By Gina Bernacchi

For better or worse, many nonprofits are rushing into hedge funds to improve their investment returns. The reason is simple: Three consecutive years of poor market performance -- from 2000 to 2002 – have led many groups to seek alternative investment strategies.

However, even though the reason for wanting to get into hedge funds is simple, hedge funds themselves are not. And if you don’t know what you’re getting into, it’s best to stay out, according to John Griswold, executive director of the Commonfund Institute, the education and research arm of Commonfund, an investment and management firm specializing in long and short-term funds for nonprofits.

“We see this as an area of potential trouble for a couple of reasons,” Griswold said. “Hedge funds are not very transparent. You don’t know what they’re invested in on a daily basis, and managers are reluctant to tell you. In many cases, managers are switching portfolios so rapidly you couldn’t keep up anyway. You have to give managers wide discretion. To some extent, there has to be a trust between the investor and the manager. That trust is developed by a process called due diligence. You get that by meeting with the manager and understanding the process, and if you don’t understand it, you shouldn’t be investing.”

Because the investment strategies of hedge funds are not highly correlated with the securities market, i.e. stocks and bonds, they offer the prospect of low volatility and high returns. Ideally, hedge funds will protect an organization from loss, because they don’t move in the same lockstep as stocks and bonds; being able to move both ways in the market theoretically gives an organization the opportunity to profit both ways.

However, because they are not regulated and hedge fund managers use a wide variety of investment strategies (such as distressed debt), they are difficult to monitor. Problems arise when hedge fund managers invest in areas that an organization may consider too risky, but the organization isn’t aware of it. Managers have wide discretion as to what they invest in, so investment committees have to pay close attention to where their money is going, or they may be putting their organization at risk.

Higher education has taken the lead in hedge fund investing, with 20 percent of assets of funds with more that $1 billion allocated to hedge funds in June 2003, and 13 percent of assets for university endowments between $500 million and $1 billion. Large institutions, such as Harvard and Yale universities, have been investing in hedge funds for years, and their positive results have spurred smaller institutions to follow suit.

“Education has a feature that other institutions don’t have: Wealthy people on their investment committees, who have been doing this for some time and encouraged universities to do the same,” Griswold said. “(Other nonprofits) look at Harvard and ask, can I get the same returns? You can get a lot closer than you are now. You should get a lot more diversified. Foundations are behind education in this regard, and health care is way behind.”

The Wildlife Conservation Society (WCS) has been investing in hedge funds since 1998 and now allocates 50 percent of its assets in that class of investment. For the fiscal year ending June 30, 2002, WCS posted a loss of $24.5 million, but its investment return was up 4.9 percent at the end of June, 2003 to $14.8 million. The negative return in 2002 was due in part to losses incurred from a substantial single issue stock gift given to the WCS. The organization’s hedge fund group still returned 2 percent in 2002 and almost 9 percent in 2003. According to John Hoare, WCS’s vice president and comptroller, hedge funds have offset WCS’s losses in its traditional, long equity portfolios.

“We feel that our returns vis a vis our peers have been sound,” he said. “We haven’t taken the large swings some others have. Through in-depth screening and careful selection we look upon hedge funds as a more stable flow of income.”

Studies conducted by the Commonfund Institute show a dramatic increase in hedge fund investing, but Griswold and others caution potential investors about the risks involved. As of June 30, 2001, some $396 million of the Art Institute of Chicago’s (AIC) approximately $667 million long-term investments were invested in hedge funds.

Although AIC declined to comment on what the organization has done since to recoup those funds, in March 2002 AIC replaced its previous investment advisers with Cambridge Associates. Experts agreed that one of the biggest challenges nonprofits face when deciding to invest in hedge funds is due diligence.

According to a 2004 report by Moody’s Investors Service, entitled “Risks and Opportunities of Hedge Fund Investments by Higher Education and other Nonprofits,” the hedge fund world is extremely complicated, and execution is critical to attaining desired performance.

“If you have a well-executed strategy, and you have a diverse portfolio of hedge funds, it should be less volatile, because you’re investing in ways that are not correlated with the market,” said Naomi Richman, senior vice president at Moody’s and author of the report. “And that’s the goal -- to reduce risk -- but that’s not always achieved.”

Hedge fund performance is closely tied to the expertise and capability of the manager, so being able to evaluate and review managers to determine their capability, as well as monitor their performance once they’re hired, is crucial. Selecting a manager involves not only an analysis of the manager’s background and qualifications and the fund’s investment strategy, it also means making sure that investing is in a manner consistent with its stated strategy and is achieving appropriate levels of return relative to its strategy and level of risk. Not all nonprofits have the management capability to do this, nor can they take the same risks some can with their investments.

For example, Shriners Hospitals for Children’s total return for the fiscal year 2002 was a negative $900 million. In 2003, it raised just more than $1 billion. But, because Shriners has to produce a certain amount of return from its endowment to run its hospitals, its investment policy has historically been conservative; thus, the organization has stayed away from hedge funds.

“Our current investment policy does not include an allocation to alternative investments, such as hedge funds,” said Bill Fawcett, corporate controller. “(Since fiscal year 2002), we hired an investment consultant who helped us structure our asset allocation model and choose new investment managers, which have been in place since June. We’ve gone to a more style-specific investment management approach,” he said.

During the change, Shriners looked at other alternative investments, but made the decision to not include anything additional to the existing real estate and mineral interest holdings. “With interest rates being very low over the past several years, we’ve had to rely more heavily on total returns from the equity markets. When you do this, you’re exposed to the bear markets we saw in 2000 to 2002. With hedge funds, you may have less exposure, but they have their own risks,” he said.

For the University of Colorado (CU), due diligence has paid off. Although CU’s treasury pool does not invest in hedge funds, the endowment run by the university’s foundation does invest. More than 30 percent of the foundation’s funds are allocated to alternative investments, including hedge funds. For the fiscal year ending in June, 2004, the foundation’s investment portfolio saw a return of almost 19 percent.

“The literature is replete with managers who have not performed, and endowments have had to write off their investments, something you always have to be conscious of when investing in these type of asset classes,” said Steve Golding, CU’s vice president for budget and finance. “We spent a great deal of time doing due diligence, finding out who the managers are, what their strategies are, the level of risk that we’re willing to take, and whether or not we’re willing to accept that level of risk in our portfolio. In our treasury pool, that’s a risk we’re not willing to take because that’s money for the short term, whereas the money the foundation manages is for the long term.”

Market research suggests that a well-constructed portfolio of alternative investments, including hedge funds, should produce higher returns with less volatility over the long term; however, hedge funds are much more sophisticated investments than stocks and bonds, and nonprofits need to educate themselves about them before jumping in. Simply investing in hedge funds doesn’t mean higher returns and less volatility, Golding said.

“In fact, if you don’t pick the right hedge funds, you can actually introduce greater volatility, greater risk and lower returns,” he said.

Gina Bernacchi is a freelance business writer based in Denver.

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