The Lure of Alternative Investments

Database: How endowment investments fared at 210 nonprofit groups

Articles: All of the advice and commentary from this special supplement on endowments

Supplement in print: Order print copies of the Endowments supplements from August 2005 and May 2004

Nonprofit leaders face a major quandary as they make endowment investment decisions these days. Like many prominent investors, nonprofit endowment managers expect that, over the next decade, what was once a standard portfolio composition — 60 percent in stocks and 40 percent in bonds — will produce returns of just 6 percent to 8 percent annually. If inflation increases at 2 percent to 3 percent, as it has in recent years, such returns may not be enough to preserve the purchasing power of an endowment that spends 5 percent of its assets each year.

So endowment managers are taking a variety of approaches to try to get to the high end of that anticipated return, or do even better. Some are investing more of their assets in real estate, which has provided strong returns for several years. Others are decreasing their investments in bonds, which are expected to provide tepid returns in the next decade, given their low yields and anticipated rate increases by the Federal Reserve. Still others are adding to international investments, or switching from “value” stocks paying high dividends to “growth” stocks that rapidly increase their earnings.

But the most popular strategy is to increase exposure to alternative investments, including private equities (such as venture-capital funds and “buyout” funds that look to take over existing companies and improve their returns), timber, oil and gas, and — especially — hedge funds.

Ten percent of the assets in the 210 endowments in a survey by The Chronicle of Higher Education and The Chronicle of Philanthropy were invested in hedge funds. An annual survey of 317 foundations and operating charities by the Commonfund Institute, the educational arm of Commonfund, which manages $34-billion for nonprofit institutions, found that the proportion of endowment assets committed to hedge funds increased by 50 percent — from 6 percent to 9 percent — from 2003 to 2004.

The increasing interest in alternative investments — which sophisticated endowment managers, especially those at wealthy universities, have used for years — is also being fueled by the ugly endowment returns during the first three years of this decade. Many nonprofit endowment managers believe the best investors have migrated to hedge funds, where the goal is typically a return that exceeds the stock market, without the stomach-churning drops that the broad market occasionally endures.

In theory, hedge funds reduce the risk of a portfolio because they allow managers to sell stocks “short” — bet against them by borrowing them, selling them, and then rebuying them, hopefully at a lower price — as well as buy stocks that they expect will rise in value. While extremely risky in isolation (since losses aren’t capped if a stock continues to rise), shorting can allow a hedge fund to break even or earn a positive return even when the broad market falls sharply, and act as a stabilizing influence on the overall endowment.

But other investors, including some who oversee endowments that were among the top performers in the Chronicle survey, believe that the high fees associated with hedge funds, and the large amount of debt that many of them use to increase returns, will lead to a bad end for many of the organizations that are funneling money into them. And even those who support hedge funds and other alternative investments say they face another big problem: Too few opportunities are available for endowments that have millions and millions of dollars to invest.

Hedge funds, which are most likely to outperform when the market is dropping (thanks to their short positions), don’t deserve much credit for the zippy returns of 2003 and 2004, when traditional stock investments led the way. The Chronicle survey found solid returns for 210 of the nation’s biggest foundations, universities, and other nonprofit organizations for the second consecutive year in 2004. Organizations whose fiscal years ended in June earned a median of 15 percent on their investments, and organizations whose fiscal years ended in December earned 11.4 percent.

But during the past year, returns have been far less generous, a factor that may be sparking some of the interest in hedge funds. The Standard & Poor’s 500, an index of leading companies in the U.S. stock market, returned just 6.3 percent for the year ending in June.

Children’s Healthcare of Atlanta, which runs two nonprofit hospitals, added alternative investments to its $1.2-billion endowment for the first time just a year and a half ago, allocating 10 percent to hedge funds and another 10 percent to private-equity funds. In August, when its board meets, the charity is expected to again increase its allocation to alternative investments — from 20 percent to 25 percent or 30 percent of assets. “I was bringing the board members along in the early days — pushing them, and saying ‘trust me,’” says Al Gasiorek, who became the charity’s treasurer two and a half years ago. “Now we’re at the point where they’re saying, ‘Let’s go a little bit faster.’ ”

Although the endowment has yet to fully invest its funds set aside for alternative investments, Mr. Gasiorek hopes to see the private-equity funds beat the stock market by five percentage points per year, over the long term, and the hedge-fund money to earn a positive return every year that is five percentage points better than what a money-market fund provides.

Georgetown University, which has a $750-million endowment, plans to gradually raise its allocation to alternative investments, including hedge funds, to 50 percent, up from a current 25 percent. The College of the Holy Cross is considering doubling its allocation to alternative investments, to 40 percent, and it is looking for hedge-fund managers who can handle as much as 20 percent of the $480-million endowment.

