The Ivory Trade

As the new issue of The Economist points out, the efficient market hypothesis was developed at a US university (The University of Chicago).  But in an ironic twist, US university endowments seem to be disproving the whole idea of market efficiency with continuously stellar investment returns for their endowments.  Was the EMH a scam perpetrated by the colleges themselves to juice returns, get rich and pay for better and better basketball teams?  Or are the universities just a lot smarter than academics figured when they cooked up the efficient market hypothesis back in the sixties?

Either way, two trends stand out loud and clear: one, large US university endowments are blowing away the S&P on a one year and ten year basis according to data collected by The Economist; and two, realizing this, the investment heads of these endowments are leaving in droves to set up hedge funds.

How exactly have they done so well?  The Economist puts forward two hypotheses: that they have extremely long-term horizons and are therefore able to undertake riskier investments, and that they get regular advice from Nobel laureates on their faculty or wealthy donors in the investment industry.  While both may be true, I have always felt the second hypothesis holds more water.  As a hedge fund marketing manager, I found university investment committees to be more sophisticated than average and willing to be early adopters of alternative investment.  For example, it doesn’t hurt Columbia University to have Mark Kingdon, one of the world’s most successful hedge fund managers on its board.  It also doesn’t hurt Yale to have its own pow-wows with leading investment professionals.

While it’s academically sound to assume a long time horizon would yield higher returns, there is not proof of this in the source used by The Economist (a report by the The National Assoc. of College & University Business Officers).  It would have been nice to see the risk-adjusted 10-year returns for these funds to corroborate this theory.

The Economist’s second major observation is that the heads of these foundations are leaving to set up hedge funds (e.g. Duke, Harvard, Cornell, Yale).  No surprise, they say, given how hard it is make over $2 million a year inside the university.  Unlike the “constraints” we discussed in yesterday’s posting, the only constraint these guys faced was a constraint on the number of zeros that could fit on their university pay stubs.

In any case, their secret seems to have something to do with hedge funds and portable alpha.  Says The Economist:

“The idea they helped develop in the 1970s and 1980s—deemed eccentric at the time—was to break the portfolio into a mix of standard and ‘alternative’ assets, as uncorrelated with each other as possible so as to spread risk. This strategy is sometimes referred to as ‘portable alpha’.”

So while we may think we have all played the suckers to US universities’ “efficient markets”, this article suggests that we may actually get the last laugh…

“Simply putting 20% into hedge funds is no longer enough. The big test of their prowess will come when lax credit conditions tighten. John Griswold of Commonfund thinks that some investment committees, stuffed with alumni, may be starting to lose track of the risks their endowments are taking.”

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