Hard lesson for US universities

American universities are a model of how sovereign wealth funds might develop.

At the beginning of last year, sovereign wealth funds were treated with suspicion by many countries. Who are these foreigners buying our assets, and for what purpose, they asked? The mood changed abruptly in September, when authorities in many parts of the world, particularly the US, made it clear that they did not mind where the money came from, just as long as it arrived. America's Ivy League universities did not have to deal with the same suspicion, but in many cases they are a model of how sovereign wealth funds (SWFs) might develop, for they share similar features and goals.

Both are behemoth institutional investors: Harvard and Yale manage investment funds in excess of US$20 billion (Dh73.47bn), which they use to preserve and multiply their wealth for future generations. The same goes for most sovereign wealth funds. Because sovereign funds and universities invest for the long-term, they also enjoy an unusual degree of flexibility when it comes to pursuing elaborate and creative investment strategies.

Economists say these similarities have not gone unnoticed by sovereign fund managers. Many funds have begun tweaking their investment strategies in the past few years to resemble those of university endowments. "I think we'll see sovereign funds trying to take some of the best practices of the endowments ? and pressing ahead along those lines," says Josh Lerner, a professor at the Harvard Business School.

After all, Harvard and Yale have achieved nearly magical returns in the past decade: Yale posted a 16 per cent average annual return on its investment, while Harvard achieved an average of about 13 per cent. Such success has made their cutting-edge investment strategies, which involve forays into less traditional asset classes such as stocks and private equity, the gold standard for institutional investors.

Only since the onset of the financial crisis have the universities shown any weakness. Even the ivory tower, it seems, could not withstand this particular financial storm. "The severe turmoil in the world's financial markets has affected all major asset classes in which the endowment is invested," wrote the president of Harvard, Drew Faust, in a letter to the university last month. "We continue to plan for a scenario in which our endowment is down 30 per cent in value for the year. To put a loss of that size in historical context, over the last at least 40 years, Harvard's worst single-year endowment return was a negative 12.2 per cent, in 1974."

Harvard's endowment stood at about $39bn last fiscal year, meaning it could lose more than $12bn. Yale projected a slightly smaller loss of 25 per cent of its endowment fund this year. Although the losses are significant, they are still roughly equivalent to economists' estimates for the losses that Gulf funds suffered last year. According to Rachel Ziemba, an economist at RGE Monitor, a global financial analysis firm, the funds' combined value probably fell by more than 28 per cent.

Mr Lerner says the recent losses are unlikely to prevent sovereign wealth funds and universities from becoming increasingly similar in their investment strategies over time. The interests and constraints of the two are simply too closely aligned. Both, however, will take a moment to ascertain how to "avoid the pitfalls" that led to the recent losses. Among the lessons that sovereign wealth funds will probably want to avoid is concentrating too much of their assets in one geographic area, especially when it comes to private equity, says Monte Brem, the chief executive of the StepStone Group, a California-based consulting company that works with SWFs.

"SWFs' portfolio[s] typically have a well diversified geographic exposure. Endowments and foundations in the US tend to be more North America-centric," he says. "We believe that endowments and foundations could benefit from a greater emphasis on international private equity markets." According to Gordon Latter, an economist at Merrill Lynch, it would make a great deal of sense for sovereign funds to start emulating universities by moving a larger share of their money into more adventurous kinds of assets such as private equity.

Investing in such asset classes can give higher returns, but doing so also requires a level of skill and manpower that few sovereign wealth funds have yet been able to achieve. As they hire more skilled fund managers, they are likely to get better access to deals, which will help them implement the strategies. Some have criticised Harvard in particular for the losses it has taken on its stocks portfolio over the past year, saying that the university should move back into the more conservative types of assets, which have done better in recent months. However, according to Mr Brem, such a move would be ill-advised at the moment, both for sovereign funds and endowments.

"Endowments and foundations are being forced to pull back from the private equity market. Historical returns tell us that investments made in the next few years will be on the top end of historical private equity returns," he says. "SWFs have an advantage in the market today. They have capital to invest... in this way, SWFs have a big advantage and are likely to become increasingly important players in the private equity market."

Mr Brem says sovereign funds have also shown an increasing interest in private equity. "There has been a bit of a pause as oil prices have dropped over the past few months, but once oil prices stabilise I expect to see a renewed focus on gaining increased exposure to private equity." If this happens, wealth funds - like endowments - are more likely to engage in private equity deals directly, rather than through an intermediary such as a specialised private equity fund.

Obviously, the sheer size of the largest wealth funds produce some problems that endowments do not face. "Many of these strategies, the bigger you get the harder it gets to implement them," Mr Lerner says, largely because there often are not enough deals available in the marketplace to execute them on such a large scale. Ironically, however, if endowments continue to grow at the rates they have seen in recent decades, they too may begin to face the same problems, says Mr Lerner. If this happens, the result may be something of a role reversal as endowments start emulating sovereign wealth funds. [e-mail]