(January 8, 2014) — Alternative strategies, including hedge funds, private equity, and venture capital, are expected to continue to outperform public equities and bonds when executed by top-tier managers, according to Commonfund.
A study of endowments and foundations’ allocations to alternatives over the last 20 years noted that these strategies provided better risk-adjusted performance with reduced volatility. Their success contributed to a monumental growth in the aggregate size of US colleges and universities’ endowments: from $100 billion in 1989 to $400 billion in 2008.
An important caveat, however, was that manager skill largely determined the extent to which alternatives worked, said Verne Sedlacek, Commonfund’s president and CEO.
“Investment talent is key, as median performance is less likely to provide consistent outperformance relative to traditional long-only strategies,” Sedlacek said.
The private equity market grew significantly in size over the last three decades, with a wider investor base of every type of long-term asset owners, the paper found. Illiquidity premiums continued to provide added returns, with more investors willing to pay big fees for higher rates of return on illiquid investments.
According to one study quoted in the paper, the average private equity return resulted in 20% to 27% more dollars than the public market from 1984 to 2008, or more than 3% a year.
“The illiquidity premium is alive and well over the last 10 years even though there has been a lot of capital raised,” Sedlacek said. “When the average is able to add 3+ percent returns per year over 10 years net of fees, it does make a substantial difference to a long-term pool of assets.”
Commonfund concluded that such illiquidity premium will allow average managers to outperform the public market, but it would take a particularly skilled manager to reach “first quartile returns.”
The hedge fund industry matured similarly, the study found, with more than 10,000 funds with $2.3 trillion in assets under management. The average endowment’s hedge fund portfolio returned 5.48% net of fees for the 10 years ending June 30, 2012—15 basis points higher than the S&P 500 return for the same period.
However, Sedlacek said achieving “consistent alpha” depended entirely on manager skill: “There is a wide dispersion of returns in alternative investments, making manager access and selection key determinants of returns.”
Despite indications of success of alternative strategies over the last few decades, endowments and foundations have been eager to exit the asset class. According to preliminary data from NACUBO and Commonfund in November, US colleges’ allocations to alternatives fell to 47% from 54% in 2012, instead investing more in US equities.
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