Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Not everyone is down on hedge funds. While institutional investors nationwide are trimming them from their portfolios, the world’s biggest academic endowment will soon allocate billions of dollars to the beleaguered sector.

A new era is underway at Harvard University’s endowment. Nirmal P. Narvekar -- formerly the chief executive of Columbia University’s endowment -- recently took the helm at Harvard, and big changes are afoot.

Harvard, like many of its peers, is widely associated with the so-called endowment model of investing, which calls for a sizable allocation to hedge funds. According to the Harvard Management Company, which oversees the $35.7 billion endowment, 14 percent of Harvard’s portfolio was allocated to hedge fund strategies last year.

The Harvard Way
Harvard's asset allocation calls for a sizable investment in hedge funds
Source: Harvard Management Company
Note: Harvard's strategic asset allocation as of fiscal year ended June 2016.

Except Harvard added its own twist to the endowment model. While peers like Yale and Columbia scoured the country for the best hedge funds, Harvard managed its hedge fund strategies internally.  

It’s easy to see why. Harvard has roughly $5 billion invested in hedge fund strategies. A typical management fee of 2 percent translates into $100 million in fees every year. Not to mention that hedge funds also keep a portion of the profits. Surely, Harvard must have reasoned,  it could do better by running its own hedge fund strategies.   

But it didn’t turn out that way, and Harvard fell behind its peers that stuck to the original endowment model playbook. Harvard trailed both archrival Yale and the portfolio that Narvekar oversaw at Columbia by 2.4 percent annually over the last 10 years through the fiscal year ended June 2016.  

Falling Behind
Harvard's strategy of managing hedge funds internally has been costly
Source: Bloomberg
Note: Annualized returns as of fiscal year ended June 2016.

Narvekar now plans to eliminate Harvard’s internally run hedge fund strategies by the end of fiscal year 2017 and replace them with outside managers. Harvard’s move comes when many institutional investors are asking if there’s any magic left in hedge funds.

The world is different today than it was for hedge fund investors a decade ago. According to HFR, $1.5 trillion was invested in hedge funds at the end of 2006. Despite outflows of $70 billion from hedge funds last year, more than $3 trillion remains invested in hedge funds.

And it's no secret that hedge funds’ popularity has crushed returns. The HFRI Fund Weighted Composite Index -- an equal-weighted index of hedge funds -- returned 14 percent annually from 1990 to 2006 (the earliest year for which returns are available). But since then the HFRI index has returned just 3.4 percent annually through 2016.

Mo' Money
The swell of assets chasing hedge fund strategies has been too much for the industry to bear
Source: Bloomberg

It’s nearly impossible to generate market-beating returns with $3 trillion. If you doubt it, ask hedge fund firm Renaissance Technologies. Its Medallion Fund returned 39 percent annually from 1988 to 2016. But to keep the money machine going, Renaissance caps the fund’s capacity at $10 billion by turning away outside money and returning profits to investors every year. Meanwhile, when HFR began tracking hedge fund assets in 1990, there was already $39 billion invested in hedge funds.   

Still, I wouldn’t count Harvard out. Buried in the HFRI averages is a huge disparity in returns between the best hedge fund managers and everybody else. Despite hedge funds’ woes over the last decade, the top decile of funds in the HFRI index returned 41.4 percent annually from 2007 to 2015 (the latest year for which returns are available), compared with 3.1 percent annually for the index and a negative 26.1 percent annually for the bottom decile.

Granted, finding the best-performing hedge funds in advance is notoriously difficult. But Harvard will have access to any hedge fund manager it wants, subject to capacity -- an advantage that few investors enjoy. That advantage no doubt fueled Narvekar’s returns at Columbia, and he will now attempt to exploit it at Harvard.

Hedge funds need a vote of confidence, and it looks as if they’ll get it from one of the world’s most prestigious institutions.  

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net