The trend has been prompted in part by the impressive record that wealthy universities have assembled using hedge funds. Yale University, whose endowment manager, David Swensen, was one of the first to widely embrace alternative investments, earned 16.8 percent per year over the decade ending in June 2004 — six percentage points better than the S&P 500.

The endowments at Yale, Dartmouth College, and the University of Michigan all earned 18 percent or more — better than the 15 percent median gain shown by other institutions in the Chronicle survey whose fiscal years ended June 30, 2004. All three institutions have more than 20 percent of their assets in hedge funds, and more than 40 percent in alternative assets as a whole.

Some well-regarded endowment managers say the migration to hedge funds is still at an early stage, and that such funds may some day contain as much endowment and foundation wealth as do traditional stock investments. The Strategic Investment Group, an Arlington, Va., company that manages more than $9-billion, about 7 percent of which is owned by endowments and foundations, last year predicted that investments by endowments and foundations in hedge funds would triple — to 30 percent of assets — by 2023.

“There’s reason to think that might happen,” says John S. Griswold, executive director of the Commonfund Institute. “It’s just sort of logical. If you’re getting better returns out of that area, over time it’s going to grow.”

A skilled manager is vital to a hedge fund’s success. While a traditional manager, betting on stocks to go up, will probably earn a positive return even if his or her picks lag the market (given the market’s long-term rise), a hedge-fund manager has no such cushion. At the same time, however, the talented hedge-fund manager should theoretically earn a positive return even when equities plunge, which may help endowments hold on to enough assets during those challenging years to continue to comfortably make planned payouts.

“We are quite positive on hedge funds for the long term, because of the constant return that endowments and foundations are seeking,” says Jeffrey R. Chicoine, managing director of Mesirow Financial Advanced Strategies, a Chicago company that manages about $8-billion in hedge funds. (About a sixth of the assets are owned by endowments and foundations.) “If they’re going to pay out 5 or 6 percent a year, hedge funds are where they’ll get the return, particularly as fixed-income returns have gone away.”

But hedge funds borrow heavily to make big bets on their favored strategies, and when those bets go awry, hedge funds can implode. The most-famous hedge-fund collapse was Long-Term Capital Management, which took an approach devised by two Nobel Prize-winning economists, but still had to be bailed out in 1998 by the Federal Reserve when its massively leveraged bets went bad. The Art Institute of Chicago landed on the front page of The Wall Street Journal in 2002 when its investment in a hedge fund lost nearly all of its value.

Such risks are of greatest concern to small foundations and endowments that are jumping on the hedge-fund bandwagon. Many small foundations and endowments hire “fund of funds” managers, which band together money from multiple institutions to spread hedge-fund bets widely, sometimes with as many as 40 managers. But Mr. Griswold points out that some small foundations and charities seek to invest directly, and may only have enough money to go into two or three hedge funds.

“They’re taking much greater blow-up risk as a result,” he says.

Others argue that the biggest risk of hedge funds is that their very popularity will make their investment approach less successful. Average returns coupled with high fees will prove costly to endowments and foundations, these critics say.

The fees that endowments and other investors in hedge funds pay to managers vary, but a typical arrangement is 2 percent of assets plus 20 percent of the return generated by the fund. That is much higher than with “long only” stock managers (who buy only the stocks they think will rise), with whom endowments can negotiate fees that cost less than 1 percent of assets. Endowments can also buy unmanaged funds that track a broad index for less than a tenth of a percentage point.

The Philadelphia Museum of Art’s $232-million endowment earned 23.1 percent for the year ending June 30, 2004 — putting it in second place in the Chronicle survey — with an allocation of just 2 percent to hedge funds.

The museum’s investment committee seeks out managers who specialize in traditional investments, control fairly small amounts of money, and look for stocks that are undervalued, according to John A. Nyheim, the trustee who chairs the committee.

“It’s done the old-fashioned way,” Mr. Nyheim says. “The fees we pay are low, the risks we take are low, and the returns we make have been good over time.”

The museum’s hedge-fund allocation has recently drifted up to about 6 percent of the portfolio, even though Mr. Nyheim opposed the move. Hedge-fund managers make fortunes when their returns are high, but even if managers don’t outperform, their fees alone could eat up a quarter or more of an 8-percent return.

“In a world of lower investment returns, how will you make out by going for high-fee managers?” asks Mr. Nyheim, who worked for Wellington Management, an investment company, and owned his own investment firm before retiring. “It’s another way for Wall Street to rip off Main Street.”

