Smaller Endowments Should Consider ETFs

The CAIA’s Hossein Kazemi says ETFs offer some key advantages over many traditional alternative investments.

Reviewed by: Heather Bell
Edited by: Heather Bell

Hossein KazemiHossein Kazemi, Ph.D., CFA, is the senior advisor to the Chartered Alternative Investment Analyst Association’s program. In a recent study he co-authored with Kathryn Wilkens, Ph.D., CAIA, titled "A Simple Approach to the Management of Endowments," they present evidence that mid- and small-sized endowments should use ETFs to implement their strategies rather than opting for expensive and illiquid alternative investments. discussed Kazemi’s recent work with him as well as his views on the role of ETFs in institutional investing. Can ETFs accurately capture the performance of alternative investments? Do investors using them for that purpose give up anything they would normally get by investing directly in alternatives?

Kazemi: If you look at any investment—whether it’s publicly traded or private—there are basically sources of returns or risk premiums, and some of those overlap between an alternative and an ETF.

For example, if you’re talking about equity-oriented hedge funds, they have certain risks related to equity markets, and an ETF can give you that. There is the time value of money—both of them, of course, can give you that—but there are some sources of risk and return that might be unique to that private placement or that hedge fund that would not be present in the context of ETFs.

ETFs can capture probably a big portion of them. It depends perhaps on the alternative you’re looking at. But they give up some, and in exchange, they receive something else—mostly liquidity, marketability and transparency, when it comes to ETFs.

It’s a matter of how much investors are giving up—they may not give up much in some cases and they may give up quite a bit in others; it depends. It’s not always the case that they have to give up something, but typically they have to give up something in at least a majority of cases. Would you give an overview of the study you did that you talked about in your recent article?

Kazemi: I was looking at the performance of university endowments and of Commonfund, which is an organization endowments can outsource management to. [Commonfund] collects performance figures from endowments each year, and does a great comparison and study of what the performance has been and the allocations, and so on. I was looking at the most recent study from Commonfund and noticed a few things.

One was that the difference between the top-performing or the largest endowments and the smaller ones was not as great as it used to be.

The other thing I noticed was that the performance density was not as great overall as it used to be. The differences within the endowments seemed to have been shrinking, but also, overall, performance was not as great as it used to be.

I started looking into it to see what was going on, and this is one of those cases in which perhaps because the endowments are so large, and some of them very large and highly diversified, that they have to invest in a lot of securities.

When you look at the overall portfolio of these funds, much of the exposure perhaps can be explained by the ETFs. In other words, what you give up by investing in ETFs perhaps is somewhat diluted when you look at the very large portfolio of these endowments.

I tried to see if I could replicate or come close to replicating the historical performance of these endowments using publicly traded, liquid ETFs. What I learned was basically that I can certainly do as well if not better than the medium-sized endowment.

Many of them perhaps don’t have access to the top managers, or perhaps some of them are not large enough, so their overhead costs are too great—these things are too much for them to overcome, so the performance of the medium endowment could easily be captured and maybe even outperformed by a diversified portfolio of ETFs. With the largest endowments, you can come close to—but perhaps not overcome—their performance.


My recommendation was that the small- and medium-sized endowments should really forget—at least on the larger scale—about investing in alternatives and in illiquid assets that the larger endowments can access. Perhaps a more sensible strategy for them would be to put the bulk or at least a meaningful portion of the allocations into ETFs.

Then, if they have access to a limited number of skilled managers, they can basically be a niche player and invest in a few of those highly skilled managers who can actually deliver alpha. Allocating their entire portfolio as if they were a large endowment like Harvard or Princeton or Yale for a medium-sized fund is just not a winning strategy. At least that’s what the data seems to indicate. What kinds of holdings were in the portfolio? How much of that was actually alternatives, and how much was just plain beta exposure?

Kazemi: The interesting thing is that the portfolio ended up basically creating something that made a lot of sense, and matched up at least in broad terms with allocations that endowments generally have.

There were investments in small-cap and Nasdaq stocks, so I think that kind of captures perhaps some of the venture capital investments. Venture capital tends to be highly correlated with small-cap and the tech sector.

Then I had some investments in real estate. Endowments do invest quite a bit actually in real estate. Ultimately, I ended up having a portfolio of about seven ETFs, two or three of them broad equity, the Russell 2000 and Nasdaq-100, then a few sectors—energy and materials. Then I had the [PowerShares Global Listed Private Equity Portfolio (PSP)] and global real estate and some cash.

I was actually kind of surprised that the quantity of models I used came out with an allocation that didn’t look too strange or too weird, and was actually pretty close to what probably an average endowment would invest in. I felt pretty good about that. It sounds like the average investor could recreate an endowmentlike portfolio using ETFs.

Kazemi: Absolutely. It’s very diversified and accesses corners of the market that provide maybe some return that we can’t get from just basic stock and bond portfolios; having a bit of private equity or real estate in there makes perfect sense.

Of course, many individuals already have real estate in their portfolio for their homes, so they may want to adjust that a little bit, maybe move more to private equity or other sectors. If you’re working in the energy sector, you may not want to put as much in the energy ETF since your job is already giving you enough exposure.


The lesson of diversification among multiple asset classes rather than just stocks and bonds, I think that can be seen in the portfolio. And if you look at the overall performance of the portfolio over time, it’s fairly stable, even during the worst of times.

In the 2007 and 2008 financial crisis, of course it had a drop down, but nothing close to what the endowments themselves experienced. Endowments were down 25%. This portfolio was down something like 10-15%. The liquidity was quite useful and quite helpful in that time period. You don’t seem as enamored with the liquidity premium that a lot of people had associated with institutional investments.

Kazemi: Like anything else, the law of demand and supply worked, and with so much money going into illiquid assets, chasing the idea of capturing that liquidity premium, that premium was bound to shrink over time.

The supply of these illiquid assets is not unlimited. A few years, ago timber became basically the investment any endowment had to have. Well, there’s only so much timber around that’s investable. The price of timber ran up, and whatever liquidity premium was there just sort of disappeared, and then you had a major collapse in the timber prices.

There is a liquidity premium when things are being priced correctly, but when you have a bit of a herd mentality, and investments are being made in areas that are just not large enough to accommodate these large allocations—not only by endowments but pension funds and so on—the illiquidity premium could easily disappear.

The fact that you’re investing in a liquid asset or the private placement doesn’t mean automatically you’re going to get the premium. There needs to be some degree of due diligence to see if prices are in line with that premium. So, one could argue that perhaps in some areas of private equity and venture capital that whatever premium was there was long gone.

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Heather Bell is a former managing editor of She has also held editorial positions at Dow Jones Indexes and Lehman Brothers. Bell is a graduate of Dartmouth college and resides in the Denver area with her two dogs.