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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
Leading Endowments & Foundations Demonstrate
New Paths to Alpha
As these trends were developing within the broad investment
community, leading endowments and foundations (E and Fs)
took the concept of diversification at the heart of MPT/CAPM
into new investment areas beyond the traditional equities and
bonds that had been investors’ primary focus.
E and Fs expanded their investable universe away from
tradable securities in liquid markets and added diversified
alpha streams in less liquid markets. E and Fs began allocating
to strategies and structures such as hedge funds and private
equity funds that offered less liquidity compared to allocations
to long-only active managers and passive beta investments.
One feature these strategies provided investors was access
to an illiquidity premium. Since these vehicles did not have to
offer daily liquidity to investors, they could invest in longer-
term strategies and themes such as distressed corporate
credit and deep-value or activist equity investing.
In addition, E and Fs allocated to strategies that were not
able to be benchmarked either because of the assets they
traded (eg, convertible bonds) or because of the investment
techniques the managers were permitted (ie, shorting and
leverage). Many of these investors viewed these allocations as
a purer form of alpha because the managers were not limited
to under- or over-weighting positions around a benchmark.
This diversification of alpha streams into hedge funds and
other alternative funds including private equity and real estate
was led primarily by the market pioneer David Swensen at
Yale University and as such became known as the Yale model.
The five principles of this model are:
• Invest in equities, because it is better to be an owner rather
than a lender.
• Hold a diversified portfolio, avoid market timing, and fine-
tune allocations at extreme valuations.
• Invest in private markets that have incomplete information
and illiquidity to increase long-term incremental returns.
• Use outside managers except for all but the most routine
or indexed investments.
• Allocate capital to investment firms owned and managed by
the people actually doing the investing to reduce conflicts
of interest.
In essence, these E and Fs invested in what they believed
were the best managers available in their respective areas,
with limited regard to how it impacted the liquidity or ability
to benchmark their overall portfolio. They viewed this
introduction of varying alpha streams as an expansion on the
concept of diversification as originally posited by MPT/CAPM.
The philosophy led the largest, most progressive E and Fs
to allocate a significant portion of their portfolios to hedge
funds. Indeed, as illustrated in Chart 42, the average E and Fs
holdings for organizations with more than $1 billion in assets
had nearly 18% of their portfolios allocated to hedge funds
in June 2002, and Yale University had 26.5% of its assets in
absolute return strategies in 2002.
The portfolios of these large E and Fs demonstrated significant
resilience during and in the aftermath of the technology
bubble of 1999-2002. Yale University’s returns and returns
on the diversified alpha stream portfolio held by E and Fs
investors with more than $1 billion in assets far outperformed
the general market and the majority of institutional investor
portfolios of the period that remained aligned to the 60%
equities /40% bond allocation model.
This is illustrated in Chart 43. Yale University made money
(+0.7%) and large E and Fs portfolios suffered far less severe
losses (-3.8%) than the traditional 60/40 portfolio (-7.8%)
during the broad equities market correction of 2001-2002.
20
10
0
-10
15
5
-5
Chart 7
60% Equities/
40% Bonds
>$1B Endowment
Portfolio
3-Year Returns
1-Year Returns
-7.8%
-3.8%
+5.6%
-2.2%
Yale University
+.7%
+17%
Sources: Yale University; Citi Prime Finance analysis & NACUBO
Commonfund Study of Endowments, 2002
Chart 43: Relative Portfolio Performance of
diversified Endowments versus traditional
60/40 portfolios