Are hedge funds dragging down university endowment returns?

Whether the portfolio labels are hedge fund, marketable alternatives or absolute return what they all share at the typical university endowment portfolio is underwhelming performance numbers that on a fiscal basis may have caught CIOs off guard in 2019.

U.S. educational endowments reported an average return of 5.3% net of fees for the fiscal year ending June 30, 2019, down from the 8% reported in 2018, according to research collected by NACUBO and TIAA in cooperation to produce their annual endowment report.

What researchers found in the 2019 NACUBO-TIAA Study of Endowments was contrasting performance figures depending on endowment size and reliance on private equity and venture capital investments.

Meanwhile, the largest U.S. endowment housed at Harvard University, saw a return of 6.5% on its $41 billion endowment for the fiscal year ended June 30, 2019, according to its annual report released last year.

Harvard Management CEO Narv Narvekar attributed the endowment’s overall poor performance to legacy portfolio assets that are illiquid residing mostly in the endowments’ natural resources portfolio, which is in the process of being unwound. The natural resources program was down by more than 12% during the fiscal year 2019.

Still the illiquid segment of the hedge fund portfolio was a drag on performance, he added. Roughly 20% of the hedge fund portfolio is illiquid.

Hedge funds contributed 5.5% in annualized gains, while making up 33% or roughly $13.5 billion of Harvard Management Company’s portfolio.

“The evolution of our public equity and hedge fund portfolios is exhibiting a significant positive impact and the early returns are encouraging,” wrote Narvekar in his annual report. “That being said, we need to maintain this momentum and improve even further in the years ahead.”

But both public equities and hedge funds over the past two fiscal years have outperformed their respective benchmarks. Combined the asset classes outperformed the blended benchmark by more than 2.25% annualized over two years.

“We are particularly pleased with our hedge fund performance, as it was not driven by positive equity markets,” said Narvekar. “By design, our current hedge fund portfolio has less exposure to equity markets than any such portfolio I have overseen during my 21 years in endowment management.”

By contrast though, private equity investments make up 20% of Harvard’s investment portfolio or roughly $8.2 billion and returned 16% over the same 12-month period when hedge funds were up 5.5%.

Data collected by NACUBO from 744 colleges, universities and affiliated foundations, revealed similar trends that while performance from private equity dominated, the investments to hedge funds were sizable. On a dollar-weighted basis, the largest investment allocations last year were to marketable alternatives (19.1%), non-U.S. equities (14.5%) and U.S. equities (14.1%).

The allocations to private equity and hedge funds could be set to grow too as diversification away from public equities remains paramount as many CIOs anticipate the end of the prolonged bull market in equities.

Kevin O’Leary, CEO of TIAA Endowment and Philanthropic Services, said that as endowments continue to play a significant role in institutions’ operations and financial strength, it is essential that they take advantage of a wide range of investment options and strategies.

“Endowment asset allocations and returns varied across different size endowment cohorts,” he said of the team’s study. “Considering larger endowments generally have greater access to certain asset classes, such as private equity and venture capital, which were some of the highest performing asset classes in fiscal year 2019, they again outperformed their smaller cohorts.”

According to the endowment study, venture capital returned 13.4% and private equity 10.2% over the fiscal year, while U.S. equities were up 8.2%. Hedge fund returns were not broken down in the study summary.

Strong 2019 performance by the largest institutions (over $1 billion) was driven by larger exposures to buyout and venture capital investments, NACUBO officials found. The second best-performing cohort were those with assets of $25 million or less.

Endowments with $1 billion or more in assets over a 10-year period reported annualized gains of 9%, while those same funds with $25 million or less in assets reported only 7.7% over the same time period.

Still, no one has topped 2011’s stellar average net returns of 19.2%. Yet, the 2019 gains still reflect the strong stock market recovery since the 2008 financial crisis as well as solid management practices, according to NACUBO.