Alternative investments have gained popularity with all types of investors in recent years, but universities, non-profits, and other entities that follow the ‘endowment’ style of investing now allocate more than half their portfolio to alternatives. Endowments like alternatives because it gives them a way to get uncorrelated alpha and strong risk-adjusted return, but a bullish equity market and strong correlations with many alternative strategies call that rationale into question.

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Endowments: Investment talent is key

The ‘endowment model’ uses long-term asset pools, whether it be a literal endowment, a pension fund, or long-term reserves, to take advantage of illiquid parts of capital markets that are out of reach for investors with shorter time horizons. In theory, taking on this illiquidity should bring some premium to investors, but that isn’t always the case.

“Investment talent is key, as median performance is less likely to provide consistent outperformance relative to traditional long-only strategies,” writes Verne O. Sedlacek, president and CEO of Commonfund Institute. “An ‘index-like’ approach to alternative investment strategies will certainly disappoint.”

When asking whether the endowment model is better than a straightforward 60/40 passively managed portfolio, especially after fees are taken into account, Sedlacek argues that talking about alternatives as a group isn’t that helpful because it really isn’t a single asset class. Private equity is different from venture capital, and hedge funds are really an array of strategies that have already been clumped together.

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Private equity correlation has grown steadily in the last decade

Hedge funds and private equity get the lion’s share of asset allocations from endowments, a combined 61%, but looking at correlations with equities shows how different they are. The correlation between all private equity and the S&P 500 has grown from 35% in 2000 to 89% last year. Hedge funds have more growth in the number of low correlation managers, though managers with high correlation to the S&P 500 (north of 90% sometimes) have also grown.

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Sedlacek concludes that endowments need to keep allocations to alternatives high if they want to maintain intergenerational purchasing power, not a surprising conclusion considering his position. But more than anything he manages to show that, unlike equities and fixed-income products, the temptation to talk about all alternatives (or even all hedge funds or private equity) as a group is really misleading. The amount of idiosyncratic risk and return is such that drilling down to the specific strategy, if not the specific manager, is necessary when deciding where to invest.