Endowments and Hedge Funds

Endowments are set to be in hedge funds for the long haul

Sophia Grene

According to many fairytales, ivory towers are frequently surrounded by high hedges, often thorny and there to keep out rescuers. In real life, the ivory tower of academe in the US has found that hedge funds are a useful source of diversification and growth for their endowments. In the rest of the world, endowments have been less speedy to take advantage of alternative assets, although this reticence is gradually dissipating.

Although they are often lumped in with other institutional investors such as pension funds, endowments and foundations have a very different raison d’être, time horizon and hence investment objective. Key to understanding this is the concept of ‘perpetuity’ – not quite as difficult to grasp as infinity but still radically different from the effect even of the long-term horizon of an open defined benefit pension fund. Most endowments exist to provide income for institutions engaged in charitable activities. They may not have significant amounts of new money coming in and they have an obligation to future generations to preserve the spending power of the endowment. ‘Intergenerational equity’, to use the phrase coined by James Tobin, an economist at Yale, requires the institution to balance spending to meet the needs of the current generation with the need to make sure it can meet the needs of future generations by a policy of purchasing power preservation.

“The endowment is managedin perpetuity,” says Nick Cavalla, recently appointed CIO of Cambridge University’s Investment Board. “With that in mind, it can afford to take a very long-term view.” For this reason, endowments can have a different attitude to risk from funds that need to align their assets with their liabilities over a mere matter of decades instead of perpetuity. Their return requirements are also quite demanding, since their purchasing power must be measured in terms of academic inflation, which tends to outpace general inflation.

Cavalla says that a typical fund might use the retail or consumer price index plus 500 basis points as a target return net of expenditure and administration. Since spending is likely to be in line with that of Cambridge University’s 4.25 percent, this means that the fund “cannot afford to be Boots’ pension fund, wholly invested in bonds.”

Laying aside the point that even Boots’ (now Alliance Boots) pension fund cannot afford to be entirely invested in bonds, this should mean that endowments were leading the way in innovative investment techniques. Since most of the advances in investment theory, particularly the insight that diversification offers the closest thing to a free lunch in the world of investment, come from academic theory, it would be surprising if there were no investment pioneers among the endowments of the world.

It has fallen to Harvard, with the Harvard Management Company, and Yale, where David Swensen has been Chief Investment Officer for more than twenty years, to lead the field. Swensen has been particularly influential, developing the Yale Model, as described in his book Pioneering Portfolio Management. It consists broadly of dividing a portfolio into five or six roughly equal parts and investing each in a different asset class, each as far uncorrelated to the others as possible. The Yale Model is an example of multi-asset class investing.

The Yale Model

Particularly revolutionary at the time, but now becoming increasingly mainstream, was his recognition that liquidity is a bad thing to be avoided rather than a good thing to be sought out, since it comes at a heavy price in the shape of lower returns. The Yale Model is thus characterised by relatively heavy exposure to asset classes such as private equity compared to more traditional portfolios.

His ideas have taken some time to spread beyond the US, but are slowly being adopted in Europe where a particular advocate has been Guy Fraser-Sampson, whose book ‘Multi-Asset Class Investment Strategy’ builds on Swensen’s theories and shows how they can and should be adopted by European pension funds.

The impact of Swensen’s influential work in endowment management extends beyond the walls of Yale, most notably to one of its main Ivy League rivals, Princeton. Andrew K Golden, who currently serves as President of the Princeton University Investment Company, worked with Swensen as an intern and then portfolio manager for the Yale endowment before joining Princeton in 1995.

Swensen’s standing in the industry is largely due to the impressive growth he has overseen at the Yale endowment fund. In the last 20 years, the fund has benefited from an annual compound growth rate of 16.3 percent, accounting for over $7.8 bn extra in Yale’s coffers.

In a recent New York Times article, Swensen noted as part of his investment philosophy that he looks for “people who define success by generating great returns, not by making as much money as they can.”

Size is the enemy of performance

Although this may sound odd, he explained that: “If you make money personally by gathering a huge pile of assets, it is great for the management company because they make bigger fees. But if the fund goes from $2 billion or $3 billion to $20 billion, they are inevitably going to reduce their ability to generate investment returns. Size is the enemy of performance.”

