Big Risk On Campus

Hot portfolios at Harvard and Yale have smaller colleges moving aggressively into hedge funds. They may be putting their endowments in jeopardy

When the multi-billion dollar endowments at Harvard and Yale reported stellar returns during the bear market, endowment managers at other colleges took notice. Harvard and Yale didn't get there by investing in boring stock index funds. Instead they did it by putting sizable chunks of their portfolios into hedge funds, the pricey, lightly regulated, and highly secretive investment pools that cater to big institutions and wealthy individual investors. As of June 30, 2005, the most recent date for which data are available, Harvard and Yale had 12% and 25% of their respective endowments earmarked for these alternative investments.

For better or worse, that success has encouraged many of the nation's biggest schools to follow the Ivies into the hedges. "In the endowment world, there is a follow-the-leader mentality," says Mike Scotto, director of alternatives research at Hewitt Associates Inc. (HEW ), an advisory firm. Schools with endowments of $1 billion or more had an average of 21.7% in hedge funds in 2005, according to the National Association of College & University Business Officers (NACUBO).

But some of the most aggressive hedge fund investors, it turns out, are the littler guys. According to a BusinessWeek analysis of data from nonprofit NACUBO, a dozen endowments had more than 40% of their portfolios in these higher-risk investments as of June 30, 2005 (table). They include the College of Wooster in Wooster, Ohio, at 82.4% and Yeshiva University in New York City at 65.3%. "We very much all envy the success of Harvard and Yale's endowments," says Bob Walton, vice-president for finance and business at the College of Wooster. "When you look at how they achieve their returns, a lot of it has come through alternative investments like hedge funds."


The big endowments have been dealing with hedge funds for years. But most smaller ones have less experience in this exotic corner of the investing world, where traders jump in and out of investments at dizzying speeds, and where information is spotty. "A lot of [small] endowments don't have the necessary head count to watch what this or that hedge fund is doing," says Jud Koss, a managing director at Commonfund, which advises endowments and other nonprofits on investments. Whereas Harvard's endowment boasts a staff of about 150, smaller ones generally employ two or three. Many hire outside consultants to help them select or monitor investments, but that's no guarantee of adequate oversight, Koss says.

More than 8,800 hedge funds operate in the U.S., using every trading strategy known to man in every imaginable asset class. Endowment managers with big hedge fund stakes say they try to steer clear of funds that use lots of leverage, or borrowed money, to juice returns -- a tactic that can magnify losses when bets go wrong. But even so-called market-neutral funds, which are designed to produce steady returns every year, expose investors to risks. Like all hedge funds, they impose limits on when investors can cash out. And many disclose to shareholders what they're buying and selling only in general terms, so assessing actual risk can be tough. Over the years there have been several high-profile hedge-fund failures, notably Long Term Capital Management in 1998. "We would never advise our clients to be so heavily invested in hedge funds, or in any other particular asset class," says Koss.

Some donors have concerns. Alan Maites, a State University of New York at Stony Brook alum, is no stranger to finance: He runs a mergers-and-acquisitions consulting firm in Chicago. Maites doesn't like the fact that some two-thirds of his alma mater's endowment is invested in hedge funds. "It's absolutely a red flag," he says. "Why are they so concentrated [in hedge funds] instead of having a more evenly allocated base?" Karol Kain Gray, associate vice-president for finance at Stony Brook, says the endowment has constructed a diverse and conservative portfolio of hedge funds that has earned 8.8% a year since 1999 with no down years.

It's difficult to argue with the numbers. For the year that ended June 30, 2005, the dozen colleges with the most exposure to hedge funds earned from 6.7% to 15.6%, according to a BusinessWeek analysis of NACUBO data. All but one beat the Standard & Poor's 500-stock index, which returned 7.4%.

Hedge funds are so named because they're free to hedge their bets using futures, options, and other derivative instruments, and by short selling, or betting that a security's price will fall. Such trades performed well during the bear market. Whereas a conventional portfolio of 60% in U.S. stocks and 40% in U.S. bonds declined by 9.9% from 2000 to 2002, the Hennessee Hedge Fund Index rose 9.6%.

Most endowments say they're attracted to hedge funds not because they expect gangbuster performance but because the funds can deliver consistent returns. With bond yields low and the stock market erratic, endowments have had to look elsewhere for reliable returns, says Peter Polinak, vice-president for finance at Hobart & William Smith Colleges of Geneva, N.Y.

But the heavy reliance on hedge funds raises concerns that smaller institutions are moving into these investments just as performance may be peaking. Hedge funds create trading strategies that exploit anomalies and inefficiencies in the markets. When they see a strategy that works, other funds copy it -- until the anomaly is gone. The more hedge funds there are, the faster opportunities can dry up.

Then there are the expenses. A growing body of research questions whether the typical hedge fund adds enough value to justify its fees of 1% to 2% of assets under management, plus 20% or so of the profits, far higher than most mutual fund fees. According to research by Richard Ennis, principal at Chicago-based Ennis Knupp + Associates, an adviser to institutional investors and wealthy families, 60% to 70% of the average hedge fund's returns from 1994 to 2002 can be explained by market movements, rather than by a manager's investment-picking skills. "Why would you want to spend that much for market exposure?" asks Barton Waring, a managing director at Barclays Global Investors in San Francisco.

Some endowments that have plowed into hedge funds are reconsidering. Oberlin College in Oberlin, Ohio, is one of them. "Hedge funds tend not to fully disclose their holdings, which exposes [investors] to some risk," says Ron Watts, the college's vice-president for finance. "That can make it challenging for us to fulfill our fiduciary responsibility." On Apr. 1, Oberlin hired a consultant to review its policies. "We're looking at reallocating money to areas we believe will be the future outperformers," says chief investment officer Marcia Miller.

Still, the overall trend is toward more exposure, not less. Reed College in Portland, Ore., now has 58% of its endowment in hedge funds, up from 43.7% in June. Hobart and William Smith Colleges is at 54.7%, up from 51.6% in June. According to a recent report by consultancy Greenwich Associates, just 3% of endowments and pension funds that invest in hedge funds say they plan to reduce their exposure significantly over the next three years, while more than one-third expect to significantly increase it. As long as the stock market remains erratic, that trend is likely to continue.

By Anne Tergesen, with Roben Farzad in New York

— With assistance by Roben Farzad

    Before it's here, it's on the Bloomberg Terminal.