Originally published in Pensions & Investments

By Mark Dixon

Investment committees of small to mid-size endowments must suffer Yale envy.

The Ivy League university has a reputation for outsized investment portfolio returns. Yale University earned an 11.5% return on its $25.6 billion endowment in the fiscal year ended June 30.

The Yale model, crafted by Yale’s Chief Investment Officer David Swensen and discussed in his best-selling book “Pioneering Portfolio Management,” forgoes large allocations to traditional stocks and bonds, and emphasizes the use of hedge funds, private equity, real estate, and other illiquid alternative investments to boost returns.

While envy leads to imitation, imitation often leads to disappointment.

Many investment committees of endowments of less than $100 million have attempted to imitate the Yale investment strategy. Or, at least they think they have, because they have used an increasing amount of “alternative” investments.

However, many have learned it’s just not that easy. Even though there are plenty of “alternative” investments that are available to these institutions, according to Callan Associates, the average endowment with assets of less than $100 million earned about 2% for the 12 months ended June 30, with a range of approximately -0.5% to 4.7%. So much for imitation.

Why such a disparity?

One of the problems is that when it comes to endowments, the amount of assets in your portfolio really does matter. Most years, the Yale model works for Yale and other large institutions because such institutions can make large, direct bets on alternative investments, not to mention accessing some of the most successful hedge funds with very high minimum investment requirements.

These investments — selected in part because they have little correlation to stocks — often lack liquidity, making them difficult to sell quickly or to mark to market in real time. This is often a good thing, because it forces patience upon the investor. If you don’t mark to market, and you can’t sell it, then there is no real concern about the “loss” because a “loss” only occurs when the investment is “realized.” But liquidity is something that is often coveted by smaller endowments, and therefore the outsized returns that often come with illiquid investments are not accessible.

In addition, these investments sometimes take years to bear fruit. While large institutions have investment staff and frequent meetings with investment committee members, smaller institutions typically do not have dedicated investment staff members. The investment duties often fall to the chief financial officer or other internal staff working with an investment consultant. The investment committees, while often represented by people with the best of intentions and excellent pedigrees, meet much less frequently and often have much less time to give to the investment process.

Investing in non-traditional asset classes such as private equity, hedge funds and real assets can add significant value to a portfolio over time if constructed appropriately, but they are more sophisticated vehicles that may suffer through extended periods of underperformance. And before investing in them, or any “alternative” investment, investment committees need to take the time to understand how each of these investments might affect a portfolio to make sure it is an appropriate investment. Otherwise, when the inevitable underperformance occurs, significant risk can occur at the committee level — the urge to change strategy midcourse.

Investing in alternative asset classes will lead to the portfolio looking significantly different at times when compared to the more traditional investment markets, both positively and negatively. And this can be very difficult for investors to understand (and live with) when things are not going their way.

Many investment committees of smaller endowments that have ventured down the path of increasing allocations to alternative investments are now questioning that decision because of the less than stellar performance of commodities, real assets and hedge funds over the past five years, when compared to more traditional markets.

While Yale was making 11.5% during the 12 months ended June 30, much of this outperformance was due to a significant allocation to illiquid, private equity and direct investments, and an extremely heavy allocation to equity-oriented assets (Yale maintains a target allocation of only 8.5% to bonds and cash). Conversely, the average small endowment, according to Callan Associates, allocated 24% to bonds and cash, with 59% to equities and 17% to alternatives as of Sept. 30. And generally, the alternatives held by smaller endowments are not performing as positively as the types of alternatives Yale is holding. So, as a smaller endowment, comparing yourself, and making a judgment of your performance by comparing it to Yale (or Massachusetts Institute of Technology or many other massive college endowments) is truly comparing apples and oranges.

What is a smaller endowment investment committee to do? All investment committees should revisit their asset allocation decisions periodically and affirm that they make sense given the ultimate goals and objectives of the portfolio, and the committee’s ability to tolerate performance that is “out of benchmark,” whatever that benchmark may be. In order to outperform a benchmark, you can’t look just like it, and these differences will lead to periods of outperformance and underperformance.

At this stage in the market cycle, it is reasonable to expect that stock market returns for the next five years will have a tough time matching the performance of the past five years, and that the low volatility environment stocks have enjoyed might turn more violent at times. And with the 10 year U.S. Treasury yielding in the neighborhood of 2%, it is unlikely bonds will provide outsized returns. For an endowment that is targeting a 4% to 5% spend rate plus inflation, this may lead investment committees to conclude they need to move toward more illiquid, or aggressive investments in order to reach their goals. And that may be appropriate. But the risks must be well understood, including the risk of reaching for additional yields in things such as high yield bonds and bank loans, and in increasing the allocation to equities.

Endowments should evaluate their portfolios to ensure the strategy matches their long-term goals and tolerance for risk. (By risk, I don’t just mean volatility or chance of loss. I mean the risk of underperforming whatever benchmarks are set by the committee as its target.) Such an evaluation could result in doing nothing or in taking corrective action to reduce or increase these risks. The key thing is to study the existing plan. Do the modeling. Quantify the risks. Affirm/change the plan.

Investors undertaking such statistical soul-searching five years ago, when few investors wanted to buy equities, would have seen real opportunities on a risk-adjusted basis. (The stock market is up more than 200% since March 2009.) Today, those same statistical soul-searchers might realize the investments that they invested in for purposes of “diversifying” their portfolio, and that have performed so poorly over the past five years, might just have the opportunity over the next five years to add the value to the portfolio they had hoped for.

So while not truly imitating Yale, there may still benefits by diversifying into alternatives.

Mark Dixon is the institutional investment consulting practice leader at Plante Moran Financial Advisors, Southfield, Mich.