Those Modeling Endowment Funds Must Consider Limitations

The success of the Yale and Harvard Endowments has cause many to consider trying to mimic their asset allocation models (see article, and previous posts here and here). Unfortunately, this offers a few problems. For one, small investors do not have as easy access to alternative investment, whether it be private equity, hedge funds, venture capital funds, or certain types of real estate. Even those that do find that performance suffers when funds that were suppose to be hedged were not. Furthermore, many of the alternative asset classes turn out to be more correlated than expected, especially during market sell-offs.

Studies are also showing that adding the diversification of alternatives to your portfolio may turn out to not reduce volatility in ways normally expected. Morgan Stanley examined the risk and return characteristics of a hypothetical endowment model portfolio that had 40 percent allocation to alternative investments. While the portfolio outperformed a traditional portfolio allocating 60 percent equities / 40 percent for bonds, it did not materially reduce volatility. The performance of US equities alone explained 94 percent of the return.

Another problem is that private investors do not have the same tax advantages of endowments, many of which have access to top-tier funds and other tax-exempt groups. In some cases, seeking an pre-tax return of 10 percent would require an average hedge fund to return 14.5 percent in order to overcome the fees. For a fund of funds, the return is even higher, at 17.1 percent due to the extra layer of fees.

Those of us in the academic world often hear the common retrain from our industry colleagues, "Well, that just the academic theory. Things are different in the real world." At least for mimicking endowment funds, the refrain may ring true.