Hedge Fund Follies

The university from which I graduated has sued its investment advisers for advising it to invest in Bayou Funds, a hedge fund that has collapsed amid the discovery of fraud in the operation of the fund (its principals have pleaded guilty and are headed for jail).

Apparently, university endowmments have been investing in hedge funds more over the past several years, in search of higher returns (according to a story in the Chronicle of Higher Education). It's worth noting that hedge funds provide those higher returns by having their investors take on greater--some times much greater--risks.

But what I found most interesting in the case of my alma mater are the following three facts:

1. The university apparently has 15% of its endowment in hedge funds. That strikes me as amazing, and not too clever.

2. The university reports a return on its hedge fund investments of 8.6% for the year ended July 31, 2005, which is apparently better than the average hedge fund return of 7.4%. However, that 8.6% return includes what apear to be illusory returns on Bayou.

3. The total return on the university's endowment was 15%.

So you take a much higher risk, and earn half of your overa1l returns. Let's do the math. If you actually earned 8.6% on 15% of your portfolio and 15% on the total portfolio, then your returns on the other 85% must have been more than 16.1%.

How does this make using hedge funds a good idea?