Is the endowment model relevant for individual investors?

The endowment style of investing, developed by David Swenson at Yale University in the mid-1980s, has gained increased attention over the past several decades as more investors seek to emulate part or all of the more diversified strategy. Yet over the past few years, criticism of the model has surfaced given its somewhat anemic performance relative to more traditional public market-based strategies.

Does the strategy still make sense, and is it appropriate for smaller investors? Current market and economic conditions likely make these two questions particularly important to advisers and their clients.

Asset allocation in portfolios addresses only systemic risk. Although all investors should be concerned about and aware of unsystemic risk as well, this article is addressing only systemic risk.

The concept behind the endowment model builds on the original modern portfolio theory of systemic risk management proposed by Harry Markowitz in a 1952 paper. By adding more asset classes beyond stocks and bonds, the modified strategy’s aim is to decrease correlation with stocks while maintaining strong portfolio performance. If the performance assets of the portfolio experience less volatility as a group, the need to use bonds as a defensive holding declines.

When David Swenson assumed the position of chief investment officer at the Yale Endowment in 1985, over 80% of the endowment’s assets were allocated to U.S. stocks and bonds, with the remaining 20% evenly spread across foreign equities and real assets.

Mr. Swensen quickly diversified the portfolio into alternative asset classes, starting with private equity and then adding various other types of alternatives over time. Today, around 75% of the portfolio is spread across venture capital, leveraged buyout private equity, real estate, absolute return (hedge funds) and natural resources. During the recent run-up in the U.S. stock market, Yale further decreased its allocation in equities.

Other endowments have taken similar actions. According to the National Association of College and Business Officers, endowments with over $1 billion in assets invest an average of 57% of their portfolio in alternative assets, not quite as high as Yale’s but still much higher than the average individual investor.

(More: Bigger isn’t always better when it comes to alternative investments)

The ongoing move into alternatives also likely results from the rapid growth in private markets. There are fewer public companies in existence today than there were in 1976 even though U.S. GDP has more than tripled over the same period. Since 1996, the number of public companies in the U.S. has dropped by more than half.

At the same time, private markets are providing far more capital for longer periods than they did in the past, as companies like Facebook and Twitter wait to become multibillion-dollar companies before listing.

Despite somewhat uninspiring performance relative to U.S. stocks in the recent past, largely resulting from their lack of equity market exposure, the continued migration of endowments away from traditional stocks and bonds suggests that they believe alternative asset classes offer better opportunity looking forward. Individual investors would likely benefit from considering the place that alternatives could take in diversifying their portfolios.

After a strong run-up in recent years, equity valuations are relatively rich. Although today’s economy looks strong, various economic indicators suggest that the expansion, soon to become the longest on record, is drawing near an end.

Moreover, regardless of an investor’s interpretation of current economic conditions, it appears sensible to expect the next decade’s equity returns to fall well below the past decade’s returns, which were driven significantly by the market’s rebound after a deep recession.

Bonds also face an uphill struggle. The nearly 40-year bull market in bonds resulting from steadily declining interest rates appears to have ended, and low interest rates combined with rate-hike expectations result in poor fixed-income prospects.

Simply put, stocks look only moderately attractive, and bonds look downright scary.

(More: Wealthy families are winning deals away from private equity)​

Today’s valuations and expected returns for both stocks and bonds likely make a portfolio allocation more similar to endowments attractive whether an investor is trying to proactively emulate endowments or just trying to avoid the pitfalls of commonly available public market investments.

Current financial markets offer individuals new means to invest in alternatives, including easier access to many areas of the rapidly expanding private markets. Yet even for investors not looking to proactively seek out new opportunities, expected stock and bond returns likely make increased diversification away from these traditional assets much more appealing.

Although the endowment investment style may not always deliver the best investment results in the short term, the model has consistently produced stronger risk-adjusted returns with less volatility than almost any other investment approach.

Now is likely a particularly valuable time for individual investors to understand how lessons learned from a model embraced by many of the world’s most sophisticated investors can help them achieve their financial goals.

(More: Market volatility brings alternative investments back into focus)​

Daniel Wildermuth serves as the chief executive officer and chief investment officer for Wildermuth Advisory, an SEC-registered investment adviser.