The Boom in Alternative Investments

Charities and colleges put more of their money into hedge funds, private equity, and other assets once considered esoteric

Database: How endowment investments fared at 247 nonprofit groups

Table: Endowments at 67 organizations that support nonprofit groups

Articles: All of the advice and commentary from this special supplement on endowments

Supplement in print: Order print copies of the Endowments supplements from June 2006 and August 2005

Not long ago, the vast majority of nonprofit endowments held the same kind of assets that a 50-year-old professional might keep in her 401(k) retirement plan — a hearty core of stocks, with some bonds and cash thrown in for stability.

Today so-called alternative investments — including private equity, hedge funds, venture capital, oil and gas partnerships, timber, and real estate — are all the rage, and even the investment committees that oversee endowments may not have a complete handle on what their managers are purchasing with the money in their endowments.

The 2005 investment results for the 247 foundations, universities, and other nonprofit organizations in a survey by The Chronicle of Higher Education and The Chronicle of Philanthropy could encourage even more endowments to begin dabbling in assets that were once considered esoteric. On the whole, endowments with large allocations to alternative investments outperformed organizations that stuck mostly to the traditional categories — stocks, bonds, and cash.

Purdue University, for example, has rapidly increased its alternative investments and plans to nearly double its allocation to alternatives again in the near future. In 1999 it had almost nothing invested in nontraditional assets, and nearly 90 percent of its endowment was invested in stocks — which put the institution in a precarious position when the stock market tumbled. The endowment dropped nearly $300-million, to $1.1-billion, over the three years ending in June 2003, which prompted Purdue to diversify.

In 2005 the university had 22 percent of its assets in alternative investments, including real estate, and the $1.34-billion endowment earned 11.9 percent over all for the fiscal year ending in June. Purdue’s investment committee approved a plan in April that calls for the university to put 39 percent of its assets into alternatives within three to five years.

“We don’t have the hubris to believe we know what’s going to happen, and when it’s going to happen,” says Morgan R. Olsen, Purdue’s treasurer. “So we believe there’s a lot of wisdom in having a diverse basket of investments.”

Nonprofit endowments notched their third straight year of solid investment gains in 2005, following the bleak years from 2000 to 2002, when the stock market plummeted. The median return for the 130 organizations in the Chronicle survey whose fiscal years ended in June was 10 percent, and the median return for the 64 organizations whose fiscal years ended in December was 8 percent. Those returns lagged behind results from last year’s survey — 15 percent and 11.4 percent, respectively.

In the survey, roughly the same number of big endowments ($1-billion or more) and small endowments ($100-million or less) have fiscal years ending in June and December. In both periods, the big endowments outperformed their smaller counterparts by at least four percentage points (13.2 percent versus 8 percent in June, and 10.1 percent versus 6 percent in December). In other words, the large endowments earned returns that were more than 50 percent higher than those earned by the small endowments in both periods.

Cambridge Associates, an investment-research and consulting company that tends to work with large endowments, including all eight Ivy League institutions, says the proportion of assets that its clients allocate to alternative investments was 25 percent last year, compared with 5 percent in 1991.

The colleges and universities in the Chronicle survey, all of which had endowments worth $1-billion or more, have even higher allocations to alternative investments.

Those colleges invested a median of 18.1 percent of their assets in hedge funds, 5.6 percent in private equity, 2.9 percent in venture capital, 4 percent in real estate, and 4.4 percent in other types of investments, such as timber and oil and gas partnerships. All told, that is more than a third of assets in alternative investments.

Meanwhile, many small endowments are staying away from — or can’t gain access to — alternatives. The Chronicle survey found that only half of the endowments with less than $100-million had even touched alternative investments.

The varying investment results in 2005 were most striking among the endowments in the survey with fiscal years ending in June. Only 43 of the 130 institutions were colleges and universities. But thanks to their large stakes in alternative investments and international equities (which produced better than twice the return of U.S. stocks), higher-education institutions claimed the top five spots for that period — Yale University, Amherst College, Harvard University, the University of Michigan, and the University of Notre Dame, in order of performance, all earned in excess of 19 percent. The first four have at least 40 percent of their assets in alternative investments. (Notre Dame declined to provide allocation numbers.) Colleges and universities also nabbed 16 spots in the top 20 for the June period.

Meanwhile, for institutions with only stocks and bonds, the results were modest. During that time, stocks rose just 6.3 percent, as measured by the Standard & Poor’s 500, and bonds gained 6.8 percent, as measured by the Lehman Aggregate Bond Index.

Colleges have some built-in advantages. Their financial strength — and the connections of their alumni — often help them gain access to the most-skilled hedge-fund, private-equity, and venture-capital managers. What’s more, many of them were “early adopters” of alternative investments, and that history also helps them gain entree to the sought-after alternative-investment funds.

“Today that’s a big relative advantage,” says Celia Dallas, head of published research at Cambridge Associates.