Swensen’s influence in Europe is also likely to grow through his presence on the Investment Board of Cambridge University.

The story of endowment investing in the UK is complicated by the complex collegiate structure of the two oldest and largest universities, Oxford and Cambridge. Each of the thirty-plus colleges in each university has an autonomous endowment fund, usually run independently of the others and the university. This diversity means that each fund is much smaller than would be the case for a similar-sized university in the US, losing out on economies of scale, but leading to an interesting opportunity for researching how endowments approach investment strategy.

UK endowments lagging behind

In a recent book, Endowment Asset Management – Investment Strategies in Oxford and Cambridge, Shanta Acharya and Elroy Dimson take advantage of this to look in detail at the effects of this diversity. With respect to alternative investments, they found a mixed picture. Even without precise and up to date figures available, it is still clear that the average Oxbridge college has a much lower exposure to alternative assets than their American counterparts. The average allocation to alternative strategies among Oxbridge colleges was 1.5 percent in 2002, compared with 7.1% in the US the same year. Average allocation to hedge funds, venture capital and private equity rose to 8.2 percent in 2003 and 9.4 percent in 2004. Although anecdotal evidence suggests that allocation to alternatives is rising in Oxbridge, it remains low compared with these figures.

Among colleges without exposure to alternative assets, the main reasons for caution seemed to relate to the potential risks of such investments as well as a feeling that the size of the endowment prohibited them. According to one bursar (whose college has no exposure to alternative assets) interviewed for Acharya and Dimson’s book, “both hedge funds and private equity funds are risk and illiquid. Hedge funds by definition have a problem. They always end up operating outside their remit.”

Although this dispiriting attitude to alternative assets is widespread, it is not universal and optimistic cracks in the wall of prejudice are growing apace. The foundation of Oxford Investment Partnership (Oxip) by five colleges is a case in point.


Set up by St Catherine’s, Christ Church, Balliol, St John’s and New College to manage endowment funds for themselves and other foundations, Oxip aims to offer an investment management service specifically designed to meet the needs of perpetual funds.

“The underlying objectives of a perpetual endowment that is mandated to have no discount rate and to value a future generation’s good equally with that of the present generation are common enough,” says Karl Sternberg, CEO of Oxip. “We aim to deliver at least 5% real returns over five year rolling periods.” Although Oxip has currently approximately 35 percent of its £200m assets invested in hedge funds, Sternberg is clear first that hedge funds are not a discrete asset class and secondly that they are not taking a risky route for their clients.

“We don’t treat hedge funds as an asset class; what we’re looking for is manager skill,” he explains. “We derive our hedge fund exposure via that manager decision rather than allocating to hedge funds a priori.” He adds that to treat hedge funds as a single asset class when they are more and more acting outside the limits of what has conventionally been described as a hedge fund makes little sense. “We try to dis-aggregate everything in terms of where the return is coming from.”

Portable alpha perspective

Cavalla of Cambridge University concurred with this view of hedge funds: “The conventional way of looking at hedge funds is that they are an asset class. The other way is to regard the hedge fund piece as a piece of portable alpha. That’s more elegant theoretically, but,” he admitted, “it’s operationally more difficult.”

He added that not everyone is happy with either view if it implies that hedge funds are a good idea. “With hedge funds, there are some unbelievers out there, who think they just offer souped-up beta with fees.” Although he himself is not so cynical about hedge funds, there is a case for being cautious about the allocation. “Manager selection is very important; it’s a very diverse space and there is a kind of revolving alpha distribution.”

In pursuit of a genuine multi-asset class diversification, Oxip will look at anything from commodities to private equity, including all hedge fund strategies, although they do have some criteria: “We rule out some hedge funds,” says Sternberg, “those that are too opaque. We want to know at least the basic principles of their investment strategy.”

Dare to do nothing

All of this is in pursuit of lowering risk by judicious use of diversification. Sternberg laughed when asked why the Oxford colleges were suddenly more daring in their investment policies: “I don’t think we are being daring – we’re reducing the volatility and the underlying risk. Is that really more daring than having 70 percent of your assets in public equities?”

