{"id":15815,"date":"2015-06-01T11:41:49","date_gmt":"2015-06-01T16:41:49","guid":{"rendered":"http:\/\/news.medill.northwestern.edu\/chicago\/?p=15815"},"modified":"2015-06-04T14:26:30","modified_gmt":"2015-06-04T19:26:30","slug":"despite-6-years-of-underperformance-hedge-funds-still-popular-among-university-endowments","status":"publish","type":"post","link":"https:\/\/news.medill.northwestern.edu\/chicago\/despite-6-years-of-underperformance-hedge-funds-still-popular-among-university-endowments\/","title":{"rendered":"Despite 6 years of underperformance, hedge funds still popular among University endowments"},"content":{"rendered":"

By Lucy Ren<\/a><\/p>\n

Despite scrutiny over hedge funds\u2019 underperformance since the financial crisis, large university endowment funds like that of Northwestern University are still holding on to \u2014 if not raising \u2014 their stakes in “alternative investments,” which are usually prone to high risk but often perform\u00a0better than\u00a0equities.<\/p>\n

Under the backdrop of soaring global equities markets and still stagnating interest rates, Northwestern University\u2019s endowment<\/a> achieved a lofty return of 16.8 percent in the fiscal year ended August 31, 2014, during which the market value of the primary fund grew by a historic level of 24 percent to $9.7 billion. The fund is now the eighth largest university endowment by net assets in the country.<\/p>\n

[field name =”endow rank”]<\/p>\n

Endowments collect and invest money or other financial assets donated to the university. Like other institutional investors, university endowments operate in long-time horizons and aim for inflation-adjusted returns that exceed stock market indexes and university spending needs. With a broad array of strategies and asset classes, endowments set out strict asset-allocation categories that are intended to achieve the best returns.<\/p>\n

As of the end of August, the hedge fund portfolio of Northwestern\u2019s endowment accounts for almost 18 percent of the fund. With a robust 11 percent return, its\u00a0<\/strong>hedge funds last year outperformed a benchmark portfolio by 4 percentage points, the greatest outperformance across all seven asset classes that the fund invests in.<\/p>\n

The endowment creates its own benchmarks that represent a broad universe or “opportunity set” of each asset class. For hedge funds, the benchmark weights equity and hedge fund indices by the fund\u2019s exposure to each strategy.<\/p>\n

\u201cOver the last year and a half we have moved to an overweight in our hedge fund portfolio, as prior to that we were underweighted,\u201d said William McLean, chief investment officer of Northwestern University’s endowment, in an interview. \u201cSo there\u2019s definitely been a conscious effort to look for some uncorrelated strategies that don\u2019t relate to equities markets’ going up.\u201d<\/p>\n

[field name=”HF compare”]<\/p>\n

The share of hedge funds in the endowment has been below the U.S. university-endowment average since 2004. The allocation peaked in both fiscal 2003 and 2004 at 20.4 percent and fell to a trough of 14.6 percent in 2011.<\/p>\n

Since 2011 McLean\u2019s team has been plowing more money into the hedge fund portfolio because of its deemed growth potential \u2014 the portfolio\u2019s return grew from 1.2 percent in 2009 to 11 percent last year, during which time its annual gain was above the benchmark that the investment office updates\u00a0every year.<\/p>\n

\"Northwestern\u2019s<\/a>
Northwestern\u2019s Chief Investment Officer William McLean discusses NU\u2019s endowment and investments at a meeting in April. (Daniel Tian\/The Daily Northwestern<\/a>)<\/figcaption><\/figure>\n

This portfolio performance stands out at a time when the hedge fund industry is faltering.<\/p>\n

Since the financial crisis, the hedge fund industry as a whole has been underperforming the stock market, measured by the Standard & Poor’s 500 stock index, every year. The bottom was in 2013, when hedge funds yielded a 9.13 percent return as measured by the HFRI index compiled by Chicago-based Hedge Fund Research Inc., compared with the market\u2019s 32 percent gain.<\/p>\n