Private foundations enjoy some of the same advantages, thanks to their prominent board members and long experience with alternative assets. Fifteen of the 19 private foundations in the survey have a fiscal year ending in December; those organizations earned a median return of 10.2 percent.

But other nonprofit institutions have trouble competing with university and foundation endowments.

For instance, even though the University of Pennsylvania fared worse than any of the 43 colleges and universities in the survey with fiscal years ending in June, it still managed to earn a better return (8.5 percent) than seven of the eight United Ways that report over the same period.

Three United Ways — of King County, Southeastern Pennsylvania, and Metropolitan Dallas — were among the bottom five organizations for the June period, with King County the only one of the three to eke out a positive return.

While institutions like Yale employ as many as 20 people to scour the landscape for promising investments, investment strategy is almost an afterthought at the United Way of America. It has focused mostly on persuading its organizations to start endowments. Fewer than half of the 1,350 United Ways have one.

Among United Ways, the United Way of Greater Rochester, in New York, has the only endowment worth more than $100-million, and it is one of only four out of 12 United Way endowments in the survey with any money in alternative investments — a 5-percent holding in hedge funds. The United Ways in the survey have 55 percent to 75 percent of their assets in stocks, with the vast majority of the rest in bonds.

“When you have such a small endowment, you can afford to put very little at risk in alternative investments,” says Mary Kay Leonard, vice president for investor relations at the United Way of America.

Other types of organizations that stick mostly to stocks and bonds also posted modest returns compared with colleges and private foundations. Ten of the 18 hospitals in the survey operate on a fiscal year ending in December, and those hospitals earned a median return of 7.7 percent. Of the 26 community foundations in the survey, 15 report in December, and that group earned a median of 8.5 percent.

The 247 endowments in this year’s survey allocated a median of 21 percent to bonds, down from 25 percent two years ago. Bond yields were low throughout 2004 and much of 2005, and while rates are now rising, many investors continue to view them as unattractive since long-term U.S. Treasuries yield only a small premium over cash.

“Some of the more sophisticated people just don’t regard debt as being a return producer,” says John S. Griswold, executive director of the Commonfund Institute, the educational arm of Commonfund, which manages investments for nonprofit institutions.

Amherst College, which earned 19.3 percent in the 2005 fiscal year, fueled by returns from hedge funds and U.S. and international equities, puts less than 5 percent of its assets in bonds.

“It’s not like the members of the investment committee are trying to do market timing” — meaning moving a greater percentage of assets into equities and other aggressive investments in a rising market, says Peter J. Shea, Amherst’s treasurer. “They’re just looking at trends, and saying the returns for bonds for the next few years are probably not going to be that good.”

But Ms. Dallas says bonds may come back into vogue if rates keep rising. She notes that bonds had a tremendous run from 1982, when yields were quite high, to when yields bottomed out two decades later. “If bond yields got to 7 or 8 percent, I think our clients would start changing their policies,” she says.

Spreading investments among different categories has helped the largest endowments do well during two very different market cycles.

Hedge funds, which are better positioned than stock mutual funds to earn a positive return in both up and down markets, due to their ability to “short” stocks (bet against them by borrowing them, selling them, and then aiming to rebuy them at a lower price), helped large endowments do relatively well during the U.S. stock market’s swoon from 2000-2. Now diversification is helping the bigger endowments leave their smaller brethren behind during a rising market.

U.S. stocks have increased since 2003, but other asset categories — international stocks, particularly those that invest in companies in emerging markets, and investments like commodities and timber, real estate, and oil and gas partnerships — are faring even better.

For many endowment managers, who have watched in awe as the Harvards and Yales of the endowment world do very well in both down and up markets, the lesson is simple: Diversification works.

The only problem may be that right now, nearly all asset categories have seen prices rise — which could reduce returns earned in the future. Money managers typically look for assets that are considered undervalued, to reduce the risk of losses and maximize future returns.

Cambridge Associates regularly evaluates asset classes, and it currently regards every one of them as fairly priced or overpriced, given the returns that are expected in future years. U.S. equities, bonds of all sorts, and venture and buyout funds are all considered overvalued. Cambridge considers emerging markets and developed markets in Asia most attractive — but neither is a bargain.”There is not one asset class today that we would regard as undervalued,” Ms. Dallas says. “I don’t recall that ever occurring before.”

Mr. Olsen at Purdue says that’s why the university’s endowment may take up to five years to fully put in place its plan for more alternative investments and greater exposure to international equities, including emerging markets. (Purdue is a client of Cambridge Associates.)

“Absolutely we worry about valuation,” Mr. Olsen says. “We still think long term that relative to our current allocation, we need to have more money in these areas. But we’re trying to be wise about it.”

Many investment experts believe that the explosion of hedge funds — an estimated 8,000 now exist — will lead to lower returns for the asset class, as hedge-fund managers all begin to chase after the same strategies. But many nonprofit organizations remain satisfied with their returns from hedge funds.

