Hedge funds are lightly regulated and high risk, but they have grown over the years as a percentage of all endowment investments by colleges and universities.
By Peter Galuszka
Hedge funds are the rock stars of today’s financial world. These lightly regulated private pools of equity, which are open only to rich players, are managed through secretive and sophisticated investment strategies. Although the risks are high, so are the potential benefits. Hedge funds can pay returns of up to 30 percent or more, considerably higher than other investments such as mutual funds or bonds. Despite the risks, many colleges and universities have chosen to invest heavily in hedge funds. One of those schools is DePauw University in Greencastle, Ind.
For a small institution — approximately 2,500 students — DePauw has a rather large endowment of approximately $470 million. So it seemed like a smart idea to invest a small amount, no more than 1 percent of its total assets, in an aggressive, high-return fund. The college’s financial advisor, Hennessee Group LLC, recommended hedge funds operated by the Stamford, Conn.-based firm Bayou Fund LLC. DePauw took the recommendation and invested $3.25 million, looking at promised returns of 15 percent to 20 percent.
Late last August, as students returned to DePauw after summer break, university officials got a shock. Bayou, which was managing about $440 million in hedge funds, quietly went out of business. A telephone recording at its office said investors would be repaid. But at the end of September, the U.S. Securities and Exchange Commission filed civil charges against Bayou principals Samuel Israel III and Daniel E. Marino, claiming they deliberately defrauded investors. The U.S. Attorney General’s office filed nearly simultaneous criminal fraud charges against the duo. Both men pleaded guilty to federal fraud and conspiracy charges and together face 80 years in prison.
“All of the investors were caught off guard,” says Ken Owen, spokesman for DePauw. The college sued Hennessee in federal court last October seeking the return of its investment.
DePauw’s predicament is a warning to many college endowment managers who are attracted by the potential returns with hedge funds. Despite Bayou’s high-profile flameout, regulation of hedge funds still remains relatively light. Not until February did the SEC began requiring the registration of funds of more than $25 million.
Although some of the big university players appear to be cooling on hedge funds, their overall popularity doesn’t seem to be slowing down. Hedge funds have grown as a percentage of all endowment investments by colleges from 1.8 percent in 1996 to 8.7 percent in 2005, according to a recent report by TIAA-CREF.
“Are colleges interested in hedge funds? Oh, my God yes. Harvard and Yale are big into it. It’s a big piece for them,” says Edward J. Stavetski, chief investment strategist and compliance officer at CMG Investment Advisors LLC in Radnor, Pa.
Big name schools with huge endowments can afford to play hedge funds in a “single strategy mode,” which takes a lot of time and effort, says Stavetski, who is a frequent guest commentator on the financial news service TheStreet.com. The strategy also helps garner larger overall returns.
For example, Stanford University has the third largest endowment in the country, with more than $12 billion in assets. The university saw its value increase 23 percent in 2005, partly because of hedge funds. Harvard, whose $25 billion endowment is the single largest in the United States, enjoyed an increase of 15 percent last year, again partly because of the secretive funds. CalPERS, the California Public Employee Retirement System that includes some college funds, doubled its investment in hedge funds to about $2 billion in late 2004. Such massive investments are not uncommon since the minimum requirement is between $250,000 and $1 million.
As in any investment, there are thousands of different hedge funds, some of which are conservative while others are high-risk. Unlike other investments, though, most hedge fund managers charge a 1 percent management fee and generally take 20 percent of the profits. Because they only sell to large investors and not to the general public, the SEC doesn’t subject them to the same regulations that mutual funds face.
Handled carefully, hedge funds can be a major advantage to any college’s portfolio, says James P. Fish, who managed the endowment at Clarkson University in Potsdam, N.Y. About 11 percent of the school’s $22 million endowment is invested in hedge funds. “There’s a good risk-reward ratio, and we’ve been very considerate of the risk,” says Fish. One key caveat is to be very careful in choosing advisors, he says. “We’re fairly new at this. We’re babes in the woods, so to speak.”
