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April 22nd, 2021

Which Endowments and Foundations Benefit from Allocating to Alternatives?

By Damian Handzy and Cady Ridall

When it comes to asset allocation, nearly all Endowments and Foundations have invested into alternatives like hedge funds and private equity. Out of nearly 400 E&Fs we examined using Investment Metrics Plan Universe, only 22 of them, or 5.6%, did not have any allocation to alternatives. With 94% investing in such vehicles, we expected to see a clear benefit to doing so. The data didn’t support that assumption.

We investigated 392 Endowments and Foundations in our Plan Universe database, dividing them into two groups: AUM of under $100M and AUM of $100M or more. Two-thirds of the E&Fs, 258 of them, fell into the smaller AUM bucket which collectively controls 12% of the total assets. The bulk of the assets (88%) are owned by the 134 E&Fs that fall in the large AUM group. The table below shows the breakdown of these two buckets into those which have an alternative allocation and those that do not. Both groups have a similar breakdown: 95% of smaller E&Fs invest in alternatives and 94% of larger E&Fs do so.

Larger E&Fs improve their returns with Alternatives

We examined the performance and risk of the four cohorts over the past 10 years. Figure 1 below shows the performance of the cohorts, revealing that only the larger Endowments and Foundations improve their performance when adding alternatives. The average small E&F lost 33 bps per year over the ten years while the average large E&F gained about 50 bps per year with the allocation. In fact, there was not a single year over which the average small E&F benefited, and there was not a single year in which the average large E&F lost.

We note that smaller E&Fs post better overall returns than larger E&Fs: 10% average returns for small E&Fs (without an alternative allocation) as compared to 9.4% average returns for larger E&Fs (with an alternative allocation).

Smaller E&Fs improve their risk profile more with Alternatives

While only the larger E&Fs improved their returns, all Endowments and Foundations improved their risk, as shown below in Figure 2. The average Endowment/Foundation lowered its annualized volatility by 0.5%.

In this case, smaller funds benefited more than larger funds, reducing their annualized volatility from 10.8% to 10.0%. Larger funds had about half that reduction in risk, going from 9.7% to 9.4% volatility, on average.

The smaller funds, by allocating to alternatives, were able to reduce their risk nearly – but not entirely – to the lower risk levels achieved by larger E&Fs that do not allocate to alternatives. But the clear winner in the risk comparison is the larger E&Fs that have an alternative allocation.

It comes as no surprise that alternatives reduce the risk of these portfolios as both hedge funds and private equity funds are known to provide uncorrelated returns to traditional equity / fixed income portfolios. But the extent to which smaller E&Fs do not benefit from such allocations did surprise us. When it comes to alternative allocations, being bigger is clearly better.

This research analysis is done using Investment Metrics Plan Universe. For more information or a demo, please click here.

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