Alternative strategies allocations have grown over the past 20 years and are proving increasingly effective in enhancing returns and reducing risk in institutional investors portfolios, according to a new white paper from Commonfund.
Alternative strategies, especially private equity, venture capital and hedge funds, have been successful in increasing institutions’ portfolio returns and reducing risk over the past 20 years, according to Alternatives Reality: What to Expect from Future Allocations by Commonfund president and CEO Verne Sedlacek.
The paper also concludes that the fundamental principles that have contributed to historically higher returns among alternative investment strategies remain largely unchanged today. The 2012 NACUBO-Commonfund Study of Endowments found that allocations to alternatives increased to 54 per cent for 831 institutions representing $406.1bn in assets in Fiscal Year 2012, up from a 23 per cent allocation in Fiscal Year 2001.
Alternative strategies have “delivered on their promise”, said Sedlacek. Private equity and venture capital have provided returns well above public market equities. Hedge funds have provided alpha across market cycles and protected in down markets. “Alternatives have contributed significantly to portfolio performance over the last 20 years, either by providing better returns or reducing volatility,” he noted
Perpetual and other long-term asset pools such as endowments and foundations and pension funds have not been able to maintain their purchasing power and spending needs over the last generation by simply allocating to a basic mix of passively managed equities and bonds, the report also noted. Active management of long-only strategies will only bridge part of the gap. Significant allocations to alternative strategies are necessary to preserve intergenerational equity and thus fulfill the long-term missions and obligations of institutional investors. But selecting the top alternatives managers is essential. Simply allocating 20, 30, 40 percent or more to alternatives does not ensure success Sedlacek added.
“While 30 years ago alternatives were exotic “alternatives” for most investors, they have now become mainstream. Over the intervening years endowments dramatically increased allocations to equities and decreased allocations to fixed income strategies. The paper advocates allocations to alternatives to enhance returns and, for certain strategies, to provide diversified sources of alpha.
“Investors have been adequately compensated with higher risk adjusted returns compared to traditional strategies. Institutions that allocate capital to alternatives exhibit higher performance in comparison to those that allocate solely to traditional assets. Thoughtfully constructed portfolios including allocations to alternative investment strategies are well-positioned to continue to outperform the “traditional” 60/40 benchmark.”
Today, nonprofits of all types and size have significant allocations to alternatives. The largest educational endowments allocate on average more than half of their portfolios to alternative investment strategies. Pension funds, while at much lower allocations, have likewise shifted assets toward alternatives in an effort to boost investment performance and dampen volatility.
The endowment model assumes that long term asset pools (endowments, foundations, long-term reserves or pension funds) can outperform investors with shorter term time horizons by providing capital to less efficient, more complicated, and illiquid sectors of the capital markets.
One study shows that the average private equity to public market equivalents ranged between 1.20 and 1.27 depending on vintage year. This means that at the end of the life of the fund or the end of the study period, private equity returns would have resulted in 20 to 27 percent more dollars compared to public market over the time period measured. This translates into more than 3 percent per year – the equivalent of what we believe to be the illiquidity premium over public markets.
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