The dismal recent performance by the endowment funds of several Ivy League universities has dimmed the luster of the funds' managers. But the performance of those managers — who in recent years have attained rock star status in the investment world — may be even worse than the numbers indicate.
Because endowments have large amounts of illiquid holdings, some of the returns posted in recent years may not have given a completely true picture of performance, observers said.
In addition, the funds have taken on more risk than is apparent from their reported results, according to critics, giving a misleading impression of risk-adjusted return.
Most of the larger endowments invest in illiquid limited partnerships put together by managers of hedge funds, private equity pools and venture capital firms. Because the deals aren't actively traded, managers use a number of valuation alternatives to come up with reasonable estimates.
Endowments must rely on these manager-produced estimates for reporting overall fund performance.
But “until someone makes you an offer (for the illiquid asset), those valuations are never going to be completely accurate,” said Matt Cooper, managing director at Beacon Pointe Advisors, Newport Beach, Calif., which manages about $4 billion, much of it from endowment and foundation clients.
“If a (private equity manager) is out raising money, he might be less conservative” with valuations, said Dan Lubek, managing director at Solis Capital Partners LLC, a Newport Beach, Calif., private equity firm.
“If he wants to primarily maintain good relations with existing limited partners, he might be more conservative,” he said.
Data show that endowment funds have had problems with pricing real assets and private equity, said Christopher Geczy, an adjunct associate professor of finance at The Wharton School of the University of Pennsylvania and academic director of the Wharton Wealth Management Initiative.
“It is possible that this (illiquid) stuff has taken a bigger hit than (the endowment funds) think,” said Robert Whitelaw, a professor of finance at New York University's Leonard N. Stern School of Business.
Longer-term returns aren't misstated, he said, but “stale prices make performance (numbers) sluggish.”
Worse than some potentially stale valuations is the underestimating of risk among endowment funds, observers said.
Researchers have found a high correlation of returns between different months for illiquid asset classes, which indicates that prices tend not to move as much as they should. As a result, volatility measures are being understated.
“The estimates of the risk of those (endowment) portfolios (are) too low,” Mr. Geczy said. “Their Sharpe ratios (appear) high and their betas low — but that's not the case at all.”
Mr. Geczy said his research on venture capital funds has found that estimated standard deviations in returns can be off by a factor of three. He is preparing a paper on statistical methods that can be used to adjust upward measures of volatility in illiquid investments.
Such adjustments would make investments such as venture capital “a much less attractive asset class,” he said.
Mr. Whitelaw said this smoothing of returns also makes it look as if alternative asset classes are less correlated with the stock markets than they really are.
There is “unstated market risk” hidden within illiquid alternative assets, he said.