Some institutions have finally lost patience with hedge funds.<\/p>\n

The California Public Employees\u2019 Retirement System, the largest public pension fund in the U.S., announced in September that it’s\u00a0eliminating its hedge fund portfolio<\/a>.<\/p>\n

CalPERS\u2019 approximately $4 billion hedge funds and hedge fund-of-funds constituted only about 1.3 percent of its more than $300 billion assets. But its complexity and high cost yet low return relative to CalPERS\u2019 size, according to CalPERS\u2019 chief investment officer, were the reasons for dropping this sophisticated portfolio.<\/p>\n

However, the hedge fund industry\u2019s disappointing post-financial crisis performance does not concern McLean much. He still counts on hedge funds to lead Northwestern’s endowment upward.<\/p>\n

[field name =”HF return”]<\/p>\n

\u201cIt doesn\u2019t worry me,” McLean stated. “The reason you have hedge funds is that, hopefully, they will protect you when you have high correlation [with the stock market.] Hedge funds have historically delivered for us what we want in the long term, which is spending plus inflation, call it roughly 8 percent. It is something to counterbalance the equity market volatility, and with still the opportunity to have decent returns.\u201d<\/p>\n

[field name =”total performance”]<\/p>\n

Back in 2008, McLean remarked <\/a>in the endowment\u2019s financial report on the brink of the financial crisis: “The Investment Office believes that long-term prospects for growth in worldwide financial markets are being masked by turmoil, fear, and uncertainty, and that the pool has many opportunities in that environment.\u201d<\/p>\n

Northwestern’s endowment soon recovered from the crisis by returning 10.8 percent in 2010, during which its hedge funds \u00a0yielded 15.5 percent.<\/p>\n

The outperformer<\/h3>\n

Regarding the endowment’s recent outperformance, McLean attributed the success to\u00a0the selection of distinguished legacy fund managers, necessarily moderated by his team’s consistent effort to keep the endowment sufficiently liquid.<\/p>\n

The investment office currently outsources about 95 percent of the fund to outside managers, and manages in-house only the fixed income portfolio, a modest asset class that the endowment keeps as an \u201canchor\u201d or safety net in case of deflationary events.<\/p>\n

The team divides its hedge fund portfolio into three strategies. The long\/short equity strategy, which used to account for half of the asset class before 2010, has shrunk to 40 percent. “Event-driven,” which takes up about 20 percent of the portfolio, also shrank after 2010.<\/p>\n

The \u201cuncorrelated strategies,\u201d a collection of strategies with \u201cvery low correlation to equity markets,\u201d was added to the portfolio in 2010, McLean said. This third strategy now accounts for the remaining 40 percent of hedge funds.<\/p>\n

\u201c[The distribution] is a reflection of the kinds of legacy managers we have in the portfolio,\u201d McLean explained. \u201cWe were mostly long\/short before, then we had some liquidity coming to the portfolio, and we\u2019ve taken that opportunity to add more returns uncorrelated [to the equity market.] \u201d<\/p>\n

Some market watchers say the hedge fund complex has finally been striking back since the start of 2015. Data from HFR shows that in the first quarter hedge funds beat their equity counterparts, measured by the S&P 500, for the first time in six years.<\/p>\n

The Yale model<\/h3>\n

Ken Redd, director of research and policy analysis at the National Association of College and University Business Officers, recalled that 2014 was a particularly good year for endowments invested in private equities, particularly with venture capital gaining a sturdy 22 percent.<\/p>\n

The return to Yale University\u2019s endowment<\/a>, which owes its legendary status as the \u201cYale model\u201d to its dedication to private equity, soared to 20.2 percent last year.<\/p>\n

Yale devoted 33 percent of its $24 billion endowment to private equity, compared to the university-endowment average 10 percent allocation.<\/p>\n

Private equities account for approximately one fifth of Northwestern\u2019s endowment. Despite earning a lofty 28.2 percent return from this asset class last year, McLean has no plan to enlarge the fund\u2019s allocation to this asset class.<\/p>\n

