November 4, 1998

Endowments Hedging Their Bets
by Louis Corrigan (TMF Seymor)

Part II: Hedge Funds Produce Mixed Results

Similar stories probably abound, but they have only begun to be told. For example, the Journal also reported on October 13 that Harvard University's endowment fund lost 10% of its $13 billion endowment between the end of July and September 25. Given the market's overall decline, that's not so shocking. Still, some of those losses are believed to have come from a $500 million August investment in Boston-based hedge fun Highfields Capital Management LP. Highfields managed to lose 10% of its value during August alone. Since the university is in the middle of a long-term drive to raise $1.9 billion, the endowment's $1.3 billion loss has become a potentially thorny issue for Harvard.

And perhaps it should be. Harvard's model portfolio calls for only 47% of its assets to be invested in U.S. stocks and bonds. In practice, however, the endowment apparently takes an even more exotic approach that includes lots of arbitrage plays to take advantage of supposed pricing inefficiencies between related assets (a favorite practice of LTCM). While it had just $11.9 billion in assets on June 30, 1997, the endowment had $29 billion in long positions and $17 billion in short positions. Harvard isn't alone in its rush into such complex investment instruments. The Journal also reported that while Yale had 85% of its assets in U.S. stocks, bonds or cash ten years ago, today just 30% of its funds are devoted to these plain vanilla investments.

The allure of hedge funds is that they promise greater asset diversification (stocks, bonds, currencies, mortgage-backed securities, options, and so on) plus the flexibility of going long or short various instruments. All that is supposed to enhance results, in part because hedge funds offer the kinds of financial rewards that attract the smartest money managers. It's simply easy to get rich being a hedge fund manager. The funds usually charge 1% of fixed assets as an annual management fee plus 20% of profits each year. So fund managers can pull down stunning multimillion dollar incomes from managing a lot of money and delivering exceptional results.

There's no question that some of the world's best money managers run or have run hedge funds. George Soros, Julian Robertson, Jr., Michael Steinhardt, and current Soros fund manager Stanley Druckenmiller are among the legendary figures. And for good reason. Between 1969 and 1995, for example, Soros's Quantum Fund delivered a truly stunning 35% average annual return. Still, the talent pool seems to be getting more shallow. The number of hedge funds has tripled in the last six years so that there are now more than 3,000 funds doing business. About 95% of the current funds have been created in the last decade.

As Fortune reported in a June 8 article about this trend, one performance index shows that the average hedge fund delivered a 17% annual return net of fees between 1990 and 1997. That's a bit less than the 18% return of the S&P 500 over the same period. As a group, then, hedge funds have underperformed the market, just like the average mutual fund.

Nonetheless, some universities have enjoyed market-beating results from their investments in hedge funds despite recent turmoil. Denison University in Granville, Ohio appears to be one school that's gotten its money's worth. Seth Patton, VP for finance and management at Denison, told the Columbus Dispatch that the university has 28% of its $314 million endowment invested in five different hedge funds, including one of the grand-daddies of the business, Julian Robertson, Jr.'s Tiger fund. While Tiger recently lost $2 billion in one day betting that the Japanese yen would fall against the U.S. dollar, that amounted to just 9% of Tiger's assets.

Denison can probably handle its corresponding loss on Tiger since the fund delivered a 91% return for the year ending June 30. Indeed, Denison has boosted its hedge fund investments over the years due to strong results. Since 1991, its hedge fund investments returned 27.8% a year, handily beating the S&P, according to Patton.

Even so, such exposure to hedge funds is considered excessive by others. In a recent survey of leading Canadian schools, the Financial Post found that the University of Toronto's endowment (that nation's largest at $1 billion Canadian) has no money invested in hedge funds. In fact about 70% of the endowment is invested in stocks, with most in index funds linked to the S&P 500 or the Toronto Stock Exchange 300.

The endowment fund at the University of Western Ontario in London reportedly has 30% of its money in Canadian equities, 20% in foreign equities, and the rest in cash or fixed-income investments. Meanwhile, McGill University in Montreal has less than 10% of its more than $500 million (Canadian) endowment invested in hedge funds through the Common Fund, a not-for-profit investment company for universities. McGill officials insist, however, that these funds are managed more conservatively than was Everest Capital.

Continue to Part III
Proper Asset Allocation