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Posted by Anna Rathbun on Thu, Jan 16, 2014 @ 09:39 AM

describe the imageAllocation to alternative investments in the endowments and pension space has grown tremendously in the last 20 years [1]. Between 1992 and 1995, flow of funds into alternative investments grew by an average of $11 billion per year, amounting to a 92% overall increase in allocation. Still, general commitment to alternatives took up only 5.5% of the overall assets in 1995 [2]. 17 years later, the 2012 NACUBO-Commonfund Study of Endowments reported an average of 54% of assets committed to alternative strategies. This article delves into the motivations that lie behind such an increase in investing in alternatives, as well as a closer look at different types of alternative investments and the risks associated with them.

Driven by Performance

The main driver for the increase in alternative investments is the prospect of higher returns: the potential for alternative investments to outperform traditional investment vehicles. The most powerful success story for alternative investments is the performance history of Yale University’s endowment, managed by David Swensen. Over a 20-year period [3], Yale’s endowment posted annualized returns of 14.2%. Yale’s endowment history also includes a chapter on dramatic outperformance from July 2000 to June 2003, when the S&P 500 fell 33% and the endowment gained 20%. During the market crisis of 2008, Yale’s endowment lost 25% of its assets, landing in the bottom decile for performance in the endowment space, but still beating the S&P 500 Index’s -26% return.

Looking at the 10-year performance for the Yale endowment between 1997 and 2007, we see an impressive annualized gain of 17.8%, driven mostly by 33.9% allocated in private equity (80% total in alternative assets). Yale’s investment team cites 30% annualized returns from private equity alone since inception in 1973. Studies show that alternatives are by far the biggest drivers of performance in the endowment space, and the Yale endowment story supports the findings in Lerner, Schoar, and Wang’s study: “the endowments with the best performance have also allocated most aggressively toward alternative investments.” [4]

Yale’s outstanding example aside, endowments in general have also outperformed most market indices over the long term. According to the same NACUBO study, over the 10-year period ending June 30, 2012, endowments on average outperformed the S&P 500 Index by 0.6% (6.2% vs. 5.6%) [5]. In addition, expanding into alternative assets has the added benefit of diversification, and a lower correlation with traditional equity and fixed income investments.

Everything Has a Price

Of course, better performance often means higher risk taken. There are opinions suggesting no real secret to the high returns of alternatives in endowments: higher returns result simply from higher risk exposure. There is truth to this statement.  The greater level of uncertainties – as represented via volatility – in private equity and venture capital, for example, means a higher premium. There is also the liquidity premium: alternative investments are illiquid in general, whether it is a venture capital commitment or ownership of hard assets.  Although endowments’ long-term investment horizon makes illiquidity of an investment less of a risk, the financial crisis of 2008 served as a reminder of the cost that comes with the liquidity premium: many universities with immediate cash needs sold real assets at less than 50% of original value and were forced to realize investment losses. Moreover, in cases of venture capital and private equity holdings, an institution may see uneven return patterns that stem from lack of liquidity in these ventures. For example, after lackluster investment results in the late 1990s as compared to the rise of the U.S. domestic equity, in fiscal year 2000, the Yale endowment returned 41%, driven by venture capital endeavors that came to fruition after a long wait period.

Higher volatility inherent in leveraged buyout, private equity, venture capital, and derivatives may mean a potential for higher returns, but it is also important to remember that not all alternative investments post double-digit returns. If the investment selection is poor, the pendulum could swing negatively. Lerner, Schoar, and Wang suggest that institutions with bigger sized endowments “benefit from superior investment committees, more highly-skilled investment managers, and the broader knowledge bases and social networks of the schools themselves.” [6] Experience and skill specific to alternative investing are crucial in determining success. Historically, there has been a great deal discrepancy in performance of alternative assets in endowments: institutions that oversaw alternative endeavors internally experienced higher volatility and losses compared to endowments that sought out experts in the field for advisement.

Finally, in the area of international alternative investments, there are always risks involved with currency, political unrest, and lack of transparency in government regulations. These risks come with a premium, especially in emerging markets.