Laurence B. Siegel, director of investment policy research at the Ford Foundation (which doesn’t invest in hedge funds, in part because of concerns about finding enough high-quality managers to take on a meaningful portion of its $10.5-billion endowment), says that if hedge-fund managers as a group are fully hedged against the stock market’s return, they lose the “cover” of the positive returns that the market earns over the long term. That means hedge funds may yield a negative real return half the time, he says, and their performance would be made worse by the high fees that hedge funds charge.

“Some larger institutions with sophisticated staffs may be able to win this zero-sum game,” he says, “but for every such winner there must be a loser.”

Yet many investment advisers believe that a skilled hedge-fund manager can consistently beat the market. Long-term studies of hedge-fund returns do show market-beating returns, but critics contend that the statistics are inaccurate, since the hedge funds that blow up or go out of business are often not included.

Hilda Ochoa-Brillembourg, president of the Strategic Investment Group, says endowments can succeed by using what investment experts call a “portable alpha” strategy. Alpha is a term that refers to the return added by managerial skill, rather than the movement of the market.

Using this approach, investors stick to the stock-market allocation called for in their plan by buying broad market investments via futures, but also make investments in a diverse range of hedge funds. If an endowment hires good hedge-fund managers, it would get the market’s return from the futures plus the “alpha” kicker provided by the managers.

“In theory, you can have your cake and eat it, too,” Ms. Ochoa-Brillembourg says.

Mr. Chicoine, of Mesirow Financial Advanced Strategies, has recommended a similar approach to some of his clients, but many have only recently obtained board approval to move into hedge funds, and they are leery of adopting a strategy that arguably adds even more risk. Portable alpha “is a cutting-edge thing,” Mr. Chicoine says. “We’ve had some clients express interest, but most candidates want to walk before they run.”

The trick, of course, is finding those hedge-fund managers who will outperform over the long term. Even endowment managers who are eager to get into hedge funds aren’t sanguine that the average manager — an estimated 8,000 hedge funds now exist — will add value over time.

“It’s really looking for a needle in a haystack,” says Lawrence E. Kochard, Georgetown’s chief investment officer, in describing his quest to invest more in hedge funds. “We think the average hedge fund will not do that well.”

Many other types of assets don’t look particularly attractive, either, endowment managers say. Bonds make up only 23 percent of endowment investments in this year’s Chronicle survey, down from 25 percent a year ago.

The University of Colorado Foundation, which has $600-million in its endowment, has sliced its bond exposure in half, to about 10 percent of its overall value. “Bonds have done really well,” says Christopher L. Bittman, the foundation’s chief investment officer. “But now I’d rather be at the bottom of my range.”

Real estate, which has been surging for years in certain urban markets, has been the biggest recent winner for the foundation. Its real-estate assets, which make up just 4 percent of the endowment, have grown 42.5 percent through the first nine months of the 2005 fiscal year. The only problem with the real-estate holdings, he jokes, is that they are “too small a part of the portfolio.”

The foundation is also seeking to increase its holdings in private equities, an asset class that has already proved successful for the organization and given it a stake in several privately held businesses. For the year ending March 31, those investments achieved a return of 24.5 percent, compared with the 6.7-percent return of Standard & Poor’s. One of the funds with which it invested, Charlesbank Capital Partners, of Boston, holds a major stake in a nearby dairy business, Aurora Organic Dairy.

The Boy Scouts of America has in the past few years committed 10 percent of its $275-million endowment to real estate, the first time the endowment has invested in real estate since the 1980s, when the real-estate market soured. For the year ending May 31, the real-estate holdings returned 31 percent.

Holy Cross, which posted an 18.5-percent return for the fiscal year ending June 30, 2004, sold about 10 percent of its holdings in real-estate investment trusts after those publicly traded investments surged at the end of last year. The college is now looking to redeploy most of those funds with privately held real-estate funds. William R. Durgin, the college’s treasurer and chief investment officer, says speculation about a real-estate bubble hasn’t scared him away from such investments, since high-quality managers will continue to do well. “All real estate is not created equal,” he says.

Private equity has been a mixed bag for nonprofit endowment managers in recent years. In 1999 Holy Cross allocated 10 percent to 20 percent of its endowment to private equity, but it has been able to invest only about 6 percent in such equities. Buyout funds have raised significant capital in recent years, but many of them have had a hard time finding investment opportunities. Some of the managers to which Holy Cross has committed capital have yet to use the college’s funds.

Williams College, meanwhile, made large private-equity investments in the late 1990s, helping to fuel a 52-percent return in the 2000 fiscal year. (Its 2004 return was a better-than-average 17 percent.) When the private-equity funds paid off, Williams had money to reinvest. “We’re re-upping with existing firms” and looking for new managers, says Helen T. Ouellette, the college’s treasurer.

Where’s the excess money going in the interim? Hedge funds.

Goldie Blumenstyk contributed to this article.

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Section: Endowments
Volume 17, Issue 20, Page B1