Hedge Funds go to College
Whatever their risk, hedge funds have assumed a more prominent role in the financial health of colleges, pension funds, and the wealthy in the past decade.
The appeal is clear: This year, the Credit Suisse/Tremont Hedge Fund Index was up 7.5 percent through August 30. By contrast, the S&P 500 stock index was up 1.6 percent over the same period.
Back in 1990, there were just 600 hedge funds, forming an insider’s club of Wall Street high-rollers who mostly ran money for wealthy families and individuals. As more institutional investors and endowments entered the market, once-secretive funds opened up a bit, with many voluntarily registering with the Securities and Exchange Commission and the Commodity Futures Trading Commission. Lonergan says that while these hedge funds often don’t reveal the full contents of their investment portfolios, as mutual funds are required to do, disclosure has improved and managers are more responsive to their investors’ concerns.
The flood of private and institutional money seeking better returns has swelled the ranks of the hedge fund industry. There are now at least 8,000 such funds, according to Hedge Fund Research, a Chicago consultancy. From the original long-short model, the range of strategies has multiplied at a dizzying pace. These days, funds profit on the minor price differences between different types of fixed-income derivatives; they bet on futures contracts; they seek out stocks in worldwide emerging markets; and they try to capitalize on price differences between regular stocks and convertible bonds. Some strategies—such as quantitative or black box trading models—are so complex they can only be devised by mathematicians.
The crowded, increasingly complex field is one reason why Reed’s investment committee, led by trustees James and Debs, is gradually reducing Reed’s hedge fund holdings and creating a diversified portfolio more akin to those of the largest private endowments, such as Harvard and Yale. The diversification, says James, is aimed at reducing the college’s exposure to poor returns in a single strategy or asset class, thus creating a lower-risk/higher-return profile for the endowment. Target areas for diversification include private equity, real estate, and energy-related investments.
But even as it diversifies, Reed is still heavily invested in hedge funds. Back in May, Business Week reported that 58 percent of the endowment was committed to investment vehicles that fit the broadest definition of the term. Lonergan says the current figure is 40 percent. Still, a recent survey by the National Association of College & University Business Officers found that, on average, 11.4 percent of assets at colleges with endowments of $100 million–$500 million were invested in hedge funds, putting Reed well above the norm.
As institutional money continues to flow into hedge funds and new funds are launched to chase it, managers find it ever harder to make profitable investments. Members of Reed’s investment committee say that makes an even stronger case for diversification.
So does the history of the stock market. Reed’s investments suffered with the rest when the tech bubble burst in 2000. The endowment plummeted from a high of $350 million in 2000, to a low of $290 million just two years later. But Reed’s hedge funds—mostly unadorned, Jones-model long-short funds—did their job under the worst possible market conditions. The endowment took an 18-percent hit that was, on balance, much less severe than the drops in major stock indexes. The NASDAQ Composite index shed 74 percent of its value between its March 2000 peak and the end of 2002; the S&P 500 was down 37 percent.
Reed’s investment committee is now working with Cliffwater, an advisory firm that helps colleges with asset class allocations, and manager selection and monitoring. James says the chief objective is to create a model that’s not so reliant on stocks—whether in hedge funds, conventional mutual funds, or individual equities. And in the absence of more oversight of hedge funds by securities regulators, one of the keys to successful management of the college’s hedge fund investments is to have a detailed understanding of the manager and his or her strategy, so Reed trustees and Cliffwater meet with all managers on a regular basis to monitor style drift and risk levels at each fund.
James, a Reed math major who was a top executive in fixed income at Morgan Stanley before co-founding a $4 billion hedge fund firm, New York-based Old Lane Partners, says a deliberate, measured approach means diversification will take time. As the college refines its long-term asset allocation targets, changes to the portfolio will take as long as three years to complete.
But the stakes are clear, he says. “If we establish a successful process, financially it can help make Reed a permanent institution, and it won’t ever have to operate on a shoestring again.”