in alternative investments.

Given the illiquidity of alternative investments, Mr. Siegel argues, endowments could be forced to sell stocks at their lows during a bear market to raise money to be able to make their payouts. The stresses could be especially great for foundations, which are required by federal law to distribute 5 percent of their assets each year and generally have no new money coming in through donations (as colleges and other charities do).

“For some foundations, the only way to raise cash will be to sell stocks at a time when they probably should be buying them,” Mr. Siegel says.

He explores a variety of bear-market scenarios in his paper, and the most dire involves a foundation that pays out 6 percent of assets and has 50 percent of its endowment in alternative investments. By the end of a “catastrophic” market, in which the stock market declines 43 percent over three years (as happened in 2000-2), the foundation’s stake in alternatives has risen to 87 percent and its liquid investments (stocks, bonds, and cash) would cover only two years of spending.

Mr. Siegel says endowments have many ways to deal with liquidity risk. Endowments with 50 percent of their assets in alternative investments should consider scaling back, he says.

The Ford Foundation, for example, keeps just under 30 percent of its assets in, or committed to, alternative investments, according to Mr. Siegel. “That’s a lot,” he says. “And maybe that’s enough.”

Endowments can also build their positions in alternative investments over several years, so that some of the earlier investments could potentially be withdrawn as later ones are being made. And some endowments retain credit lines — so that they can borrow, if necessary, to make a payout — but Mr. Siegel notes that can be risky if an endowment’s investments don’t bounce back.

The Kresge Foundation, in Troy, Mich., which has 48 percent of its assets in alternative investments, currently owns options on the U.S. stock market that will rise in value as stocks decline, and could potentially be sold to meet the required 5-percent annual payout.

“We think about liquidity quite often,” says Robert J. Manilla, senior investment director at Kresge. “We can tell daily what our liquidity is across all of our investments. That’s a large reason why we hedge for equity corrections.”

David R. Brief, chief investment officer at the Jewish Federation/Jewish United Fund of Metropolitan Chicago, says he is happy to currently have 18 percent of his group’s endowment in bonds. More than a third of the endowment’s assets are in alternative investments, with the remainder primarily in stocks. He knows of a few endowments with no assets in fixed income — an uncomfortable position to be in, he notes, when markets are in free fall.

“It’s not just about returns — it’s also about liquidity,” Mr. Brief says. “Some investors are now scrambling because they have a lot less liquidity than they thought they would.”