Sunday, November 25, 2007

Shrewd Investment Strategy, or Reckless Gambling?

By Richard Vedder

The lead story in Sunday's Columbus Dispatch was about growing concern among leading politicians and others over the large hedge fund investments of Ohio's public universities. Ohio State, Miami, and Ohio University all have invested roughly 15 percent of available funds (mostly endowments) in hedge funds, investments unregulated by federal authorities, where investors often do not even know specifically where their funds are invested. Is it appropriate for institutions serving the public good to have "secret" investments not know even to the institution's financial officers?

Everyone agrees these are risky investments, but they also have yielded very high rates of return over the past decade. Should universities be making these kinds of risky investments? The argument for doing so is that, if endowments are large, investing in a number of these funds simultaneously has acceptable risks but the potential for big returns --and the evidence of the last decade seems to support that argument. If a university invests equally in 10 hedge funds, two of which fail but three of which have huge returns, the aggregate combined returns on the 10 funds probably will be pretty good; if a university had invested in only one of those funds, however, there is a 20 percent chance that the investment would turn out disastrously --an unacceptable risk. By big diversification into many such funds, risks are minimized --or so it is argued. Since minimum hedge fund investments are usually fairly substantial, only those with fairly big endowments --perhaps $100-200 million or more can safely even consider these investments.

Yet I am still somewhat skeptical of investing in highly risky ventures. As the crash of several private equity markets offerings and big problems with sub-prime lending (both areas where hedge funds invest heavily) attest, the past stellar earnings record may not be emulated in the future. While it is true Harvard, Yale and Princeton can afford to take a $100 or $200 million investment loss from the crash of a fund, smaller schools (like my own Ohio University) that depend heavily on endowment funds to augment very tight budgets could face severe adverse consequences if hedge fund valuations turn south. The notion that hedge funds are protection against falling equity markets strikes me as a dubious argument and an excuse for reckless use of monies designed to augment educational services.

As publicity grows on the great returns that the big schools are getting on hedge fund investments, I fear lots of smaller, less wealthy institutions (such as my own Ohio University) are moving into them in a big way --just as the returns on them are on the verge of crashing. Harvard spends only 3 or 3.5 percent a year of its endowment principle on operating funds, and apparently feels it can gamble some funds because its wealth is so great that even with a big endowment loss it still could maintain current payouts from endowment. But most universities are not in that position. As we review federal tax policy towards universities, a review of investment policy from endowments is very much in order.


TC said...

Rich, you said "As the crash of several private equity markets offerings and big problems with sub-prime lending (both areas where hedge funds invest heavily) attest, the past stellar earnings record may not be emulated in the future." I suspect I may be missing the point but the hedge funds use the money from loans - subprimes, etc. as leverage for their extremely risky investments. This is why all the foreclosures are causing the collapse of the hedge funds - because the leverage (securitization) is evaporating big time.

This is foolish and will result in American tax dollars bailing out the big banks and private equity firms - not Joe Schmoe who lost his home. This will create a paradox. The government will poor more money into the free market at a time when that is exactly what the economy does not need to slay the inflation dragon. I am of the opinion that this is going to get ugly. I can already think through how this parallels the college business model. The only difference is that colleges and universities will die a slower death.

Anonymous said...

In my opinion, Gambling is something that every human being has the right to do, and politicians should keep their noses out of what people do for entertainment or within the comfort of their own homes.