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Endowments, which embraced hedge funds years before other less adventurous investors, are treading more carefully now after the financial crisis left deep scars.
As the Standard & Poor's 500 index oscillated wildly between May's peak and October's trough, endowments held tight, riding the wave of instability. But they are asking a lot more questions.
Endowments and foundations are free to engage in the most unrestrained form of institutional investing because their liabilities are not clearly defined, unlike other institutions such as benefit pension plans.
Although there is no sign that educational endowments, foundations and family offices are retreating from alternative investments and hedge funds, these institutions are increasing their cash allocations and taking a more cautious approach to investing.
"Most of the endowments now track the liquidity of their investments better ... as well as the performance manager in a more formal way," said Cristian Tiu, assistant professor of finance and managerial economics at State University of New York at Buffalo. "They are paying attention to these issues that perhaps they were not paying as much attention to in the past."
Educational endowments have increased their cash holdings to around 5 percent to 10 percent from 1 percent to 2 percent before the financial crisis, according to investment management firm Commonfund.
"Before the downturn, endowments behaved as if liquidity was free. Now we know that liquidity is not free," said William Jarvis, managing director at Commonfund.
Family offices are preferring small to mid-size hedge funds with stringent risk monitors.
"Family offices do better investing in small hedge funds than large ones because small hedge funds are more nimble and have more investment options available to them," said Ken Wittenberg, chief investment officer at Ascent Family Group.
A large hedge fund with $20 billion US under management cannot invest in a company with $200 million of market cap because even if the stock doubles, it is not enough for the hedge fund to benefit financially, Wittenberg said.
The pool of good investment options is smaller for large hedge funds.
As most institutions do not have the resources for an in-house investment strategy team, they are treading more carefully when transferring asset management responsibility to a third party.
"The financial crisis woke people up to the question whether they were taking care of their fiduciary obligations as an investment," said Ken Phillips, founder and chief executive officer of HedgeMark, a portfolio risk management platform for foundations, endowments and other institutions.
"So if you don't know what your manager is investing in, then it opens up an entire question on whether you are meeting your fiduciary duties. If it wasn't for the crisis, maybe no one would have woken up," Phillips said.
Endowments generally do not have the internal staff and the fiduciary analytical capability to monitor hedge funds or private capital managers on a regular basis.
Most endowments, foundations and family offices can't do without hedge funds.
"These institutions don't typically do big swinging changes in asset allocations. They realize they need diversification, they need the returns. The question is how do they manage those portfolios in a prudent way as fiduciaries," said Jarvis.