The Role of Alternatives: Are Alternative Investments Right for Your Endowment or Foundation?

The answer for most nonprofits is a resounding yes. We believe the use of alternative investments in long-term investment portfolios is, with few exceptions, a prudent choice for nonprofits. Over the past decade, a 60/40 or even 80/20 asset allocation to the S&P 500 Stock Index and Barclays Capital U.S. Aggregate Bond Index, respectively, has proven to be a solid choice as the market has risen relatively unabated. However, this approach carries a high degree of volatility and drawdown risk that, in conjunction with a nonprofit’s annual spend, can have a severe impact on a portfolio in less favorable market environments.

The addition of uncorrelated return streams from alternative investments strategies may lower overall portfolio volatility while also enhancing return opportunity. Nonprofits are typically long-term investors and, in some cases, are designed to exist in perpetuity, so it is only natural to seek out alternative investments that can assist these institutions in providing more stable and repeatable returns to support their missions for the years to come.

The Need for Greater Diversification

The 60/40 portfolio that many investors in the non-profit segment have relied on as the standard has proven susceptible to economic stressors. An example of this downside vulnerability was the beginning of the Covid-19 pandemic, when the S&P 500 alone fell more than 30% from mid-February to mid-March 2020. This fragility, when paired with an uncertain future and expectations for lower equity and fixed income returns, makes this a prime time to consider alternative asset allocations. Verger’s team of professionals recommends a thorough review of your investment policy and asset allocation targets at least annually to ensure they continue to meet your organization’s investment objectives.

In the current zero-rate environment, strategic diversification is more important than ever. Non-profit investors seeking out alternative sources of return on their investments will benefit from an asset allocation that offers flexibility, resiliency, protection from relative risk, and liquidity in both up and down markets when those organizations need it. The addition of complementary alternative investments to an existing portfolio may serve to improve the risk/return ratio and diversify return sources, which may help to provide more stable and consistent return streams.

Regardless of the catalyst, the market will continue to ebb and flow, and non-profits must be prepared to determine just how much risk they can take moving forward to maximize returns. To execute an appropriate financial plan, it’s important to have the best fiduciary partners working with you to guide your organization based on your specific needs and goals. Verger is a valuable ally to have in your corner as you venture into alternative assets.

Benefits of Alternatives

The inherent illiquidity of many alternative assets makes them an attractive choice for a wise long-term investor. By diversifying your portfolio with alternatives such as absolute return strategies, hedge funds, private equity, venture capital, timber, and real estate, you create less volatility over time. Additionally, as Yale University’s long tenured CIO, the late David Swensen, said, “Illiquidity induces appropriate long-term behavior.”  

As their returns tend to have a lower correlation to the standard asset classes, alternative assets have become increasingly popular among non-profit organizations seeking to offset market volatility and generate higher returns during periods of lower returns for the more traditional asset classes.

If you have the flexibility to forego the short-term liquidity associated with traditional investments, then alternatives align with endowment long-term objectives. Additionally, these investments frequently provide institutions with exposure to less efficient markets that may have the potential for outsized returns. A recent study by financial data firm Pitchbook concluded that merely adding a 20% allocation of randomly selected private equity buyout funds added between 0.4% and 0.9% of annualized performance at the total portfolio level.

Verger views alternatives as a vehicle to access uncorrelated returns, risk factors, and investment talent. In fact, Verger currently has roughly 56% of our portfolio, as of March 31, 2021, dedicated to alternative investments.

How Alternatives Fit into the Portfolio

While the benefits can be substantial, alternative investments also carry potential risks, so an institution must assess what risks it can accept over its investment horizon. These strategies, particularly those with greater illiquidity, are best utilized for those with longer investment horizons and readily accessible liquidity from other parts of their portfolios. Additionally, alternatives are best utilized as a piece of a larger overall allocation strategy, where each investment or asset class plays a role in providing a total portfolio solution. It would be unwise to rely solely on a purely alternatives-based portfolio, as that may subject an investor to a variety of risks, including the opportunity cost of not investing in more traditional strategies. Through a more balanced investment portfolio, including various traditional and alternative strategies, an organization may benefit from the diverse nature of its return streams.

Expertise in Alternative Investments

Of course, an important factor to consider before diversifying into alternatives is how to add these strategies to your portfolio in an efficient and cost-effective way. A valid concern for investors is their ability to identify and access high quality managers who deliver the appropriate risk and return trade-off. Often, the barrier to entry is a lack of access to top tier managers and strategies, which may dissuade an investment committee from making allocations to alternative strategies and lead them to maintaining the status quo. This is where an outsourced chief investment officer (OCIO) can help mitigate the growing pains your portfolio may experience.

Verger offers a turnkey solution specifically designed for non-profit organizations to diversify and potentially improve both their investment portfolios and long-term outcomes. Rather than building an alternatives and private capital program from scratch, our model has the potential to be immediately additive to achieving your organization’s goals. The benefits of utilizing Verger include immediate access to professional investment strategies customized for your organization and limiting the risks associated with investing in alternatives as well as the initial loss that often comes with private investments, known as the J-curve.

Given the uncertainty surrounding future returns from the more traditional asset classes and the potential for greater volatility going forward, many nonprofit institutions have embraced an allocation to alternatives. If your institution hasn’t yet begun investing in alternative assets, now may be the time.

All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.

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