NEW YORK (HedgeWorld.com)–Analysts at Fitch Ratings are watching hedge funds closely as they become a larger part of endowment fund portfolios.

In a recent report called “Expanding Our Understanding of Contracting Endowments,” Fitch discusses hedge funds’ increasing role within Fitch’s ratings of schools’ ability to pay their debt and whether hedge funds can play a role in improving investment performance.

Fiscal year 2002 saw college and university portfolios of greater than US$1 billion lose close to 4%, Fitch notes in the report.

On top of those losses, schools typically pay out 4.5% to 6% of their endowment each year, said Pam Clayton, an analyst for Fitch. That means some endowment funds probably shrank in size during the fiscal year, absent new contributions to the fund, potentially hurting higher education’s financial strength, particularly in terms of their income statement.

To help boost returns and reduce volatility, endowments increasingly are using hedge funds and other alternatives, Fitch states, pointing to a study indicating that large endowments, again those greater than US$1 billion, have close to 28% of asset allocated to alternatives.

When evaluating a school’s endowment fund allocation for its ratings, Fitch focuses on investment management team quality, trustee oversight and investment monitoring. Fitch views a large allocation to alternatives as a concern “if proper controls are not implemented to ensure timely reporting and monitoring of investment performance.” But should controls be established, then a more aggressive policy with regard to hedge funds, and equities, might be appropriate, Fitch says.

PBarr@HedgeWorld.com