NP Times / Nonprofits Move Nest Eggs

Edited By Paul Clolery

Into Hedge Funds, Despite Shady Past

Hedge funds generally represent the kind of risky and vaguely defined investments that nonprofits try to avoid, partly because the initial stake usually far exceeds what most organizations can afford.

Intermittent controversies add uncertainty, such as last month's announcement by New York Attorney General Eliot Spitzer of a $40 million settlement with a hedge fund called Canary Capital. Headed by the son of a prominent New York philanthropist descended from the founder of Hartz Mountain pet food, Canary allegedly arranged for illegal after-hours trading with several prominent mutual funds, leaving other mutual fund investors at a competitive disadvantage.

This past August, the National Association of Securities Dealers (NASD) brought three separate enforcement actions against other funds, alleging fraudulent offerings worth millions of dollars. Those actions reflected NASD's increasing attention to the sale and marketing of hedge funds and private investment partnerships.

This past July the Securities and Exchange Commission (SEC) shut down a well-known hedge fund operated by Lancer Management Group and headed by Michael Lauer of Greenwich, Conn., for allegedly inflating the value of penny stocks in an effort to defraud investors. Among the big losers was Morton H. Myerson, namesake of the Dallas Symphony Orchestra's concert hall.

At the same time, the SEC sought opinions on whether regulators should stick their noses deeper into the hedges, a question that kicked off lively debates among investment experts.

"Regulation is, in some sense, incompatible with the fundamental role and character of hedge funds," said Richard J. Herring, finance professor at the Wharton School of Business in Philadelphia. "Hedge funds are designed by law to operate with maximum flexibility."

Despite their checkered history, hedge funds have drawn increasing interest from conservative foundations and other well-endowed nonprofit organizations that need consistent returns to maintain their missions. "This has been a growing asset class over the last few years, especially when other asset classes have not been performing well," said Doug Wheat, director of SRI World Group in Brattleboro, Vt. "Especially with equity markets being flat or down, nonprofits have been turning to investments that can potentially make money."

Since 1990, the hedge fund industry has grown from fewer than 300 funds to about 7,000 today, with more than $650 billion under management. Among the largest investment managers serving the nonprofit industry is Commonfund, of Wilton, Conn., which handles about $29 billion for 1,500 nonprofit institutional investors, including endowments and health care facilities.

Seeded by a Ford Foundation grant of $2.8 million, the Commonfund began operations on July 1, 1971 with $72 million from 63 endowments. Just 12 years later, the nonprofit became one of the pioneers in the use of hedge funds, giving members a way to counter the cyclical downturns in both stocks and bonds.

New funds serving the nonprofit industry continue to develop. In its sixth annual survey of hedge fund investors, Hennessee Hedge Fund Advisory Group of New York reported that the largest increase in hedge fund investments in 2003 was from endowments, increasing from 6 percent in 2002 to 16 percent in the 2003 survey.

This past August, San Francisco-based EGM Capital announced that it would increasingly target nonprofit groups, promising to forgo its 10 percent incentive fee if the fund failed to achieve a 5 percent return.

"We're confident that at least 30 percent of the portfolio is positioned at all times to make money," said Donald Johnston, vice president of marketing and client service for EGM.

The Jewish Community Foundation of Los Angeles last year announced plans to increase its stake in alternative investments, including a variety of hedge funds, by as much as $16 million or 10 percent of its asset base.

Interest in hedge funds has increased so much among nonprofits this year that five Catholic health care organizations recently created a fund geared toward "socially responsible" investments that do not conflict with the church's religious principles.

Known as the Good Steward Fund, the "fund of funds" was set up by Highland Associates of Alabama, a Birmingham consulting firm that specializes in investment strategies for 501(c)(3) organizations. While other socially responsible hedge funds have sprung up in recent years, none offered a "fund of funds" in which a number of fund advisers employ their own strategies under the guidance of a single supervising manager.

For the five Catholic health care organizations that formed the original hedge fund group, the overarching mandate was that the investments serve socially responsible investing (SRI) principles. "What's unique about this is that there's really been a hole in socially responsible investing," Wheat said. "I would include in that real estate, hedge funds and private equity. I'm of the opinion that there's actually quite a bit of opportunity for other providers to develop products in these areas."

Partners in the hedge-fund deal include San Francisco-based Catholic Health West (CHW), Catholic Health Initiatives (CHI) of Denver, Catholic Health East (CHE) of Newtown Square, Pa., Catholic Healthcare Partners (CHP) of Cincinnati and St. Louis-based Ascension Health. The group plans to open the fund to other like-minded nonprofits once the SEC approves the deal.

How they work

Although the definition of a hedge fund can vary dramatically, depending on the investment and the level of risk, two factors that separate them from traditional investment funds are the ability to use short selling and leverage.

Short selling allows an investor to borrow a stock or asset, sell it with the expectation that the value will decline and buy it back at a lower cost, pocketing the difference in price. If the stock increases in value, the investor loses the difference in price between the sell and buy dates.

Leveraging means borrowing against the value of a portfolio to purchase more shares. If the new shares purchased with the borrowed money rise in value, the investor has a positive return on his investment. If the asset declines, the investor likely faces a "margin call" that could be ruinous if the investor lacks the cash to return the borrowed money.

"Neither of those criteria would prohibit a socially responsible investment product from being offered," Wheat said.

