How Endowment Competition Fuels Alternative Investments

Alternative investments are all the rage among university endowments, and an academic paper aims to understand the factors at play motivating this shift.

(January 17, 2013) -- College endowment allocations to alternative assets are associated with the allocation policies of their near competitors, according to an academic paper by two Yale University professors.

"This is true even controlling for regional effects, size and richness," the authors write.

The paper -- titled "Competition Among University Endowments" and written by William Goetzmann and Sharon Oster of the Yale School of Management -- notes that keeping up with the Joneses can create positive externalities. The authors pose this big question: Is the shift to alternative investments a benefit to the universities who respond to competitive pressure by reallocating?

The answer, the authors show, is that relative performance of a university’s competitors’ endowments influences its asset allocation policy and the decision to change it. The general direction of the change is toward marketable alternatives, such as hedge funds.

But is this allocation shift a good thing? The authors test whether endowment performance relative to a school’s nearest competitor is associated with the likelihood of changing investment policy, and conditionally, whether the nature of that change is consistent with the goal of “catching up” to its closest rival. "Conditional on indicating a policy change, we find that endowments appear to use marketable alternatives – i.e. hedge funds – to catch up to competitors. More generally, we find evidence that endowments with below median holdings of alternative investments tend to shift policies in that direction," the paper concludes. Furthermore, the paper asserts that endowments with recent positive experience with various alternative asset classes tend to increase exposure to them.

The conclusion? "If the returns to marketable alternatives continue as they have historically, then the competition will have been a good thing. If, on the other hand, markets are efficient – or at least access to managers who can take advantage of inefficiencies for the benefit of clients is limited, then this shift may have long-term costs," the paper notes.

Endowments are not the only ones piling into the alternative investment bandwagon. Earlier this month, Agecroft Partners, a third-party marketing firm, found that pension funds will continue to be the largest contributor to growth in the hedge fund industry worldwide in 2013. The goal among pensions is to enhance returns and reduce downside volatility in portfolios in order to help manage massive unfunded liabilities. As a result of declining interest rates, forward looking return assumptions are currently around 3% for fixed income portfolios managed against the Barclays Aggregate Bond Index, which currently represents approximately 30% of pension funds’ total assets, Agecroft noted. "With current actuarial return assumptions averaging approximately 7.5%, we will see pension funds shift more assets from fixed income into hedge funds as long as interest rates stay low."

Some in the industry, however, asserted that Agecroft's predictions may be slightly farfetched. "It seems a little more ambitious than what may actually occur," said David Gold, senior consultant of manager research at Towers Watson. "Pension funds in the US will definitely continue allocating to hedge funds, but a lot of those searches will be replacement searches--or a recycling of capital. So, net new growth might be more limited." He continued: "Having a diversified portfolio and allocating to a number of managers across sectors remain critical."

Read the full paper here.

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