\u201cWe are pretty comfortable where we are now,\u201d McLean said.<\/p>\n

Redd said Northwestern’s stability in allocating assets is typical across university endowments of all sizes.<\/p>\n

[field name=”breakdown”]<\/p>\n

Consistently in the past 10 years, approximately 60 to 65 percent of the larger-endowment assets have been in alternative assets, which include hedge funds, private equity and derivatives, Redd said. Large endowments are particularly attracted to legacy fund managers across alternative investment strategies, whereas for smaller endowments, only about 35 to 40 percent is devoted to these riskier yet often more rewarding assets.<\/p>\n

Large endowments are less inclined to make radical changes, largely because of their longer time horizons and high exposures to alternative asset classes, which often require holding periods of five to ten years.<\/p>\n

\u201cIt gives them every incentive to hold onto those assets from good times to bad,\u201d Redd added, \u201cknowing that if you sell at the wrong time\u2014maybe after a crisis–you might experience some pretty steep capital losses because of the high surrender charges. So schools know that, and they tend not to go down that route unless they absolutely have to.\u201d<\/p>\n

After the financial crisis, a radical transformation that spread across endowments is governance.<\/p>\n

\u201cWe doubled our efforts in making sure that our interests with our managers are fully aligned,\u201d McLean said, “so that when they take risks, we understand the risks that they were taking, and both of us would benefit equally if they did well.\u201d<\/p>\n

McLean said the outside managers are required to supply adequate liquidity to the endowment at all times.<\/p>\n

\u201cInstitutions are now much more engaged with their portfolio managers through their finance committees and their boards of directors than they were prior to the financial crisis,\u201d Redd said. \u201cAnd I think they want to remain more engaged so that if there is another potential crisis on the horizon, they will be more prepared for that.\u201d<\/p>\n

A more\u00a0challenging decade for endowments<\/strong><\/h3>\n

In the fiscal 2014 financial report<\/a> of Northwestern\u2019s endowment, McLean acknowledged the short-run concerns that returns over the next decade \u201cwill likely be lower than over the previous decade.\u201d He explained in the interview that this prediction was largely caused by the current interest rate environment.<\/p>\n

McLean said it is becoming harder to find attractive places to invest.<\/p>\n

\u201cHaving low rates has caused asset prices to rise,\u201d he added, “so when you have asset prices at such an expensive level, there is less room for them to go up further.\u201d<\/p>\n

In addition to the interest rate concern, trends like the falling energy prices and the strengthening U.S. dollar will continue to have different implications across asset classes, McLean said.<\/p>\n

Photo at top: Northwestern University’s endowment is the eighth largest in the nation, by assets under management. The entrance arch to the Northwestern campus in Evanston, Ill.(Rdsmith4\/Creative Commons<\/a>)<\/div>\n","protected":false},"excerpt":{"rendered":"

By Lucy Ren Despite scrutiny over hedge funds\u2019 underperformance since the financial crisis, large university endowment funds like that of Northwestern University are still holding on to \u2014 if not raising \u2014 their stakes in “alternative investments,” which are usually prone to high risk but often perform\u00a0better than\u00a0equities. Under the backdrop of soaring global equities […]<\/p>\n","protected":false},"author":29,"featured_media":15821,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[27,436],"tags":[],"class_list":["post-15815","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-business","category-spring-2015"],"yoast_head":"\nDespite 6 years of underperformance, hedge funds still popular among University endowments - Medill Reports Chicago<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/news.medill.northwestern.edu\/chicago\/despite-6-years-of-underperformance-hedge-funds-still-popular-among-university-endowments\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Despite 6 years of underperformance, hedge funds still popular among University endowments - Medill Reports Chicago\" \/>\n<meta property=\"og:description\" content=\"By Lucy Ren Despite scrutiny over hedge funds\u2019 underperformance since the financial crisis, large university endowment funds like that of Northwestern University are still holding on to \u2014 if not raising \u2014 their stakes in “alternative investments,” which are usually prone to high risk but often perform\u00a0better than\u00a0equities. 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