What Needs to Change?

By Tommi Johnsen, PhD and Preston McSwain, December 15, 2020

In the investment world, calls for change are common.

The latest talk is that 60/40 or 70/30 approaches, which allocate assets to traditional stocks and bonds, are past their prime. More and more we hear that investors are missing out and “need to” act.

Messages to families are that “life can be better after… allocating 40% or more of their assets to private investments” or other types of alternative investments that are common in what many call an endowment model.

What Does Peer Reviewed Research Show?

Alternative fund and allocation presentations can be impressive. If you are a family or individual investor that might have different goals, time frames, and tax profiles as compared to institutional investors, however, do you need to join the endowment investing club?

We’ve asked this question before and written about how bad inputs or ingredients might be incorrectly influencing some alternative recommendations.

Now, new independent research is also questioning the effectiveness of endowment style, alternative-heavy portfolios.

This time in a paper published by the academic peer reviewed Journal of Portfolio Management, researched and written by an institutional investment insider, Richard Ennis, who founded a large endowment and pension fund investment consulting firm, Ennis, Knupp & Associates.

After analyzing the results of approximately 100 large endowments and 46 pension funds over a recent 10 year period, this is what he observed:

Sizable Allocations to Alternatives

Investments in alternatives steadily increased over the past decade and accounted for approximately 28% of pension fund assets and 58% of endowments.

Analyzing how increases in allocations to alternatives affected fund diversification, Ennis then found this:

Alternatives Failed to Diversify

When allocations to alternatives were added to simple stock and bond portfolios, the characteristics or variability of returns did not change. R², a measure of diversification, stayed the same for both endowment and pension funds – allocations to alternative investments did not provide meaningful diversification benefits.

As Ennis said:

“These are noteworthy results.”

“The finding that the correlation between funds with significant alts. exposure and marketable securities benchmarks is near perfect, runs counter to the… oft-cited [diversification] reason for incorporating alternative investments in… portfolios.”

Looking at performance in more detail, the case for alternatives did not improve.

Detailed regression analysis of return streams found that traditional public securities, not alternative strategies, were the “essential drivers of… portfolio return.”

In addition…

Alternatives Decreased Returns

Ennis points out multiple examples of alternatives detracting and creating underperformance as compared to a best fit simple 70% equity and 30% fixed income index benchmark (70/30).

Among the pension funds and endowments analyzed, a reduction in total return of 0.36% per year was observed for every 10% increase in allocations to alternatives.

And, related to the impact of increasing alternative investments to the recommended 40% levels we mentioned at the start…

Negative Alpha

Analysis showed an annualized 2% reduction in alpha when allocations to alternative increased to the 40% level some institutional advisors promote.

Where does this all bring us – again?

Simple Outperformed

The total return of the pension and endowment funds studied underperformed a simple 70/30 index portfolio by 1.0 – 1.6% on average per year for over 10-years.

What is one reason why?

The Costs of Alternative Approaches Are High

The study documents that the costs of running the pension funds and endowments can exceed 1.50% per year, which approximates the level of endowment fund underperformance illustrated below.

In the end, Ennis makes these pleas:

“If experience tells us anything… it is that low cost trumps genius over the long run.

“The key… is to overcome the temptation to be clever.

“Capture broad market exposures at the lowest possible cost with minimal maintenance.”

“Keep it simple.”

One criticism of Ennis’s paper is that the time period might be too short (only one 10-year period). Next, debate could be had that the allocations he used to non-US equities might be low (U.S. markets have substantially outperformed over the last 10 years). Finally, he used indices versus investible, net of fees index funds (real life costs matter).

However…

Ennis’s research matches what we found when we analyzed the performance of a simple 70/30 portfolio of index funds as compared to top performing endowments over the past ten 10 year periods.

We assumed a 50% allocation to U.S. equities, which included small-cap, and 50% to non-U.S. equites, which included emerging markets. In addition, we implemented allocations with investible, net of fees index funds.

What did we find?

Keeping It Simple Consistently Outperforms

If an investor kept it simple, they could have ranked in the top quartile of all endowments and foundations in the U.S. over 10 consecutive 10-year periods spanning 2000-2019, which includes multiple economic cycles and large up and down market periods such as the end of the dot-com bubble and the 2008-2009 financial crisis.