Endowments' heavy hedge fund allocations 'grossly uneconomic,' study suggests

The smart money might not be so smart at investing after all – at least, when you look at how universities are doing it.

A new study suggests large university endowments' hefty investments in hedge funds and other alternative assets have not paid off, raising concerns over the high fees and lackluster returns associated with the strategies.

As MarketWatch reported, Richard Ennis, a distinguished veteran in institutional investment consulting, found that two-thirds of major university endowments allocate their portfolios to alternative investments that have delivered no excess returns compared to the public markets since the 2008 financial crisis.

By contrast, public pension funds, which hold a smaller share in alternatives, have outperformed large endowments in recent years.

Ennis blamed the disappointing post-financial crisis performance largely on costs, calling alts investing "grossly uneconomic" and asserting it will not last in the long run.

“What you get with alts is pretty much the same as what you get with stocks and bonds," he said. "The main difference is that you pay at least 10 times more for the alts.”

While boosters point to the various benefits of private-market investments, Ennis cited various articles of research showing they carry annual costs ranging from 5 percent to 8 percent, while hedge funds’ total expenses amount to about 3.44 percent per year – a steep price considering the sub-1 percent fees low-cost mutual funds and ETFs have opened up for investors broadly. Ennis’s own analysis of public pension fund data estimated alternative investment costs at 3.6 percent annually.

Returns across major alternative asset classes have also failed to justify the expense. Hedge funds produced an annualized return of 4 percent over the past 15 years, trailing a blended public-market index of 52 percent stocks and 48 percent short-term Treasury bills, which returned 4.5 percent. Private real estate investments, measured over 25 years, also posted lower returns when stacked up against publicly traded REITs.

“There is every reason to believe that alts, with their extraordinary cost and ordinary returns, will continue to underperform consistently and by a wide margin,” Ennis said.

The report adds to a growing body of evidence showing that investors tend to overpay for alternative investments in the long run. A separate study by LCH Investments in January found hedge fund clients have lost more than half of their gross profits to fees over the past two decades, up from about 30 percent in earlier periods.

Private equity firms have also faced renewed pressure from institutional investors to improve fee transparency. An SEC-led legal battle for greater clarity in hedge fund and PE fund fees came to an anticlimactic end in September,  but a coalition of large asset owners andpension plans, the Institutional Limited Partners Association, have since renewed their call for standardized reporting on costs and returns, citing challenges in evaluating fund managers.

While retail investors have favored low-cost strategies and investment vehicles, Ennis argued endowments and pension funds may be more locked into alternative investments thanks their complexity and possibly conflicted interests of those that recommend them.

“The funds’ [chief investment officers] and consultant-advisors, who are responsible for formulating and implementing investment strategy, have an incentive to recommend complex strategies,” he wrote.