November 4, 1998

Endowments Hedging Their Bets:
Is This How You Want Your Donations Invested?

by Louis Corrigan (TMF Seymor)

The near collapse of troubled hedge fund Long-Term Capital Management (LTCM) has attracted widespread attention. Yet most investors would seem to have been little affected by this debacle aside from the temporary uncertainly it injected into world markets. After all, hedge funds only accept money from institutions and from individuals with a net worth exceeding $1 million. Happily or not, that excludes most of us. If folks like Merrill Lynch (NYSE: MER) CEO David Komansky want to "invest" part of their personal fortunes in such high-risk ventures, that's their business.

On the other hand, there's a potentially quite troubling story hidden beneath the surface of LTCM's near demise. The institutions stuck in the middle of the recent hedge fund squeeze include endowment funds for universities and other non-profit organizations. These endowments get a fair amount of their investment capital from people like you and me, and they're supposed to be in the business of doing good works. If they're so willing to gamble our donations on emerging market debt, a backlash may be around the corner.

Although donating money to a university, for example, is commendable, few of us bother to demand real accountability in how our money gets invested before it gets spent. That could be a serious mistake. You may do better by your alma mater if you hold off on that next check until you're convinced the managers of its endowment fund have had a proper Foolish investment education.

Putting together a complete list of affected endowment funds is pretty much impossible given that few institutions want to own up to the pain caused by the recent hedge fund blow-ups. Few who advise endowments in their selection of hedge funds seem willing to give specifics either. Still, some names have begun to trickle out. Last week, the Wall Street Journal reported that the endowment fund for Yeshiva University and its Albert Einstein medical school in New York still had $5 million invested in LTCM even after the fund had returned $13 million of the endowment's money last year. Most of that $5 million is probably gone for good.

Of course, many institutions have been hurt as numerous hedge funds have taken hits on their high-risk investments. Last week's Journal article also noted, for instance, that the $2 billion endowment of the Mass. General and Brigham & Women's hospital lost nearly all of its $20 million investment in Russian bonds. Ironically, famed Fidelity Magellan stockpicker Peter Lynch, a champion of plain vanilla buying-what-you-know equity investing, sits on the hospital's investment committee. He must have been outvoted. (I'll ask Lily Tomlin next time I see her.)

No doubt some endowments have enjoyed market-beating long-term results from their hedge fund investments even after discounting the recent troubles. Nonetheless, it's worth asking whether the trustees on these institutions' advisory committees are really exercising proper fiduciary responsibility. After all, it's unlikely that many of the people donating money to fund scholarships, library acquisitions, new construction projects, or faculty enrichment programs have any idea that their money is being temporarily funneled into speculative trades on Russian debt or arbitrage gambles on the relationship between the Japanese yen and the U.S. dollar. Responsible stewardship of endowment dollars involves some reasonable risk-taking, but many hedge fund investments cross that line.

It's not just that these funds select high-risk investments that many donors would consider imprudent and inappropriate for their own portfolios. Most hedge funds also increase their risks by leveraging their assets via margin loans from banks and brokerage firms. While few if any have ever carried the extraordinary leverage that LTCM managed (some reports put the ratio at 50 to 1), it's certainly not unusual for a hedge fund to borrow 40 cents on the dollar, as Everest Capital Ltd. did. Though Fools can debate how much margin is too much, little or none seems preferable, with 40% being way beyond acceptable.

I mention Everest because it offers even more reasons for concern despite the fact that it has received little media attention outside of the Journal's reporting. Consider that by early September, Everest Capital's two hedge funds had lost $1.3 billion of the $2.7 billion under management at the beginning of the year, according to an October 2 article in the Journal. The Everest Capital Frontier Fund, which is focused on emerging markets, was down a stunning 68% for the year.

Institutions feeling the pain include the endowment funds of Yale University in New Haven, Connecticut; Brown University in Providence, Rhode Island; Emory University in Atlanta, Georgia; and the University of Iowa in Iowa City. Cambridge Associates, a Boston-based investment advisor to endowments, reportedly steered $100 million into Everest. So these endowments could have lost $48 million from their Everest investments alone. How many scholarships would that cover?

Alan Swanson, VP of communications and administration for the University of Iowa Foundation told the Chronicle for Higher Education that the foundation had lost just $4.6 million from Everest, or less than 1% of the endowment's $558 million market value. Iowa is the only school endowment to offer specifics on its Everest losses.

However, Donald J. Reaves, executive VP and CFO for Brown, which has an endowment of over $1 billion, told the Chronicle, "When you're investing in an endowment, you're in for the long haul. You're not going to panic." Reaves said that Brown had been invested in Everest for the last two years. For most of that period, Everest had delivered outstanding results. The Frontier Fund, for example, was launched in 1995 and returned 43% that year, 70% in 1996, and 50% in 1997.

With that, however, the fund had peaked. The losses this year undermine this otherwise terrific track record. Consider that $1 million invested in the fund at its inception would now be worth just $1.17 million based on the Journal's numbers. That amounts to a 4.2% compound annual growth rate. The same amount invested in an S&P 500 index at the beginning of 1995 would now be worth more than $2.55 million thanks to a 27.7% compound annual growth rate, excluding this year's dividend reinvestments. While the fund's short-term performance no doubt offered a rush, Brown University would have done better if it had kept away from this hedge fund's dangerously thin air.

Continue to Part II
Hedge Funds Produce Mixed Results