Not All Endowments Are Created Equal

The 2012 study by NACUBO and The Commonfund reports that the size of the endowment plays a role in gaining access to the more lucrative alternative choices. Let’s take private equity/venture capital as an example since they have historically shown to act as driver of performance. In the case of the Yale endowment, the biggest driver of performance has been the 34% allocation to private equity. According to the NACUBO study, institutions with endowments over $1 billion committed an average of 26% to private equity, and on the other side of the spectrum, institutions with balances under $25 million had only 8% in private equity. The determinant for this discrepancy is the sheer dollar amount that the institution is able to commit to private equity – traditionally, private equity firms have set seven or eight figure sums as a minimum investment. Such a large sum can only be assumed by top endowments.

The size bias, however, is not the only explanation. The larger institutions tend to have access to better information and more resources that lead to better timing. The large endowments of elite universities had an early entry to the coveted private equity investments – as of the late 1990s, most of these lucrative private equities and hedge funds have been closed to new investors.

Those who want the high returns of endowments have attempted to emulate the investing styles of these institutions. Smaller endowments and small-scale investors, however, cannot benefit due to the size bias as stated above. Newer private equity offerings have dropped their minimum required funds to as low as $250,000, but these firms often do not have enough performance history in order to invest with confidence. Recently, private equity investment opportunities have become more accessible to smaller institutional investors via fund of funds. These investment vehicles usually require lower minimum commitment and offer diversification – as in the case of mutual funds, the investor is exposed to a variety of investment opportunities. Because of the daily liquidity requirement of mutual funds, however, the liquidity premium for private equity and hedge funds is unavailable to the average investor through open-end funds. Also, fees for these funds tend to run high and may encroach on the extra returns one may see from alternative investments.

For investors who want minimum commitment, one may obtain indirect exposure to private equity ventures by buying shares of ETFs and mutual funds that invest in public shares of private equity firms. Bear in mind, however, that the values of these shares represent not only the private equity ventures of these firms, but also the other aspects of these public firms that may or may not add value to the stock prices. Finally, venture capital opportunities available to large endowments can be mimicked by smaller investors via investing in micro-cap stocks and micro-cap open-end vehicles.

Outside of the private equity, venture capital, and hedge options, other alternative investments are more accessible to endowments without the benefit of the size bias. Real estate, both in the form of hard assets as well as via REITs, offers a good long-term investment option. Commodities, energy, and natural resources can be volatile in the short-run, but in the long-run, a stake in these assets through ETFs or mutual funds can offer much more than just inflation protection. In all, extending the investment strategy to alternatives may result in higher performance that is less correlated with traditional investment vehicles through increased diversification.


Every portfolio depicts a different story based on the desires and limitations of each institution. As alternative investments become more readily available to investors, they provide an opportunity for institutions to diversify while offering the potential of higher returns. Developing a sound portfolio requires institutions to acknowledge specific factors, such as necessary cash requirements, size, resources, time horizons, available investment vehicles, etc. Fund managers must take calculated risks when dealing with alternative investments to ensure the higher risk translates to potential for higher returns. When selected appropriately, incorporating alternative investments in a portfolio complements exposure to traditional investments and may offer opportunities for better outcomes.

[1] In this article, alternative investments include private equity, hedge funds, absolute return,
market neutral, long/short strategies, event-driven strategies, derivatives, venture capital, private equity real estate, energy and natural resources, and distressed debt.
[2] Hardy, Donald J. and Thomas J. Healey. “Growth in Alternative Investments,” in Financial Analysts Journal. July/August 1997, pp. 58 – 65.
[3] Fiscal period ended June 30, 2012.
[4] Lerner, Schoar, and Wang in “Secrets of the Academy: The Drivers of University Endowment Success.” In Journal of Economic Perspectives. Volume 22, Number 3. Summer 2008. PP. 207 – 222.
[5] This study includes 831 participating institutions.
[6] Pp. 208


AR HeadshotAnna Rathbun is a Director of Research in the CBIZ Retirement Plan Services Group. She can be reached at 216.520.6622 or You may also reach a CBIZ Tofias & Mayer Hoffman McCann Not-For-Profit & Education advisor at and 617.761.0600.




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