Why Harvard Is Smarting

WSJ.com: By CRAIG KARMIN and GREGORY ZUCKERMAN

Harvard University's endowment fund has graduated some of the most sought-after money managers in the hedge-fund world.

Now one of those stars is teaching Harvard a lesson of its own.

In the past month, the university lost about $350 million through an investment in Sowood Capital Management, a hedge-fund firm founded by Jeffrey Larson. Mr. Larson managed Harvard's foreign-stock holdings until 2004, when he left to set up Sowood, which recently lost more than 50% of its value amid bad bond investments....

While $350 million is a relatively small hit for the $29 billion Harvard endowment, the nation's largest, it highlights the risks as colleges nationwide embrace nontraditional investments such as hedge funds and private equity. Investments like these are less regulated than more traditional options, and often engage in the risky practice of investing borrowed money in hopes of amplifying their returns.

Along with Yale University -- where the roughly $18 billion endowment has achieved annual returns of about 17% in the past decade -- Harvard was among the first universities to embrace such alternative investments. The goal is to seek good returns that don't move in tandem with stock and bond markets, thereby giving diversity to the overall portfolio.

The strategy worked particularly well in the 2000-2002 period, when hedge funds generally did a much better job than other investments in protecting their clients' money from losses in the aftermath of the dot-com stock bust. ...

Harvard Management Co., which manages the endowment, has long been viewed as one of the nation's more successful and trailblazing investment-management firms. It boasts an annualized return of 15.2% in the past 10 years through June 2006. That compares with an 8.9% median return for endowments and foundations over that time period, according to Wilshire Trust Universe Comparison Service.

As Harvard's returns grew, so did its money managers' paychecks, which soared into the millions of dollars a year. That sparked controversy among alumni and others associated with the university, who argued that investment managers shouldn't be paid better than the school's Nobel Laureate professors, or its deans.

Mr. Larson's $17.3 million in payments in 2003 from Harvard were among the large salaries that drew complaints from alumni several years ago.

In 2005, Mr. Meyer and some of his top staff left the university amid complaints about their pay. ...

Nationwide, university endowments continue to show a greater risk appetite than pension funds and other large institutional investors. The top 53 university endowments, with nearly $217 billion in assets, have invested about 18% of their money in hedge funds, according to data provider HedgeFund Intelligence. The average public pension fund has only about 5% in hedge funds.

Kevin Lynch, a managing director at consulting firm RogersCasey, says there are at least two good reasons why universities have more readily welcomed hedge funds and private equity. Unlike public or corporate pension plans, which make annual payouts to beneficiaries, endowments have longer-term investment horizons, and therefore are more comfortable with the fact that alternative investments generally require investors to stay in for years.