More Endowments Hedge Their Bets Against Market Conditions

Hedge funds have bolstered the returns at the biggest endowments in recent years, and that success

has led midsize and smaller endowments to allocate more money to such funds.

But some experts warn that hedge funds’ high fees and popularity — as well as proposals circulating in Congress that would subject them to greater taxation — may reduce their attractiveness in the future.

Hedge funds use a wide range of investments designed to protect, or hedge, against changing market conditions. In The Chronicle’s survey of endowments held by 268 nonprofit groups, the median allocation to hedge funds among endowments with $500-million to $1-billion in assets is now 18 percent, meaning that half had more allocated and half less. In 2005, the median was 10 percent.

Endowments with assets between $100-million and $500-million have a median of 9 percent of assets in hedge funds, up from 8 percent in 2005.

The Community Foundation of Greater Memphis, which has a $30.6-million endowment, began increasing its allocation to hedge funds, and reducing its allocations to bonds, in 2003. About 10 percent of the endowment is now in hedge funds, while bonds have dropped from 35 percent to 25 percent of the portfolio.

The foundation, which also has 62 percent of its portfolio in stocks, earned 14 percent in 2006. Mack McCaul, the foundation’s vice president for finance, hopes to diversify further — perhaps into private equity — as the endowment gains in size.

“The Ivy League endowments have opportunitiesthat we don’t have,” Mr. McCaul says. “As we grow, we’ll continue to have more opportunities for different asset classes.”

Long-Term Effects

Some investment experts believe that hedge-fund returns are likely to disappoint investors over the long term, citing the funds’ high fees.

A typical compensation arrangement is “2 and 20,” where a manager earns 2 percent of assets each year, plus 20 percent of the return. Warren E. Buffett, the renowned philanthropist who runs the investment conglomerate Berkshire Hathaway, wrote in this year’s letter to shareholders that such fees are “grotesque” and would reduce a gross return of 10 percent by more than a third.

Another concern is that with the proliferation of hedge funds — thousands of hedge funds now manage a collective $1.6-trillion, according to Hedge Fund Research, which tracks the industry — the strategies used by the funds to produce returns may become less effective.

Even the best hedge funds may lose some luster among endowment managers if a proposal being considered by the leaders of the U.S. Senate Finance Committee becomes law.

Hedge-fund returns are taxable even to nonprofit endowments if the funds use debt to amplify returns. To avoid paying, many large endowments invest in hedge funds that are organized in offshore tax havens, like the Cayman Islands. This month, members of the Senate Finance Committee told reporters that they are considering introducing legislation that would make offshore investments in debt-financed hedge funds taxable.

Among the 80 endowments in The Chronicle’s survey with $1-billion or more in assets — mostly private foundations and college endowments — a median of 18 percent of assets were invested in hedge funds, though it is unclear how much was invested offshore. A 2005 study published in Tax Notes Today found that 75 percent of Duke University’s hedge-fund holdings were in offshore corporations.

Richard E. Anderson, a consultant at Hammond Associates, in St. Louis, which provides investing advice to roughly 60 college and university endowments, says the Internal Revenue Service has issued numerous letter rulings sanctioning the use of the offshore accounts to avoid taxation on hedge-fund investments.

The proposal to make offshore hedge-fund returns taxable is part of a broader set of changes being considered as a way to raise federal revenue, but no legislation has yet been introduced.

This month, the House Financial Services Committee held a hearing about whether private-equity funds should be subject to greater regulation and taxation.

Douglas Lowenstein, president of the Private Equity Council, a Washington association, testified that investments made by pension funds, foundations, and university endowments in private-equity funds benefit “tens of millions of Americans” by allowing those entities to earn better returns than they could get from the stock market.

The proposed changes to hedge fund and private-equity funds could lead to cuts in the portion of endowments allocated to such categories, investment experts say.

“We don’t know what the new Congress is going to do,” Mr. Anderson says. “The Democrats have a variety of opportunities to create mischief, especially if the part of the party with a populist bent holds sway.”

Weighing Risks

James Burns, an investment manager in Melville, N.Y., whose company directly handles about $70-million for several small nonprofit endowments, believes that most charities should think twice before wading into alternative investments, including hedge funds.

While the returns may look attractive, some of the strategies used to generate returns — such as buying commodities or shorting stocks (betting that they will lose value) — may subject the endowment to more risk than its board members or executives realize they are assuming. Mr. Burns fears that in a market downturn charity leaders might make a hasty decision to reduce risk, which could compound losses.

“What would they do if something was on fire in the portfolio?” he asks. “I’m afraid there would be a knee-jerk reaction rather than a well thought-out decision.”

That’s why some endowment are taking a methodical approach to adding new types of investments.

The Ludwig Institute for Cancer Research, in New York, which earned 15 percent on its $1.29-billion endowment in 2006, has been investing in hedge funds since the late 1990s, and they now make up nearly 31 percent of its assets. Xing Chen, the institute’s chief investment officer, calls the institute’s lack of investments in private equity “a relative weakness.”

But he adds: “I don’t want to chase returns and get in at the wrong time.”