Yale University and other large endowments achieved spectacular gains from the early 1990s through the late 2000s, establishing the precedent for the so-called endowment model of investing. The gains came primarily from the addition of alternative investments (e.g., private equity, hedge funds and real estate) to their portfolios. Public pension funds began adopting the endowment model in earnest about 20 years ago. Central to the endowment model is a multiasset-class framework for diversification. It is based on the theory that “uncorrelated” asset class returns will improve risk-adjusted performance through more efficient diversification than might be achieved via stocks and bonds alone. Alternative investments, or alts, came to feature prominently among the asset classes. For large endowments, the allocation to alts is now 60% of total assets. The figure for public pension funds exceeds 30%. As the number of asset classes expanded, so did the number of actively managed investment portfolios. Large endowments use more than 100 active managers, on average. Large public pension funds use more than 150 active managers, on average. This is the look of public fund investing today: many asset classes, 30% or more of assets in alts and scores of active managers.
Endowment-model gains dried up about the time of the global financial crisis of 2008. Why? Alternative investment markets began to evolve dramatically in the 1990s. The impetus was the flood of money pouring into private markets and hedge funds then. For example, between 1995 and 2018, the value of publicly traded real estate investment trusts in the U.S. grew twenty-fivefold, from $50 billion to $1.25 trillion, with private market real estate investing giving way to public. Hedge fund assets under management increased twenty-sevenfold between 1997 and 2018. Private equity assets under management increased thirty-sevenfold between 1994 and 2019. As a result, pricing in all three markets became better aligned with public market pricing. An indication of this is the elevated correlation of alts and public equities. The correlation coefficient between the alts mentioned above and U.S. stocks now averages nearly 0.9, a very high figure.