Review & Outlook

Our take on the investing, financial, & economic themes of the day

The Underperformance of Alternative Investments

24 June, 2014 by Ben O'Brien in Commentary

We’ve written a series of posts recently about the push by fund companies and brokers to get small investors into “alternative investments” such as private equity, hedge funds and commodities. We tend to think most alternative investments are unsuitable for most individual investors. Part of our argument against this strategy is that these are mostly complex and illiquid investments that are better suited to large institutions. It turns out, however, that even the large institutions who specialize in these sort of exotic investments have not fared very well in recent years. Some of the most prominent proponents of alternative investments have been Ivy League college endowments. Blogger Barry Ritholtz writes today of attending a conference of non-profit investors addressing this issue:

A large part of the impetus for this sort of conference is the solidifying consensus that what has become known as the Yale model — outsized investments in hedge funds, venture capital and private equity — no longer works. Indeed, the performance numbers for the past 10 years make it clear that this model has failed to live up to its promise for a while, perhaps because there just aren’t enough good alternative investments to go around. Note that none of this is cutting-edge theory or newly discovered knowledge. Rather, it is a result of institutional inertia, where even a failing approach to investing holds on to its adherents long past its sell-by date.

Ritholtz cites a Wall Street Journal article that demonstrates how the increased allocation to alternative investments has hurt performance as simpler strategies with more exposure to U.S. stocks have performed much better.

Since the start of 2009, when the market began rallying, the S&P 500 has climbed 137%, including dividends, to record levels. By contrast, the average hedge fund is up 48%, according to research firm HFR Inc., while the average hedge fund that is focused on stocks has risen 57%. Over that same time, private-equity funds have climbed 109% on average, while venture-capital funds rose 81%, according to Cambridge Associates.

The longer term performance of alternative assets is somewhat better, and indeed these are designed as long term investments. Still, the underperformance of Harvard’s endowment was enough to prompt the fund’s manager to step down recently amid a lot of publicity. The Wall Street Journal compiled returns of the Ivy League endowments since 2009:

A simple, low-cost 60/40 stock and bond portfolio would have trounced the ultra-sophisticated Ivy League strategies during this period. This is one reason why the individual investors should put a premium on simplicity and transparency and always be wary of following the so-called “smart money.”