Endowment investing is not for everyone

(MoneyWatch) The success of the Yale Endowment has led many endowments, foundations and even individuals to focus on alternative investments and try to capture the liquidity premium available in illiquid investments. However, adopting such a model may be impractical.

First, there is the question of liquidity. In addition to heavy exposure to private equity, the strategy often includes investments in hedge funds, many of which invest in strategies that try to capture the liquidity premium. And in general, hedge funds themselves are illiquid investments. While endowments differ from individual investors because of their very long investment horizons -- allowing them to take liquidity risk that would be inappropriate for individual investors -- even Yale learned in 2008 that financial crises could lead to calls on its endowment to provide liquidity. One of the worst mistakes investors of all types make is to treat the unlikely as impossible. The result is that when the unlikely does occur, they may be forced to sell illiquid assets at the worst possible time: when the price of liquidity is highest.

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Second is the low correlation alternative investments exhibit to core assets such as stocks and bonds. The problem is that the benefit of low correlation comes from the ability to rebalance the portfolio when assets perform differently. Unfortunately, it can be expensive and difficult to rebalance assets that are illiquid, especially during crises when the price of liquidity increases. And that calls into question whether any diversification benefit is only a theoretical one.

The third issue is that many alternative strategies -- such as the carry trade and merger arbitrage -- exhibit low correlation to stocks while having risks that tend to show up at the same time as the risks to stocks show up. Assets that perform poorly in bad times should carry large risk premiums. However, it's important that investors account for stocklike risk in these investments when designing their portfolio. Otherwise, they will greatly underestimate the portfolio's downside risk during extreme events such as the financial crises of 2008. This issue also applies to all of the alternative strategies that seek to capture the credit risk premium, including high-yield or junk bonds, and emerging-markets debt.

The fourth issue is one discussed by both Yale's David Swensen and PIMCO's Mohammed El-Erian, who managed Harvard's endowment. Quoting from Swensen's book Unconventional Success:

Understanding the difficulty of identifying superior hedge fund, venture capital, and leverage buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating active management results.

El-Erian was asked, "Can an individual investor hope to replicate the fantastic results of the top endowments?" He responded: "It would be like advising my son or daughter to drop out of school to play basketball with the goal of becoming the next Michael Jordan."

As a final caution, consider the following: For the 2011 fiscal year, large, medium and small endowments all underperformed a simple mix of 60 percent stocks and 40 percent bonds over one-, three- and five-year periods. The 91 percent of endowments with less than $1 billion in assets has underperformed in every time period since records have been maintained. This evidence should act as a cautionary tale for any institutional or individual investor who's considering adopting the "Yale Model."

Image courtesy of Flickr user 401(K) 2013.