Before 1998 the Wildlife Conservation Society, in New York, stuck to a 80/20 split between stocks and bonds — a fairly conventional allocation for the time. That year its investment committee voted to put 15 percent in hedge funds, and it had doubled the allocation by the time the stock market began to decline in 2000. Its investments in hedge funds — and its endowment over all — lost money in only one year of the bear market, 2002, when both the hedge funds and the endowment declined about 4 percent.

“No one could foresee what would happen, but by being in hedge funds we didn’t take a big hit,” says John G. Hoare, the organization’s controller.

The hedge funds have continued to help the $393-million endowment in recent years. In 2005 the society earned 8.6 percent for its fiscal year ending in June, which lagged behind the median in the Chronicle survey over the same period. But it would have been worse without strong hedge-fund returns (12.3 percent), which offset lackluster performance in stocks and bonds.

The organization invested 42 percent of its assets in hedge funds in 2005, and now 50 percent of the endowment is held in those funds. The gains are costly to achieve — a typical fee structure for hedge funds is 2 percent of assets under management plus 20 percent of the return generated by the fund. But the 12.3-percent return is after all fees have been paid, so Mr. Hoare sees good value in the expertise the charity is buying.

“As long as the returns justify the fees, we’ll pay the fees,” Mr. Hoare says. “Ultimately it’s the return after fees that counts to the institution.”

At the Community Foundation of Jackson Hole, in Jackson, Wyo., the returns haven’t always justified the fees. The endowment, which has just $8-million, had been managed by the community foundation’s investment committee until April, when the foundation hired the Milestone Group, an investment manager in Denver.

The community foundation had already liquidated an unperforming hedge-fund investment before the move. Conversations with Milestone have prompted the community foundation to reduce its overall allocation to hedge funds from 20 percent down to 8 percent.

The endowment had been managed conservatively by the investment committee, which helped when the stock market was declining but has hurt during the rebound. In its fiscal year ending in December 2005, the Community Foundation of Jackson Hole earned 4.7 percent, which put it near the bottom of the 64 organizations in the Chronicle survey with the same fiscal year.

“We weren’t happy with the performance,” says Karen Coleman, the community foundation’s chief financial officer, in explaining the decision to hire an adviser. “We were concerned that we weren’t capturing the upside as much as we should. It’s hard for a committee to follow numerous investment opportunities and categories in the way that an investment adviser can do when that’s what they do day in and day out.”

The St. Louis Symphony is increasing its hedge-fund allocation modestly, from 3 percent to 5 percent. But its investment committee worries that hedge funds generally “don’t have a long enough track record,” so the endowment directs most of its assets to other investment categories, according to Jim Garrone, the symphony’s chief financial officer.

That was a good move in 2005 — the $112-million endowment earned 16.4 percent for its fiscal year ending in August, thanks to strong performances by U.S. equities (22.8 percent) and international equities (30.8 percent). The hedge funds returned only 9.2 percent.

The symphony’s investment committee recently voted to reduce its allocation to U.S. stocks — from 41 percent to 30 percent — and increase its international investments from 18 percent of the endowment to 25 percent.

“Everybody seems to think international stocks will perform better than domestics over the next few years,” Mr. Garrone says.

At a time when the experts say both long-term and near-term returns may be modest, some experts say the best strategy may be for endowment managers to rigorously evaluate their current investment plans and look to make minor tweaks and wring out costs and inefficiencies.

That’s the approach taken by the Minneapolis Foundation, which earned 7.7 percent on its $552-million endowment during the 2005 fiscal year, which ended in March. The community foundation has lifted its fixed-income returns by allowing its manager to add a small helping of junk bonds, which have higher yields.

The community foundation also uses a manager whose sole responsibility is to buy future contracts using the cash sloshing around at the end of each day to keep the desired asset allocation on track and the endowment fully invested.

Previously the foundation directed individual stock and bond managers to move around the cash, which generated extra trading commissions and sometimes made it challenging for the foundation’s endowment to be fully invested.

Steve Hosier, the community foundation’s investment associate, says the manager has earned a thirtyfold return on the management fees the foundation has paid.

Mr. Hosier also is paying attention to the trading costs of the endowment’s managers. When commissions seem high, he puts managers on notice that he’s aware of “soft dollars,” in which investment managers agree to pay higher commissions to a brokerage firm than they might find elsewhere, in return for investment research by the firm. “We’re OK with some of that, but we also realize that it’s a cost, and we care about it,” Mr. Hosier says.

For now the Minneapolis Foundation has no alternative investments, aside from a 10-percent allocation to real estate.

“Until we really understand and can control the things that have complete transparency,” Mr. Hosier says, “we don’t want to go into an area that may not have full transparency and may require us to spend a lot of time monitoring and studying.”

Maria Di Mento contributed to this article.

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Volume 18, Issue 16, Page B1