Although most, if not all, endowments and foundations attending the annual Nacubo (National Association of College and University Business Officers) conference in January last year were left shaken from the losses suffered at the end of 2008, most investment officers HFMWeek spoke to at the time declared they would stand by their hedge fund allocations.

“They are performing better than the equity markets so we will continue to use them,” said Roger Kempa, investment officer and assistant treasurer, Wayne State University in Michigan, at the time.

A year later, investors remain similarly committed. “Most of our clients weren’t pleased with their returns, but they were realistic,” said David Shukis, director of Hedge Fund Research and Consulting at Cambridge Associates – an independent consulting firm that provides investment oversight and advisory services to 825 clients including colleges and universities,  foundations,  hospitals, museums and libraries, as well as family offices and other institutional investors.

In fact, while most hedge funds and alternatives performed poorly, in line with most other investments last year, the average allocation to alternatives for US endowments and foundations with at least $1bn jumped from 52% in 2008 to 61% in 2009, according to the 2009 Nacubo-Commonfund Study.

Preliminary results from the latest study show that the institutions returned an average of -18.7% (net of fees) for the 2009 fiscal year (1 July 2008 - 30 June 2009). The study covered data from 842 US institutions of higher learning with a total of $306bn in endowment assets, a drop in assets of almost $100bn since last year’s study.

For Cambridge, redemptions last year came mainly from investors rebalancing their portfolios; for example, those that were overweight in hedge funds due to the fall in equities and had capital calls for assets such as private equity that had to be met. Private investors such as family offices comprised the majority of investors pulling out of hedge funds.
As long-term investors, endowments and foundations adapted their investment strategies to take advantage of the market conditions, they expected a number of changes in the hedge fund space as a result. Issues such as risk management, transparency, hedge fund fees were brought to the forefront and investors demanded an improvement.

“The main concern among hedge fund investors was liquidity. Hedge funds imposed gates and this posed the biggest problem for our clients,” said Shukis.  “Following the crisis, investors have found that some managers are providing better terms such as lower fees and more flexible lockups. There has been a modest improvement over the entire industry, but that hasn’t been universal.”

What most investors hoped for was a lowering of fees. The expectation coming out of 2008 was that there would be a dramatic reduction in the standard 2/20 fee structure. But the demand for hedge funds returned quicker than anyone expected.

“We tried to negotiate fees but we found the quality of managers we invested in would not negotiate,” said Ralph Alvarez, associate vice president for Budget/Planning and Financial Services, Florida State University.

Newer hedge funds and those under pressure lowered their fees to enhance their terms, but overall, fee reduction throughout the industry was marginal. Investors have realised that to get the best talent, they have to pay.

However, the adverse market conditions created opportunities for many managers and investors. Hedge funds that have survived the past year have proved themselves to be extremely proficient managers.

“I see some interesting prospects in the hedge fund space and we will certainly be looking into them,” said Bruck Fink, director of investments at Saint Mary’s College in Indiana, whose $100m endowment will be starting a move into direct hedge fund strategies for the first time.

Saint Mary’s College has traditionally invested in funds of hedge funds (FoHFs) but is now in the process of increasing its exposure to single manager funds. With the portfolio doing well in the recent recovery period, it is something the endowment is ready for, says Fink.

And the college isn’t the only endowment thinking of doing the same. The Florida State University, which has an endowment of $399m, will also eventually move to an exclusively direct hedge fund portfolio, Alvarez revealed.
“The original intention for the FoHFs was to diversify the portfolio. Now we want to be more targeted when it comes to investment style.”

Florida State University is advised by Cambridge Associates, and Shukis adds that the move from FoHFs to direct investing has been a long-term trend among endowments. “As investors become more comfortable with hedge funds, many of them move to building direct programmes with our assistance," he says.

But FoHFs still make sense for diversification and Shukis believes there are some excellent FoHFs out there. In fact some investors still have faith that FoHFs offer diversification, expertise and thorough due diligence on underlying managers.

The $350m University of Wisconsin System Trust Funds will be searching for its first hedge fund investment (outside of a mandate managed by GMO) and will most likely use a FoHF, Doug Hoerr, director of finance, pointed out.  “We think it is good value and are willing to pay the double layer of fees for that level of expertise.”

While investors built up exposure to credit and distressed strategies over the past year or so, Shukis has not seen much in the way of dramatic changes in allocations to strategies. However, there have been a fair number of changes in the names of hedge funds in the portfolio. “Firms [like Brevan Howard and Moore Capital] that were previously closed suddenly reopened offering an ‘upgrade’ for an investor’s portfolio and many took advantage of that.”

Investors are also looking to the secondary market to purchase hedge funds, such as the Florida State University, Alvarez revealed. But that doesn’t mean smaller and start-up managers will not see any interest going forward.
“We are still actively looking for newer managers and exploring ways investors can diversify their portfolios,” advised Shukis, stating that there are still arguments for investing with newer managers. “They are dedicated to succeed and can participate in smaller transactions. There are opportunities out there but people need to be selective,” adding that Cambridge Associates prefers to see a year or more of performance from new managers.  However, while performance is important, it is only one aspect of the due diligence process. “We qualify managers based on a multitude of qualitative factors as well,” says Shukis.

Most of all, investors are looking for those managers that can add value and can satisfy their concerns following recent events. According to Shukis, the main thing managers have done to address these concerns is to hire a third-party administrator, addressing risk and transparency concerns.

With risk management a greater consideration, endowments are also looking further afield for new opportunities.  “Over the last month I have seen an increase in managers that had launched just before the crisis, coming to people’s attentions,” Shuklis points out. Endowments and foundations are also keeping an eye out for long/short equity hedge funds coming from outside of the US.

“As the hedge fund market develops in Asia, Europe and LatAM, there is an appetite developing there,” Shukis speaks from his experience with clients.

Endowments themselves are also hiring more in-house staff to add that extra layer of governance and understand funds thoroughly. However, there is also the option of outsourcing the investment duties altogether. Last year, the University of Colorado’s $825m endowment’s investment portfolio management was outsourced to Perella Weinberg Partners.

Similarly some US pensions have taken the same route. Shukis is no stranger to the movement – today  Cambridge  provides hedge fund outsourcing services to nearly  250  clients, many of whom were long-standing consulting clients of the firm before migrating to the comprehensive oversight model.  

“It is definitely an area of our business that is set to grow, Many endowments see it as a good option as their portfolios become more complex and they recognise they do not have the resources or the bandwidth to provide the necessary level of oversight.”   

He adds that in a traditional format there is an investment committee, internal investment staff and a consultant that work together.  But today, many committees are concerned that they cannot dedicate enough time, given a quarterly meeting cycle, and they seek a partner who will be accountable for the day-to-day oversight.   

“Have you ever worked with an investment committee?” asked one investment analyst at a large US endowment. “It’s tough,” he said. But in an environment like the industry has experienced this past year and a half, it can be appealing to have a significant decision maker.