Recent data shows that the aggregate investment loses at college endowments have been at least $94.5 billion (see WSJ article) from the five month period between July 1 and November 30 of 2008.

Source: Wall Street Journal
The loses have resulted in an average 23 percent decline - less than the 29 percent loss by the S&P 500 during the same five month period. Losses from illiquid investments, such as real estate and private equity, are not included in the reported numbers. Such losses are causing many schools to consider spending cuts, and may force some to increase endowment spending rates. On average, college endowments spend 4.6 percent, but this figure could rise to 6 percent, higher than the minimum 5 percent annual payments required of private foundations.

There have been a number of stories over the last few years of academic endowments moving into alternative investments, in particular hedge funds, private equity, real estate, and natural resources, such as timber. While many of these funds have been hurt during the recent downturn, many still found their portfolios falling less than the general market (see previous posts here and here). While losing "only" 20 percent is not as bad as 30-40 percent (although many with budgets getting cut would disagree with losing any money), other consequences of the move into alternative investments are often overlooked, including the valuation of such assets, funding commitments, and issues with liquidity.

A recent WSJ article highlights some of these difficulties. For one, hedge funds often have lock-up periods, keeping endowments in these investments at a time when shrinking budgets and donations are calling out for liquidity (see previous post here). In the case of private equity, the consequences of liquidity risk are even worse since not only is your investment "tied-up," but as a result of previous funding agreements, new capital calls may force you to commit another 50-75 percent of your initial investment, once again at a time when liquidity is tight and budgets are shrinking. While such need for liquidity is challenging for any fund, it is even more difficult for a fund that has decreased equity exposure to the 10-20 percent range, or lower, and has nearly all but eliminated interest bearing fixed income from the portfolio.

As with any shock to the system, strategies will be re-evaluated, and changes will be made. Unfortunately, for many academic institutions this will involve not only changes to the composition of their endowment portfolios, but also an evaluation of their capital improvements, expansion plans, operating budgets, and financial aid for students.

The UNC Chapel Hill Board of Trustees announced that their endowment lost about $320 million (see Charlotte Observer article). A big loss indeed, but when you consider that the endowment is currently worth about $2.5 billion, the approximately 13 percent loss is not too bad when compared to the broader market - albeit some funds are more conservative and are geared towards protecting the capital at all cost (something worth considering once again for everyone). On the other hand, the fund appears to have underperformed other endowments - the top 30 university endowments (each over $1 billion in AUM) have lost on average about 9.8 percent. Then again, "just down 10-13 percent" is usually followed by "we need to cut spending and raise tuition," which is not what anyone wants to hear or say right now. Just ask students, faculty, and of course, parents.

The success of the Yale and Harvard Endowments has cause many to consider trying to mimic their asset allocation models (see article, and previous posts here and here). Unfortunately, this offers a few problems. For one, small investors do not have as easy access to alternative investment, whether it be private equity, hedge funds, venture capital funds, or certain types of real estate. Even those that do find that performance suffers when funds that were suppose to be hedged were not. Furthermore, many of the alternative asset classes turn out to be more correlated than expected, especially during market sell-offs.

Studies are also showing that adding the diversification of alternatives to your portfolio may turn out to not reduce volatility in ways normally expected. Morgan Stanley examined the risk and return characteristics of a hypothetical endowment model portfolio that had 40 percent allocation to alternative investments. While the portfolio outperformed a traditional portfolio allocating 60 percent equities / 40 percent for bonds, it did not materially reduce volatility. The performance of US equities alone explained 94 percent of the return.

Another problem is that private investors do not have the same tax advantages of endowments, many of which have access to top-tier funds and other tax-exempt groups. In some cases, seeking an pre-tax return of 10 percent would require an average hedge fund to return 14.5 percent in order to overcome the fees. For a fund of funds, the return is even higher, at 17.1 percent due to the extra layer of fees.

Those of us in the academic world often hear the common retrain from our industry colleagues, "Well, that just the academic theory. Things are different in the real world." At least for mimicking endowment funds, the refrain may ring true.

The Swiss funds-of-funds firm Gottex Fund Management is launching a new fund that will emulate the investments and strategies of some of the larger U.S. academic endowment funds, such as those at Harvard and Princeton (see the HedgeFund.net article). The new Gottex fund will also allocate around 65% of the fund to alternative investments. Why 65%? When preparing the fund, the Gottex group found that a 65% exposure to alternative investments, when combined with traditional investments, did the best over the long-term. No indication if that means risk-adjusted or not. As for the alternative investments, everything from hedge funds, private equity, long-only equity, commodities, fixed income, real estate, and other real assets will be utilized. Given the current environment, the timing could prove advantageous. As mentioned by fund manager William Landes, "For the short-term the challenging environment for alternative products like private equity and hedge funds was where the opportunities lie. If I put my investor hat on, I would say that if I have a six to nine-month tactical horizon, global equity markets and some alternative markets are actually where I want to be.” Given the move by many academic endowments towards greater exposure to real assets, commodities, private equity, and international equities, any new fund emulating the likes of the Harvard fund may offer no other choice.