Alternatives Have Been ‘Kryptonite’ to Alpha — At Least for Public Pensions

Richard Ennis finds public pension funds in the U.S. have generated negative alpha of approximately 1.2 percent annually since the global financial crisis in 2008.


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Private equity, hedge funds, and real estate have failed public pensions for more than a decade.

A study that will be published in The Journal of Investing shows that not only did alternatives not deliver better returns, but adding them to portfolios actually destroyed alpha, the portion of return seemingly not explained by risk. Most people in finance define it more loosely: as the return on an active investment above what an index fund would provide.

“Alpha appears to respond to the presence of alts as if the latter were kryptonite — the greater the exposure, the harsher the effect on alpha,” wrote Richard Ennis, author of the study, a former editor of the Financial Analysts Journal, and co-founder of EnnisKnupp, one of the first investment consultants.

According to the study, public pension funds in the U.S. have generated negative alpha of approximately 1.2 percent annually since the global financial crisis in 2008. Ennis found that private equity didn’t help — or hurt — excess returns. But both real estate and hedge fund exposures detracted significantly from performance.

Endowments, public and corporate pensions, and other U.S. institutions have put about $2 trillion into alternative investments. Institutions have made a dramatic shift since about 2000 from holding mostly public stocks and bonds to adding extensive investments in private markets, because they’ve been convinced that many of these strategies will outperform public markets and add diversity and lower the volatility of their portfolios.

And there was plenty of high-profile evidence that alternatives would be a good bet. They had an exceptional track record in the years leading up to 2008, protecting some big investors who had incorporated them when the technology bubble burst. David Swensen, the CIO of Yale University’s endowment, also unwittingly popularized alternatives because his enviable returns were pinned to them.


Despite the shift in the composition of institutional portfolios, Ennis undertook the study because little research on the behavior of alternatives and whether they improve portfolios has been conducted. That’s because the investments are private — by definition, unlisted companies don’t trade on an exchange where prices are broadcast in real time — and only public pension funds and some large endowments disclose detailed and timely performance data.

Ennis collected data on the most transparent institution, U.S. public-sector pension funds, for the 13 fiscal years ending June 30, 2021. His collection methodology demonstrates how hard it is to get comprehensive information on alternatives. Ennis was limited by a number of funds that had different fiscal year-ends, making comparisons difficult, and pensions that didn’t explicitly say that their reported rates of return were net of fees.

He then used returns-based analysis to explain the returns of a 59 public pension fund-composite and 59 individual funds. From there, he calculated the returns that have been generated above a passive investment — in other words, alpha. Returns-based analysis is a widely accepted method based on the work of Bill Sharpe that identifies underlying market exposures from a series of returns.

Ennis found that in addition to the destruction of alpha, alternatives don’t offer the diversification benefits that institutions expect. “Stock and bond indexes alone capture the return-variability characteristics of alternative investments in the public fund composite for all intents and purposes in the post-GFC era,” said Ennis.

The study also analyzed asset allocation data to see how excess returns are affected by changes in the amounts invested in alternatives overall, private equity, real estate, and hedge funds. According to Ennis, the analysis showed that alpha can change as alternatives are substituted for stocks and bonds. “For every percentage point of assets allocated to alts in the aggregate, there is a corresponding 7.3 bps reduction in annualized total fund alpha,” according to the study.

“Alts are becoming less alternative all the time, but the puzzle Ennis is pointing out is that as they become more commoditized, costs haven’t moved enough,” said Rishi Ganti, founder of Orthogon Partners, which invests in untraded or esoteric assets. “There can be a premium for truly differentiated strategies. But high fees on well-competed strategies eliminates outperformance.”

Private equity’s contribution to the destruction of alpha is minimal. A one percentage point increase in private equity only reduces alpha by 0.2 basis points. But hedge funds and real estate are quite damaging, accounting for a 70-basis-point reduction each.

As Ennis points out, it’s not possible to prove that alternatives destroy alpha. But as he writes in the study, “The simple natural experiment described here won’t resolve the private-versus-public debate. What I can say is that I find no support for the proposition that private equity has added value to pension fund returns in the post-GFC era.”

Investment costs, in finance, are partly to blame, according to Ennis. He estimates that private real estate costs 2.3 percent annually, 3 percent for hedge funds, 5 percent for private equity, and 0.8 percent for commodities. The typical annual cost of investing public pension money, with an average 30 percent in alts, costs 1.2 percent, close to the margin of underperformance that Ennis details in the paper.

“Institutional investors should consider whether continuing to invest in alternatives warrants the time, expense and reduced liquidity associated with them,” he wrote.