Like many small- to middle-size players, Howard University uses a “fund of funds” approach, which is in the lower- to middle-range of sophistication. That type of fund is easier to manage and less labor intensive than the more targeted single strategy funds that Harvard and Yale employ. And although they don’t offer the same level or reward as more directed funds, they also avoid some of the inherent risks. Stavetski says schools with small endowments should stick with traditional investments, while universities with middle-sized endowments can use funds of funds. “Smaller schools just can’t get the depth of research” needed to deal in hedge funds, Stavetksi says.
The news of Bayou’s collapse was disturbing, but not devastating for Howard. The school, which has an endowment of $446 million, the largest of any historically Black institution, had some money in hedge funds with Bayou, but managed to get most of it back. The fund of funds approach they used help offset the damage. Although the fund Howard had with Bayou took a hit, the university still recouped about 90 percent of the money they had invested overall, says Sidney H. Evans Jr., chief financial officer and endowment manager. DePauw, on the other hand, invested directly in Bayou funds, so when the company collapsed, the school lost big.
Despite the Bayou situation, Evans is not negative on hedge funds. The trick, he says, is for money managers to be “concerned, conservative and not do more than a certain percentage.” Howard keeps about 10 percent of its endowment in hedge funds, but the majority of the university’s assets are in small to mid-cap funds (35 percent) and bonds (25 percent). Another 15 percent is invested in international funds, 10 percent in private equity and 5 percent in real estate.
Evans, who is new to Howard, says hedge funds are part of his strategy to increase the university’s assets. So far, the university has earned only 7.6 percent, “and I’m not happy with that as a new CFO,” Evans says. One strategy he has used is to encourage his hedge fund manager to share more information “and they did, and we got better returns,” he says.
The Bayou mess was only one of several recent black eyes for hedge funds. They have been in the news most recently in a controversy involving Biovail, a Canadian drug maker. Executives from Biovail have sued Connecticut-based SAC Advisors, one of the largest and most influential hedge funds, claiming that SAC ghostwrote a negative stock analyst’s report about Biovail. The lawsuit contends that the phony report was a ruse intended to depress Biovail’s stock. The drug maker says SAC planned to borrow shares of Biovail stock at a high price and then sell it back at a lower price while pocketing the difference. The practice, known as “shorting,” is very common in the financial world — shares are borrowed at a higher price and sold after they drop.
SAC denies the charges, but the accusations have gotten wide play in the nation’s business media and on CBS’s “60 Minutes.” The incident has renewed calls for more regulation of hedge funds. Leaders in the hedge fund industry, which now totals $1.5 trillion, have so far stymied attempts at more regulation. One reason that hedge funds are hard to police is that their investment strategies can be extremely complicated and hard to understand.
That puts more responsibility on the shoulders of university endowment asset managers to vet the funds before they invest.
“You have to have hedge funds in your strategy,” says Evans at Howard. “You need to do your due diligence, and they have to be in the top 10 percent. I don’t care how good they say they are.”
Says Jeff Margolis, director of institutional sales and marketing at TIAA-CREF, “Overall, use of hedge funds is still increasing, but it has peaked and has started declining for now among some of the early adopters, generally the largest endowments.”
College endowment officials may still be smitten enough to take the plunge, but if they do, they must be ready for the unexpected. That’s a lesson that’s been learned the hard way at DePauw. “It was a substantial loss, but it wasn’t crippling,” says Owen, DePauw’s spokesman.
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What Are Hedge Funds?
Like mutual funds, hedge funds pool investors’ money and invest those funds in sophisticated financial instruments in an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the likelihood of investment loss.
Unlike mutual funds, hedge funds are not required to register with the U.S. Securities and Exchange Commission. This means that hedge funds are subject to very few regulatory controls. Because of this lack of regulatory oversight, hedge funds have generally been available solely to accredited investors and large institutions. Most hedge funds also have voluntarily restricted investment to wealthy investors through high investment minimums, often more than $1 million.
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