Undoubtedly the worst debacle involving leverage came in 1998 with the collapse of Long Term Capital Management, the world's premier hedge fund with a management team that included former vice chairman of Salomon Brothers John Meriwether, Nobel Prize winners Robert Merton and Myron Scholes and former star Salomon traders Lawrence Hilibrand and Eric Rosenfeld.

Fearing the impact of the collapse, William J. McDonough, president of the Federal Reserve Bank of New York, convinced 15 American and European banks to pool $3.5 billion to refloat the fund in exchange for a 90 percent stake in the assets and a promise that a supervisory board would be formed.

While the collapse sent seismic ripples through the investment world, today's hedge fund managers point out that LTCM's investment policy was not representative of the industry in general. While the typical fund only borrows about two times its asset base, LTCM hit a level 30 times the asset base.

"Hedge funds as a group suffer from popular misconceptions that arise when a few funds suffer big losses," said Dion Friedland, founding president of the Hedge Fund Association and chairman of Magnum Funds. "The vast majority of hedge funds make consistency of return, rather than magnitude, their primary goal, looking for absolute returns. Most hedge fund managers invest large amounts of their own capital in their funds and are motivated not only to increase it but to preserve it."

Hedge fund investors rank among the economic elite because they are limited to institutions and wealthy individuals with at least $1 million in net worth or who have earned more than $200,000 in each of the previous two years. For the well-heeled investor, joining such a fund offers a "hedge" against declining markets through short-selling. While the SEC forbids hedge funds from advertising or soliciting clients through the media, investment bankers are increasingly holding informal get-togethers at which connections between hedge fund managers and investors are made.

That kind of net worth networking adds to the reputation of hedge fund investors as "crony capitalists" and heightens suspicions that hedge funds are to blame for the volatility of markets the past three years.

"Many in the investment community would have you believe the hedge fund industry is riddled with unregulated cowboys who are talking down the market, shorting companies into submission, and full of conflicts as well as con artists," Hennessee's Managing Principal Charles Gradante told a New York investment conference last year. "Certainly we have had some bad apples, but these should not define an industry that is fundamentally good."

For foundations that have seen assets decline in the market slump of the past three years -- with little upside from the bond market -- hedge funds have proven beneficial, assuming the fund manager is highly skilled. Because hedge funds charge significant incentive fees and require the managers to invest in the same funds as their clients, top managers are attracted to the industry.

"The performance of hedge funds in 2001 and 2002 has made it increasingly prudent to consider hedge funds as an equity or bond investment within traditional asset allocation," said Elizabeth Lee Hennessee, founder and managing principal of Hennessee Group LLC, in New York City. "Someday, we believe it will be considered imprudent not to include hedge funds within a stock and bond allocation."

With financial markets in turmoil in 2002, the Hennessee Hedge Fund Index had its first decline since its inception in 1987, finishing down 3.4 percent. However, that doesn't look so bad compared to the major stock market indices: For 2002, the Standard & Poor's (S&P) 500 Index fell 22 percent, the Dow Jones Industrial Average dropped nearly 17 percent and the NASDAQ plummeted 31 percent.

Another index, developed by Van Hedge Fund Advisors International of Nashville, Tenn., showed a narrower loss of 0.2 percent among U.S.-based hedge funds during 2002. Offshore hedge funds notched positive returns of 0.5 percent.

The big winners for 2002 were short-selling hedge funds, which averaged a gain of 32 percent in the Van index. While most hedge funds use short selling to some extent, these funds specialize in it. Market Neutral Arbitrage funds, which take advantage of various market inefficiencies and maintain a low overall market exposure, saw solid gains in 2002. These funds averaged net returns of 8.5 percent in the United States and 7.5 percent offshore.

By comparison, independent and community foundations representing $45 billion of assets suffered losses of 6.3 percent across all of their investments last year, the 2003 Commonfund survey showed.

The 63 community foundations in the survey distributed their collective $45 billion across these asset classes: domestic equity (48 percent); fixed income (25 percent); alternatives, including hedge funds (14 percent); international equity (11 percent); and cash (3 percent). The numbers were rounded up to the nearest whole number, thus the 101 total.

In a new section of the survey this year, 12 percent of educational institutions indicated spending a portion of an endowment's corpus. Losses among education endowments came to 6 percent in 2002, compared to 3 percent in 2001. The last positive return was a healthy 13.2 percent in 2000.

During the past 15 years, hedge funds in the United States have generated a 17 percent net compound annual return, well ahead of the S&P 500's return of 11.5 percent. With the equities markets on a sustained upswing for 2003, investment experts anticipate the flow of money into hedge funds could slow.

For the first six months of the year, funds built around short selling suffered a net loss of nearly 15 percent, while the Van Global Hedge Fund Index, a compilation of all strategies, showed a 9 percent gain.

Success could prove to be the Achilles heel of the hedge fund industry. Expanding the clientele of the hedge funds by bringing in organizations that operate on narrower margins could backfire if the funds become more closely regulated, experts said.

"I don't think people really get terribly upset when somebody with $10 million loses a couple million dollars," said Marshall E. Blume, finance professor and director of the Rodney L. White Center for Financial Research at the Wharton School of Business. "But once average investors get hurt, as they will, all bets are off. The threat is that broadening the investor pool will inevitably lead to the regulation of hedge funds."