Economists address hedge fund limits

Yale’s endowment, which topped $15 billion this year, may see one of its most significant sources of investment returns wane if the market follows predicted trends.

Leading Yale economists and investment officials recently echoed national concerns that hedge funds — which, as a part of the absolute return asset class, make up approximately a quarter of the University’s endowment — show signs of declining performance.

The hedge fund boom that Yale and Harvard are credited with helping create may be on the decline, Yale School of Management professor William Goetzmann said.

“As hedge funds increasingly chase the same strategies, there are fewer anomalies to exploit,” Goetzmann said in an interview. “So managers will find it much harder to produce exceptional returns … I think there has been a flattening out of the performance of hedge funds on average.”

Hedge funds tend to invest in volatile markets, making them both riskier than mutual funds and potentially more profitable. Because Yale and other large universities tend to hire managers who draw high returns, a limited pool of institutional endowments have historically led hedge fund investment and popularized it for smaller investors.

Zachary Bagdon, executive director of the International Center for Finance at the School of Management, said while hedge funds have become a trillion dollar industry, they were much more profitable during the 1990s, when there were fewer players and lots of investment opportunities that could yield high returns.

“It is easier to make a hundred percent return on 100 million dollars than it is to make a hundred percent return on a billion dollars, because you would need to find ten of those high yielding opportunities,” Bagdon said. “As a whole, the hedge fund industry has been institutionalized. In many ways, it has become too large.”

Economists attribute the decline in yields to both the presence of new and inexperienced managers who are attracted to the business, and the recent influx of money narrowing the availability of good investment opportunities. Hedge funds limit the amount of money they manage at any given time.

“As that world of hedge funds has grown, its attracted a lot of managers who are fairly new to the business and not all of them are as wise and talented as the people with more experience,” Goetzmann said.

Though he criticized the effects of inexperienced investors’ increased access to hedge funds in a New York Times column last week, Yale Chief Investment Officer David Swensen continues to include hedge funds in his investment portfolio. In his article, Swensen suggested the government ought to take measures to prevent unsophisticated players from investing in hedge funds.

Justin Dew, a senior hedge fund specialist at Standard & Poor’s, said Swensen’s complaints about the hedge fund industry are misplaced, given Yale’s continuing success with the market.

“The irony is he’s so strongly stating that it is changing, but he’s received such a benefit from the business,” Dew said. “The issue can be alleviated in ways other than cutting investors completely. I think the answer is not necessarily limited access, I think the answer is better due diligence on the part of any investor to know what they’re getting into.”

The hedge fund industry is not in a true decline, Dew said, but is temporarily slacking as part of the natural market cycle.

Dew is one of several hedge fund specialists who have recently criticized Swensen’s comments in the press. Swensen said he was surprised at the ferocity of the overall backlash and said his critics have not challenged his claims in a constructive way.

“The only conclusion I can come to is they can’t attack my arguments so they’re attacking me personally,” he said.

Several economists said the overall rate of return for an institution depends largely on its management skill and style, so the success of endowments for large universities such as Yale are not necessarily tied to hedge fund performance.

“David Swensen has proven he’s extraordinarily capable,” said Damon Manetta, public affairs manager for the National Association of College and University Business Officers. “It’s entirely possible that he may change the asset allocation. His track record proved that Yale will come out very well regardless.”

Under Swensen, Yale’s endowment earned a 22.3 percent return in the fiscal year ending June 30, bringing the fund’s total value to $15.2 billion.

But despite Swensen’s success, Yale may not be immune from the difficulties plaguing the hedge fund industry, said John Griswold, executive director of the Commonfund Institute, the educational arm of a group that provides fund management and investment advice to many universities.

“They probably have pick of the litter in terms of investment opportunities, but it is a problem for Yale to a certain extent,” Griswold said. “As Yale gets larger, the number of areas where it can find potential return is shrinking, that’s including hedge funds.”

Due to low market performance, some endowments are looking now for other opportunities to generate premium returns, Griswold said.

“There’s a realization that there probably is a peak that has arrived or will arrive soon, and there are other investment vehicles that may be more attractive to institutions than hedge funds are right now,” he said.

Bagdon said hedge funds have begun looking beyond traditional investment opportunities with investments ranging from private equity and stocks to international opportunities and real estate and commodities.

Reuters reported Monday that hedge fund inflows for the third quarter of 2005 have shrunk to less than half of their levels in the year’s first quarter.

Comments

  • chrastil

    Frank Turner also was a terrific mentor to graduate students in History. He introduced me to countless ideas and useful approaches to teaching and scholarship – using the British Arts Center to teach European intellectual history, asking what is “nineteenth century” about a particular historical issue, crafting an effective junior seminar. As much as he was steeped in Yale, Frank remained a Midwesterner and knew how to reach out to those of us who came to Yale from that area of the country. As I became a faculty member myself, he counseled me to seek a balance between scholarship and the other good things in life. I am proud to pass along Frank’s legacy to my own students. –Rachel Chrastil (Cincinnati, OH)