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Alternatives Reality: What to Expect from Future Allocations

Commonfund today announced the release of the white paper, “Alternatives Reality: What to Expect from Future Allocations” by Verne O. Sedlacek, President and CEO, Commonfund. The paper explains why 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. 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 percent for 831 institutions representing $406.1 billion in assets in Fiscal Year 2012, up from a 23 percent allocation in Fiscal Year 2001.

Throughout the paper, Mr. Sedlacek shows that alternative strategies have delivered on their promise. 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.

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. 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.

Mr. Sedlacek discusses some key factors driving the success of alternative strategies:

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.

Nonprofits of all types and size have significant allocations to alternatives. Today, 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.

Alternatives are not an asset class. Rather they are an amalgamation of investment strategies that are included in a portfolio for specific purposes: (1) growth; (2) deflation hedge; (3) inflation hedge; and (4) diversification/uncorrelated alpha.

Why the “Endowment Model” of investing has been so influential and synonymous with increasing allocations to alternative investment strategies including hedge funds, private real estate, private equity and venture capital and other less liquid or illiquid strategies compared to public markets. 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.

Manager selection is critical. There is a wide dispersion of returns in alternative investments, making manager access and selection key determinants of returns. Allocations to alternatives should be only for investors that can access top-tier managers, since the distribution of returns among alternative managers is far greater than it is among traditional managers.

Alternatives benefits: Venture capital and private equity are designed to provide enhanced returns relative to public equity markets at the “cost” of liquidity. Hedge funds are designed to dampen portfolio volatility, protect against market declines and provide uncorrelated return streams over market cycles. Private equity offers a greater alignment of interests between investors and the users of capital.

Today private equity is a global investment business. The techniques of U.S. private equity have been expanded outside the U.S. That has allowed substantial assets to be raised for investments in Europe (and other developed countries) and more recently in the Emerging Markets.

Illiquidity Premium. There is a natural illiquidity premium in private equity investing. Since private investments cannot be easily liquidated they should offer investors a higher return than similar investments in a liquid (public) market. Active management is an important aspect of creating value justifying the illiquidity premium, and skill matters. The illiquidity premium is able to add an average 3 percent returns per year over ten years net of fees, and does make a substantial difference to a long-term pool of assets.

One study shows that the average private equity to public market equivalents (PMEs) 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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