Answering the rephrased question as to why UK educational endowments are looking seriously at a more innovative style of investing, he pointed to the need for a higher level of professionalism in the investment management to accompany the increasing professionalisation of fund raising.

“As far as the universities are concerned, they have realised that if they are going to go to donors and ask for large amounts of money, they are going to have to show that they will manage it in a responsible way.” Although the bursar quoted above clearly wouldn’t agree, Sternberg thinks that the very illiquidity of some of the assets Oxip invests in is an advantage, offering as it does a premium for those long-term investors who can cope with the illiquidity.

In the year and a quarter since it was established, Oxip has already garnered four external endowment clients, as well as some high net worth investors, who invest through a feeder fund structure. This kind of thinking is gaining ground. It is also becoming more popular among foundations with other aims.

Although foundations may by definition end up no longer working to an investment horizon of perpetuity, (for example if a cure for AIDS were to be found, AIDS research foundations could logically be expected to spend their endowment to zero on making sure the cure were available to all), in practice they are likely to work in a similar way to educational endowments.

Trend remains towards alternatives

Fig 1In America, it is possible to see the progress of endowments’ ventures into alternative assets in a relatively straightforward way, thanks to an annual survey. Every year, the National Association of College and University Business Officers (NACUBO) releases a survey of the investment strategies of higher education endowments. The NES is the largest and longest running yearly, voluntary survey of higher education institutions and their foundations about their endowment holdings. Survey information is collected and calculated on behalf of NACUBO by TIAA-CREF. Seven hundred and sixty-five (765) institutional participants from the United States and Canada took part in the 2006 NES, the largest group in the 34-year history of the study and the sixth consecutive year of record-breaking participation since NACUBO began their partnership with TIAA-CREF in 2000.

In 2006, an increasingly diversified investment strategy helped managers of higher education endowment funds earn an average one-year return rate of 10.7 percent, the survey said. For many higher education endowments, the ten-year average compounded 8.8 percent return rate is close to the average return target needed to meet both current and long-term spending goals for the benefit of their institutional stakeholders.

Although 78 percent of endowment investments were in fixed income and equities, the 2006 study reflects a continued and steady trend toward alternative asset classes and away from traditional ones. Allocations to traditional assets have declined 1 to 2 percentage points a year over the past ten years. As a result, over the past decade, the portion of investments in asset classes other than equities and fixed income has more than tripled, from 5.4 percent to 17.3 percent of investment portfolios (see Figure 1).

European issues

In Europe, it is much harder to set the context for endowment and foundation investment strategies. This is due to the usual European problems of lack of transparency and comparable data. Across the different countries of Europe, there are varying definitions of ‘foundation’ and in several jurisdictions there is little requirement for those foundations to publish accounts in any set format.

Consultants Watson Wyatt are attempting to rectify this situation somewhat by instituting a research initiative to build up a database of the relevant information. Working in association with Prof Elroy Dimson of the London Business School, Watson Wyatt found that the 50 largest European foundations outweigh their American peers in terms of aggregate assets by more than ten percent, totaling €147 billion.

They may have more money, but they spend less (due largely to more favourable tax policies for charitable spending in the US) and are much less likely to have significant investments in alternative assets.

According to the research, European foundations still invest around one third of their assets in founder or sponsor stock, although eight of the largest invest more than ten percent in alternatives such as private equity and hedge funds.

The average US foundation allocates nine percent to alternative assets while US university endowments have diversified significantly more, allocating on average 30 percent to these asset classes.

“Asset allocation among European foundations in general is heavily influenced by their respective backgrounds and not necessarily by risk management, investment principles or spending targets,” according to Watson Wyatt’s Mirko Cardinale. “As a result many are taking a large single bet on equity markets and would do well to diversify their risk exposure. There are some notable exceptions though, particularly among the larger foundations, probably due to having higher governance budgets. Notwithstanding, as the not-for-profit sector in Europe grows in size and importance, their management will come under increasing scrutiny, putting a much sharper focus on governance and the reconciling of performance objectives.”