Thinking Outside Stocks

Lots of money

In asset management, the first lesson is staying diversified. For the average household investors, the public markets are the place to put their money to work. Equity, bonds, commodities, and, for the more adventurous, derivatives are what one finds in most individuals’ portfolios. But for institutions with hundreds of millions in cash, whether it is college endowments or insurance companies’ pooled premiums, the investment options become more colorful. Private equity, hedge funds, and real estate are three examples of alternative asset classes that institutional investors often turn to in order to complement their public market investments.

The illiquidity and large capital requirements of the alternatives make them inaccessible to the average investor, which are also big risk factors that allow those with the means to invest in them to demand return premiums. While alternative assets behave differently from public securities and derivatives, they are by no means immune to the swings of the economy. Through the course of the financial crisis, institutional investors have had to face the challenge of reevaluating the role that assets like private equity and hedge funds play in their portfolios.

The relationship between risk and reward is frequently evaluated by asset managers when they perform due diligence on potential investments. For large investors, the excess returns that come with alternatives also bring along higher risk. For the managers of private equity and hedge funds, their losses in the crisis bought them an expensive lesson in investing, but most of the surviving funds maintain their fundamental strategies. For the institutional asset managers, their losses gave them enough of a scare that they had to rethink their asset allocation targets.

In the International Monetary Fund’s (IMF) September 2011 Global Financial Stability Report, it notes that “the empirical results and survey responses indicate that asset allocation strategies of private and official institutional investors have changed since the onset of the global financial crisis. Most importantly, investors are more risk conscious, including regarding the risks associated with liquidity.” It seems only natural that this risk aversion might divert interest from the riskier alternative assets. Yet, given the need to diversify and recover losses, there has actually been new interest in alternatives. For example, pension funds surveyed by the IMF increased their allocation in these investments from 10.9% in 2006 to 15.6% in 2010.

Looking at university endowments in the U.S., the amount of money invested with alternative fund managers has actually increased during the crisis. Based on the annual study on university endowments by the National Association of College and University Business Officers, in aggregate, endowments have increased their alternatives allocation from 35% in 2006 to 52% in 2010. This rise is most dramatic for the largest endowments (with $1 billion or more), from 40% in 2006 to 60% in 2010. Smaller endowments, with more limited resources, have expectedly smaller amounts invested outside of equities and fixed income. However, it may be premature to cite this evidence that the crisis increased the demand for private equity and hedge funds. This increase may simply be due to the fact that with the size of endowments decreasing and the illiquidity of alternatives, these institutional haven’t been able to adjust their allocations quickly.

One group in particular caught the attention of the media when time came for assessing damages post-crisis: Ivy League universities. The Yale Model, named after the university, was popular among investment managers of college endowments. It called for a significant allocation to “private- equity and real- estate funds or commodity-related assets”. In the past two decades, this strategy brought great returns to these endowments, especially those of Harvard, Princeton, and Yale. Yale and Princeton allocated 70% of their endowments to these assets, while Harvard had 57% of its money committed. From 1998 to 2008, “the Yale endowment gained 16.3% annually, while Harvard rose 13.8% a year and Princeton, 14.9%. The Standard & Poor’s 500 logged an average annual increase of just 2.9% in that span.” So how did the lauded alternatives fare in the crisis? While the jury is still out as the economy recovers, evidence from the few years after the crisis shows that they endured worse losses than traditional assets. Private equity, real estate, and commodity related investments took average write downs of around 50% (exact loss is difficult to determine as the returns on these investments are realized over the long term).

If the results from the Ivy League are any indication of overall financial conditions of institutional investors, it is hard not to be pessimistic toward alternative assets. They are a source of liquidity risk, and, as the crisis has shown, are not completely uncorrelated with the public market. However, with still large amounts of cash to invest, institutions need a way to include more return drivers in their portfolios. Currently, that means looking outside of the sluggish stock market and at private equity, venture capital, real estate, and hedge funds. It is not that the wound from the crisis is not deep enough to steer the likes of Yale and Harvard away, but instead the need to reenergize investment in companies means potential future benefit for those who have the money to fill the void. Institutional investors may provide the push that the economy needs to get back on track.