Alpha, Beta and the Endowment Model

Abstract

Alpha, or outperformance of a benchmark, can be generated in many ways within a portfolio. It can be created by picking the top hedge fund managers, or by capturing the illiquidity premium via alternative assets. Venture capital is a major source of alpha for long-term investors. Alpha can also be achieved by active asset allocation using both tactical and strategic beta tilts. For the top endowments, these and other innovative portfolio decisions have created great, long-term alpha versus a global balanced benchmark with 70% stocks/30% bonds. Since asset allocation plays a large role in determining portfolio returns, it is interesting to compare how beta (or index fund) portfolios have compared historically versus sophisticated institutional portfolios. We compare 3 decades of performance: the 10 year period before the Internet Bubble’s peak (FY1988-1998), the 10 years including fiscal year 2000’s spectacular gains (FY1998-2008), and a more recent period (FY2008-2018). The Endowment Model will no doubt continue to help colleges to fulfill their missions, and enable public pensions to meet their retirement obligations. However, for some investors, over-diversification can dilute manager alpha and lead to performance that is similar to beta portfolios. Given its complexity, the Endowment Model is not a one-size-fits-all strategy, and is best suited for larger investment teams with considerable resources. For those institutions constrained by limited resources, using a balance of alternative assets and beta could achieve the best of both worlds. For instance, mid-sized investors might be better served by streamlining their portfolios with a liquid beta core, coupled with satellite alternative assets. And smaller investors could only use index fund portfolios and still achieve alpha. An index fund portfolio may be no substitute for a world-class endowment fund, but it could be an ideal investment solution for some long-term investors.