Hedge funds riskier for smaller non-profits, study says

NEW YORK — Small endowments and other non-profit organizations might be more vulnerable to the risks of hedge fund investments than their larger brethren, according to new research from the Global Credit Research unit of Moody's Investors Service, New York.

That's because many smaller colleges are jumping into hedge funds with large allocations — some as large as 50% of assets — without investing enough in their own investment management infrastructure to ensure good manager selection and ongoing monitoring, according to the research.

Moody's research showed that most larger endowments — those with more than $1 billion under management — have been investing in hedge funds for some years and have gradually built up sufficient staff experience and strong investment processes.

That gradual movement into hedge funds protected these big funds on the downside when market conditions punished investors that still had a big exposure to publicly traded stocks. Smaller colleges, with their higher allocations to public stocks, were punished badly by the poor markets and now are trying to make it up through allocations to hedge funds. But they are moving far more quickly, with too much money and less skill than larger institutions with a longer track record in the asset class.

For example, the median return of the endowments of Moody's-rated private colleges and universities of all sizes was 14.4% in 1998. That median return dropped to 9.3% in 1999, jumped back up to 10.3% in 2000, and then plummeted. In 2001, the median return was -2.8% and in 2002, -7.2%. Last year, it rose to a virtually flat -0.1%.

The report's authors noted that the three-year market slump had a more marked effect on smaller endowments and non-profits that still had large exposures to publicly traded equities, with some suffering 40% drops over the three-year period.

Larger endowments that had already reduced exposure to public markets through bigger allocations to alternative investments fared better than other endowments and foundations, Moody's researchers found. Moody's cited statistics from the National Association of College and University Business Officers' 2003 Endowment Study showing that in 2001, endowments of $1 billion or larger had a median return of -1.6%, compared with -3.6% for all endowments; in 2002, large endowments returned a median -3.8% vs. -6% for the entire universe; and in 2003, the median large endowment return was 4% vs. 3% for all colleges. NACUBO survey statistics also showed that endowments with more than $1 billion had an average hedge fund allocation of about 20%, compared with about 7% for the whole universe.

Moody's researchers reported a broad movement toward increased hedge fund investment by endowments of all sizes as college investment officers and committees seek ways to recoup market losses.

In addition to what Moody's called "overly aggressive" hedge fund investment by smaller colleges and non-profits, such as those institutions committing more than 50% to the asset class, researchers noted three main risks for smaller endowment investors.

One is execution and operational risk, which is "the risk that an institution will not achieve market-average returns from its hedge fund portfolio because of poor manager selection and oversight," according to the report. Moody's researchers noted that the kind of due diligence necessary to select the best-performing hedge fund managers may be beyond the expertise levels of staff and investment committees. Similarly out of reach may be a process for on-going manager monitoring and independent portfolio valuation.

Moody's researchers also noted that ideally, the investment committee for a non-profit or college should set asset allocation parameters, leaving staff to implement them through hedge fund manager selection.

But too often, said the report's authors, ill-equipped investment committees are making manager selection decisions or are blindly following the advice of their consultants.

Moody's also pointed to a second layer of risk: insufficient diversification of hedge fund investments. Moody's researchers noted that they found examples of endowments investing with too few hedge fund managers, in some cases as much as 50% of assets invested with just two or three firms.

Moody's also identified liquidity risk as a potential problem for smaller endowments and non-profits because hedge funds generally have a 90-day minimum lockup period for investments, and an increasing number of hedge funds have moved to three-year lockups.

Moody's researchers said: "This risk derives mainly from the role of endowments as ‘rainy day funds' for periods of financial stress. ... If one of these institutions had a major disruption of its revenue-generating ability ... and it needed to spend money from the endowment to pay debt service or other operating expenses, the illiquidity of the hedge fund investments could become a serious credit issue."