ALTERNATIVES - Direct Approach

Ball State University plans to strengthen its hedge fund due diligence by cutting out the middleman.

Like many endowments, the Ball State University Foundation is focused on enhancing its risk controls. The approach it’s taking, however, is very different from that of most of its peers.

The Muncie, Indianabased university got a wake-up call two years ago when a $2.6 million investment it had with New York based PlusFunds Group was jeopardized by that Þrm’s bankruptcy. Now, as many endowments flock to funds of hedge funds to help diminish their risk, Ball State is shifting its allocations to direct investments.

Ball State began investing in hedge funds in 2004 on the suggestion of its adviser, St. Louisbased Hammond Associates, as a way to diversify its portfolio without being correlated to the equity and bond markets. “Spreads had narrowed, the yield curve was flat, and things were as complacent in the Þxed-income market as they could be,” says Thomas Heck, 54, the treasurer and vice president of operations for Ball State’s $200 million portfolio, explaining why the foundation moved into hedge funds at the time.

The endowment initially allocated $26 million between two funds of hedge funds, five single-manager hedge funds and a managed futures index fund run by PlusFunds. Its investment committee also adopted Hammond’s proposed target allocations: 20 percent domestic equity, 20 percent international equity and 15 percent each in fixed income, private equity, real assets and hedge funds.

But in October 2005, when news broke that Phillip Bennett, the CEO of Refco -- PlusFund’s broker-dealer, which held PlusFunds’ assets -- had altered his company’s balance sheet to hide $430 million in bad debts, the endowment pulled its PlusFunds allocation on the advice of Hammond. “Our institution had never been through a manager problem,” says Heck, who has a master’s degree in accounting from Ball State. “Now we’re much more aware of, and appreciate the importance of, manager due diligence.”

PlusFunds’ inability to recuperate all of its assets from Refco, coupled with numerous redemptions, forced the firm to file for bankruptcy -- proceedings that are ongoing. Bennett awaits trial for his role in Refco’s downfall.

Ball State’s current hedge fund allocations, which include direct investments with seven funds and two funds of hedge funds, constitute 19 percent of its portfolio, or $39 million. Heck will not identify any of the portfolio’s managers but says that over the next 12 months, the endowment will reallocate the investments currently with funds of hedge funds to an additional four or Þve single-manager funds -- a move he says will mean significant savings in fees.

Although many endowments are willing to take on an additional layer of fees in return for the extra protection that multimanager funds provide, Heck believes the thoroughness of Hammond’s due diligence is actually superior to the oversight done by most fund-of-funds firms.

The endowment has yet to reach its exposure targets and is juggling some of its allocations. To raise its private equity allocation (currently 8 percent) closer to its 15 percent target, it is paring back its hedge fund investments to 15 percent. But with the school currently starting a new capital campaign, the endowment is slated to receive additional funding, and Heck says the dollar amount of the portfolio’s hedge fund investments is unlikely to change.

“Hedge funds are more defensive for us,” says Heck, who initially joined the endowment as controller in 1988, when it had only $30 million in assets and was managed by a local bank. “We look at private equity as a returns generator.” He expects the portfolio’s private equity investments to generate returns in the mid- to high-teens, compared with expectations for returns in the high single digits from its hedge funds. For the 12 months ended April 30, the endowment’s hedge fund portfolio returned 11.8 percent, net of fees. The two funds of funds generated an aggregate 9.5 percent, and the direct investments returned 13.9 percent. Comparatively, the HFRI fund of funds index returned 8.4 percent for the period.

The endowment is also creating a chief investment officer position -- a post Heck has set his sights on. Though David Bahlmann, the foundation’s president and CEO, is involved with investments, Heck is currently its only full-time investment professional. Resource constraints have kept him from visiting managers before they are hired, but once the CIO post is filled, Ball State plans to step up in-person visits and its own oversight.