Universities are struggling to make ends meet, just as everyone else is. In fact, the lingering economic malaise has been a triple whammy for them especially for American institutions, which relymore on private financing sources than those of other countries. In the United States, students, parents and alumni have given about as much as they can afford. The same goes for state governments,many of which are burdened by deficits. And endowment funds, operating in one of the worst bear markets for stocks in the past century, have struggled to break even. The investment funds of 654endowments lost 6 percent in the 2002 fiscal year, which ended in June 2002, after a 3.6 percent loss a year earlier, according to a study by the National Association of College and UniversityBusiness Officers. The 2001 loss was the first since 1984, and the back-to-back losses are the first since the association began this annual survey in 1971. Against such a backdrop, many endowmentshave been trying to increase returns by committing large sums to alternative assets like hedge funds, commodities and real estate. The appeal of such investments, in particular hedge funds, is thatreturns tend not to be correlated with those of mainstream assets like stocks and bonds. That strategy would cushion the blow of a bear market. More than that at least according to an academicconstruct called modern portfolio theory a fund that is invested in several types of assets whose returns are only loosely correlated will experience higher returns for an equivalent amount of riskthan a less diversified portfolio. The proportion devoted by endowments to alternative assets nearly doubled in the four years through June 2002, to 7.5 percent from 4.1 percent, according to thebusiness officers association. Hedge funds were 5.1 percent of total assets in 2002, compared with 2.8 percent in 1998. Vanderbilt University has used alternatives since the 1970’s and allocates justunder half of its $2 billion endowment to them, including nearly 30 percent in hedging and arbitrage strategies. As a result, the endowment has gained 8 percent annually over the past five years.William Spitz, vice chancellor for investments at Vanderbilt, in Nashville, Tennessee, marveled at the fact that so many other universities had embraced alternatives recently.
If you look at some U.S. institutions, they’re much more heavily exposed to hedge funds than we are, Spitz said. Vanderbilt’s portfolio is pretty typical, he said, adding that the rest of the endowments have moved fairly heavily and rapidly into alternative investments. Their presence in the portfolios of private universities like Vanderbilt and, especially, the Ivy League is nothing new, said John Griswold, executive director of the Commonfund Institute, an organization that creates portfolios for nonprofit groups in which assets are disbursed among many managers with complementary investment styles.
In cases like Harvard, Yale, Princeton and Stanford the marquee names they have been doing this for many years, Griswold said. They had trustees and directors who were familiar with these investment strategies.
Yale’s endowment recorded an annualized return in the decade through June 2002 of 16.9 percent, a performance that ranks in the top 1 percent of universities. In its latest annual financial report, Yale, which is in New Haven, Connecticut, attributed its success in large part to its investment in alternative assets, which comprise about 60 percent of its $10.4 billion portfolio Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management, the report said. Managers of state university funds have been increasing their exposure to alternatives, thanks to the poor returns available from stocks since the technology bubble popped and to the need to extract as much money as possible from endowments when other funding is scarce.
There is some pressure to spend more, even in a down market, because you don’t want volatility in the operating budget, Griswold said. It is hard to plan a budget and fund activities when income is uncertain.
Although state universities have been slower to adopt alternative investment, he said, the largest ones that have significant monies have been coming into it rapidly.
They have been the most aggressive and fastest-growing endowments, Griswold said. They see the need for private money to tide them over and give them some degree of financial independence from state legislatures.
Among the state universities that he said had committed substantial amounts to alternatives are those of Virginia, Michigan and North Carolina.
Virtually all of the big ones are looking at it, if they haven’t gone into it already, Griswold said. North Carolina has gone into alternatives to the exclusion of almost all else. Only 20 percent of its more than $1 billion endowment is invested in conventional stock and bond portfolios. The rest is spread among real estate, commodities, shares of companies not listed on stock exchanges, and several hedging strategies in which one type of asset is bought and a related type is sold short essentially a bet that its price will decline. A common approach is to buy stocks believed to be undervalued and sell others, often in the same industry or country, that are deemed overvalued. Such arbitrage strategies can be safer than ordinary investment portfolios because they do not depend on the markets’ going in the right direction. If done properly, they can make money in up or down markets and avoid the swings that occur with shifts in sentiment and the economy.
We would argue that our portfolio is more conservative than others because we’re in alternatives, said Mark Yusko, chief investment officer at the University of North Carolina. It has certainly been more successful. In the past five years, roughly the time that Yusko has been at Chapel Hill since he was hired from the University of Notre Dame to make a big shift into alternatives, the fund has gained 6.1 percent a year, compared with 1.5 percent for the typical balanced stock and bond portfolio. That ranks among the top 25 percent of endowment funds; North Carolina was previously in the bottom 25 percent. Yusko credited the turnaround to the endowment fund’s greater diversification, as well as to the fact that the best money managers have set up shop in hedge funds.
We follow talent, he said. The talent has left the traditional world for the alternative world. There has been a tremendous brain drain in the last five years. We would rather be with smart managers, even if they are not using traditional strategies.
Other universities may not have gone as far as the board at North Carolina on alternatives. Still, they make up substantial portions of the largest endowments, 27.7 percent on average, of those with more than $1 billion of assets. By contrast, endowments of less than $25 million were only 3.6 percent invested in alternatives, reflecting the fact that minimum investments in hedge funds can be in the millions. It is unclear whether endowments have truly been won over to alternative investments or were just fleeing a sinking stock market. A Commonfund preliminary survey of activity in the 2003 fiscal year found a decrease in investment in alternatives to 11 percent of assets from 15 percent a year earlier.
It’s probably the rebound in stock markets rather than any active asset allocation, said Griswold, the Commonfund executive director. Alternatives seemed to pick up a lot of the slack as people got out of the stock market and diversified their portfolios. Now money is flowing back into stocks; that naturally squeezes other assets unless there is comparable performance, he added. Yusko, of the University of North Carolina, said he believed that the move into alternative investments was completely secular and that as people come to understand the risk-reduction tools available through arbitrage strategies, they will continue to be embraced.
He added: One hundred years ago, no one owned equities; 50 years ago, no one owned real estate; 20 years ago, no one owned high- yield bonds; and 10 years ago no one owned hedge funds. There has been a natural progression in the academic world and the real world.
* Conrad de Aenlle writes from London about investment and business topics. [Not to be reproduced without the permission of the author.]
