Infovest21 Investor Focus: Role of Hedge Funds in Small/Medium Sized Endowments

Larger endowments have been investing in hedge funds for a long time and will continue to do so. Some have allocated a large chunk of their portfolios to hedge funds. According to National College and University Business Officers, the average endowment allocated 52% to alternatives in fiscal year 2010. Wilshire finds that endowments and foundations with assets greater than $500 million allocated 21.2% of their portfolio to alternatives in the second quarter of 2011 compared with 11.4% in the first quarter. The allocation to alternative for all sized foundations and endowments was 6.2% in the second quarter.

Increasingly, smaller and medium-sized endowments are starting to allocate to hedge funds. The endowment’s smaller size allows them to make investments that are small in size, yet have a potentially meaningful impact on the fund. The endowment’s smaller size also provides the opportunity for the endowment to invest with small and mid-sized managers.

Lehigh University, with assets of $1 billion, allocates 30% of its portfolio to hedge funds. Lehigh University’s chief investment officer Peter Gilbert observes, “These smaller managers that we are able to invest with are generally undiscovered by the broader institutional investment universe. They tend to be very entrepreneurial, nimble and able to take advantage of unexploited investment niches and opportunities. The managers may be focused on any number of different asset classes and strategies such as emerging markets, opportunistic credit, hedge funds and venture capital.”

Lehigh doesn’t view hedge funds as an asset class but rather a tool that can be used for different investment purposes. “We look at hedge funds in context of the portfolio and hire hedge fund managers to perform a specific function within that portfolio context. It is not about finding the best hedge fund manager but finding the most appropriate manager for the required role,” adds Gilbert.

Another endowment, which allocates about 15% of its $200 million portfolio to hedge funds and which prefers being anonymous, says it uses hedge fund managers in its alternatives bucket and in its long-only bucket. “If we have a long/short hedge fund manager which is 60% net long, we would prefer using that manager than a traditional long-only manager.” They like hedge funds because they preserve capital and are more flexible than long-only managers.

Having a good consultant is also critical for the small and medium-sized endowment as the consultant does considerable due diligence. Also if the small endowment can’t meet the manager’s requirement investment, it can use the consultant’s capacity with the manager.

Smaller endowments say they are generally too small on a relative basis to have their own managed account. Some pointed to liquidity as a potential problem.

Other small endowments argue that hedge funds are not appropriate for smaller endowments. For example, Philip Jackson of Arkansas State University, says large endowments have the resources and human resources to perform due diligence. The large endowments have chief investment officers and a staff whereas smaller endowments do not.