Even though on average hedge funds had a down year last year, they still outperformed the broader market and many other asset classes. As a result of this out-performance, the money allocated to hedge funds had become one of the larger positions within many investment portfolios, causing portfolio managers with defined asset weighting to reduced exposure to their hedge fund investments in order to get portfolio allocations back in-line. Now, as a result of broader market and other asset classes rallying over the last few months, the allocation to hedge funds is smaller than required, reducing redemption requests which began increasing last fall (see the NY Times article). With fewer redemption requests, hedge funds can quit hording cash (in anticipation of new withdraws), and instead start putting capital to work in the market. As mentioned by the authors of the NY Times article, given their high fees, new regulations, and negative press, it may take some time before new money makes it way into hedge funds at the same pace managers saw just a few years ago. Nonetheless, the reduced selling alone could be enough to start increasing returns and attracting new interest among investors. This alone could be good for all investors, regardless of their individual exposure to hedge funds and other alternative investments.

Just as the media and regulators continue to discuss the use of alternative investments and the active trading of hedge funds in contributing to the downfall of the economy and the stock market, many private investors are seeing each as a way to help protect themselves from recent market uncertainty (see New York Times article). While a more conservative trading mentality has been the norm for high net worth investors, many are now questioning its usefulness in the current market environment. Many investors who in the past have relied on a simple mix of stocks, bonds, and cash, and now turning to managed futures, financial futures, hedge funds, funds-of-funds, mutual hedge funds, currencies, commodities, and other avenues for gaining exposure to alternative investments.

Maybe even more interesting is how these same investors are becoming aggressive in moving away from a strict buy-and-hold approach, and instead are looking to take advantage of short-term trading opportunities - a move that indicates in part that such investors are not only opportunistic, but also worried about placing longer-term bets on the markets. As mentioned by Paul Speargas, senior client at WMS Partners:

“The buy-and-hold strategy, which was almost universally accepted by the investment and academic community over the past several decades, is no longer the sole investment strategy to be employed in order to deliver solid investment returns. A thoughtful balance between long-term investing and short-to-intermediate term trades is likely the recipe for investment success in the volatile years ahead.”

Given the interest by clients to still utilize hedge funds, commodities, futures, and alternative investments, not to mention the desire of the Fed and Treasury to have investors step-up and provide capital to purchase distressed assets, it might be good to pause and reflect before slapping or over-regulating the trading hands that are still willing to check the temperature of the investment waters.

Per a recent SEC filing, and as reported in a WSJ article, the Harvard University Endowment appears to have cuts its holdings of public stock by about two-thirds. This is two-thirds of a position that has already been lowered over the years as a result of an increased exposure to alternative investments. About 70 stocks and publicly traded funds were recently valued at less than $600 million within a fund that was valued in total at nearly $37 billion last June - before losing a reported 30 percent of its value. While it appears that Harvard may have sold some of these assets near the bottom, they may have had little choice given that a significant portion of their portfolio is either managed by external managers and/or is illiquid, such as timber, real estate, and private equity investments (which in some cases could have additional funding obligations) - see a previous post that discusses potential liquidity risk issues at Harvard.

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.

Recently it was reported that the Harvard Endowment had fallen at least 22 percent and was on its way to possibly a 30 percent loss once alternative investments are considered (see previous blog post). Now, the WSJ is reporting that the Yale Endowment has fallen 25 percent since the end of June when the endowment was valued at $10.1 billion (see WSJ article). Of interest is how marketable securities in the endowment "only" fell 13 percent, giving Yale a problem similar to Harvard - decreasing alternative investments, such as real estate and private equity, have caused the overall losses to be more severe than expected. As with Harvard, the diversification and increased use of alternative investments has helped Yale weather the downturn in the equities markets, but at the cost of decreased liquidity. The subsequent fall of less traded real estate and private equity markets has introduced a form of liquidity risk that was either unexpected, uncovered, deemed unimportant, or some combination of the three.

Fortunately, such endowments do not have the same problems with redemption requests that hedge funds experience, and can therefore possibly hold assets longer, waiting for more liquid markets. On the other hand, the academic endowments do rely on their investments for funding scholarships and supporting the general operating budget, among other things. At Yale, the endowment supports 44 percent of the $2.7 billion annual budget, or nearly $1.2 billion per year. With a decline of twice this amount in the endowment, belts at Yale will definitely needed to be tightened given that a guaranteed 16 percent return on the remaining approximately $7.5 billion would be needed in order to pay current expenses and still keep the principal in place. Of course, this just got more difficult now that the market is on its back, not to mention that the only sure bet in town - Bernie Madoff and his "guaranteed return" hedge fund - are out of business. Difficult times indeed.