Traditional versus Alternative Investments
This month’s PartnerTalk stems from an ongoing conversation between two investment professionals turned prominent thought leaders, Larry Siegel and Richard Ennis. Interestingly enough, and perhaps a reflection of the times we are currently living through, this back-and-forth “conversation” actually played out via a series of articles, commentaries and rebuttals, published in the Journal of Investing. If you are interested in reading the various pieces written by both Larry Siegel and Richard Ennis, they can be found via the link below in this footnote.¹
Their broad conversation actually centers on the merits of what’s referred to as the “endowment model” of investing, popularized by the late David Swensen (the Yale endowment’s former CIO) who recently passed away.² In an initial article, (Commentary: Problems with the Endowment Model), Richard Ennis defines the endowment model’s primary characteristics as employing: (1) various asset classes to achieve diversification benefits; (2) a significant allocation to alternative investments and; (3) a very large number of individual investment managers and managed portfolios (i.e., for some large endowments, 100+ managed portfolios).
Of these three characteristics, it is the use of alternative investments that I am focusing on in this note. I’ve chosen so in part for brevity and in part because I believe this topic will become increasingly relevant in a (potentially prolonged) era of low interest rates and low expected returns for US equities.
Although there is no singular definition for alternative investments, the label generally refers to any investment that is not a publicly traded stock, bond, or cash instrument (commonly referred to as “traditional” investments, the counterpart for “alternative” investments). As you can likely imagine, this leaves a very broad swath of what may be considered an alternative investment. Some of the types of investments that are often found under this label and commonly used in portfolio construction include: private equity, hedge funds, commodities, and real estate.
Richard Ennis is highly critical of the heavy use of alternative investments that many large institutional investors employ. His argument draws on two key points: alternative investments have dragged down recent performance and have failed to provide adequate portfolio diversification. To assess performance, Ennis uses data from the National Association of College and University Business Officers (NACUBO) for a group of large endowments (those with greater than $1B in assets).
He notes that after generating strong excess returns during a period he titles “The Golden Age of Alts” from 1994 – 2008, endowment performance reverses and is persistently poor during what he describes as the “Post-GFC (Global Financial Crisis) Era” of 2009 – 2020. Ennis notes that over this final post-GFC period, the large endowment cohort held approximately 54% on average in alternative investments. Regarding the reason for the poor performance of alternative investments broadly, Ennis cites “greater pricing efficiency in those markets combined with alts’ unrecouped annual costs of 2%-4% of asset value” (P4, Commentary: Problems with the Endowment Model).
Regarding the lack of diversification benefits, Ennis finds high correlation coefficients during the “Post-GFC Era” between the Russell 3000 Index (US stocks) and various categories of alternative investments including real estate, private equity, and hedge funds. Higher correlation coefficients indicate that these broad categories of investments would not have provided meaningful diversification benefits when included with a portfolio of US stocks.³ Strengthening this point, through further analysis, Ennis also finds that “stock and bond indexes alone [i.e., traditional investments] capture the return-variability characteristics of alternative investments in the endowment composite for all intents and purposes…” (P4, Commentary: Problems with the Endowment Model).
In debating the merits of the endowment model, Siegel responds to Ennis with a few points of his own related to alternatives. His primary contention is that, as with any form of active management, if an investor believes that skilled managers exist and that he or she can identify such managers in advance, it makes sense to use active management (including alternative investments) in a portfolio. He believes that focusing on costs, liquidity risk, and higher correlations with traditional investments will help investors improve their odds of success with alternative investments. Importantly, he also states that alternative investments are a broad grouping which is often difficult to generalize about. This is an important point, as even within a particular type of alternative investment category (hedge funds, for example), there is often significant variation between how individual funds perform and behave.
From PMA’s perspective, we side more with Richard Ennis in this debate. PMA’s general approach has never been to use alternative investments in our clients’ portfolios in our almost 40-year tenure as an investment manager. The traditional investments we have used to create well-diversified portfolios for our clients (stock and bond mutual funds) have held up well over a variety of market cycles and distressed market environments. This is not to say that alternative investments have no place in portfolios—for investors with sufficient capital, a very long-term investment horizon, access to top-tier alternative investment managers, and the ability to manage these types of investments in the context of a broader portfolio, they may serve a valuable purpose. But still, there must be alignment between the type of investments used and an investor’s (or firm’s) investment philosophy.
PMA’s investment philosophy centers on risk control, transparency, liquidity, and managing investment costs. We believe very strongly in these four principles. These principles themselves generally exclude private investments (such as hedge funds or private equity funds) from our investment universe because they are often very costly to invest in and may: place varying types of restrictions on accessing capital, involve significant use of leverage and derivatives, and provide limited transparency into the underlying securities. Certain alternative investments such as commodity futures are publicly traded and fall into a separate class from private investments. Nonetheless, upon evaluation and further reevaluation, PMA has found the costs of these types of investments to outweigh the benefits.
The alternative investment landscape will continue to evolve through time, and PMA will monitor it accordingly, though our core investment beliefs will remain unchanged. If you are interested in discussing alternative investments or PMA’s investment approach in greater detail with your adviser, please do not hesitate to reach out to us.
¹ https://larrysiegel.org/is-the-endowment-model-a-good-investment-strategy/. Larry Siegel is the Gary P. Brinson Director of Research at the CFA Institute Research Foundation in Charlottesville, VA, and an independent consultant. Richard Ennis is the retired chairman of EnnisKnupp and a past editor of the Financial Analysts Journal.
² See: https://www.wsj.com/articles/david-swensen-yale-endowment-chief-who-changed-the-course-of-institutional-investing-dies-at-67-11620305438.
³ It is important to note that Ennis is analyzing indexes containing a broad collection of alternative investment vehicles in each category, not individual standalone investments. This does have implications for the diversification point, but this is beyond the scope of this memo.