Consulting titan Richard Ennis warns of blind faith in alternatives

Richard Ennis, one of the pioneers of investment consulting, emerged from retirement recently to stand athwart the flood of institutional money gushing into alternatives, yelling “Stop!”

Or at least, “Let’s review our assumptions here.”

That stand has made Ennis — co-founder in 1981 of what became investment consulting giant Ennis Knupp & Associates — a lonely, if highly respected, voice in the industry.

Some asset owners view the rethink Ennis is almost singlehandedly pushing for now as a useful, much-needed exercise after a decade or more when allocations to hedge funds, private equity, infrastructure and now private debt have continued to accelerate at the expense of traditional exposures to publicly traded stocks and bonds.

Others see Ennis as more Don Quixote, tilting at windmills, than caped crusader.

Ennis, in a recent interview, said his four decades advising institutional clients on their fiduciary duties compelled him to re-enter the intellectual fray at a moment when, in his eyes, investors’ continued rush into costly alternative strategies — despite questionable results — is being driven by magical thinking.

The behavior of the people managing $10 trillion in institutional assets today smacks less of the influence of leading business schools like Booth or Wharton and more of Hogwarts School of Witchcraft and Wizardry, said an exasperated Ennis, who served from 2007 through 2010 as executive editor of the Financial Analysts Journal.

Following a decade off the financial grid in the wake of Hewitt Associates’ 2010 acquisition of Ennis Knupp & Associates, Ennis resurfaced in 2020 with a mission: to apply analytical rigor to institutional investors’ ever-more passionate embrace of private markets and hedge fund strategies.

“I hadn’t looked at investments for 10 years. I mean, I checked out totally,” said Ennis, in favor of more eclectic pursuits, such as studying Buddhist thought for its implications on questions of right and wrong.

And wrong — in the guise of agency problems and conflicts of interest — is what Ennis said he found when he awoke, Rip Van Winkle-like, by his own telling, to see what was transpiring with alternatives allocations.

In Ennis’ view, groupthink — “it’s OK to do this, everybody does this” — mixed with the gravitational pull of the enormous amounts of money spun off by alternatives allocations have left fiduciaries, the industry’s “chief investment officer-consultant-asset manager complex,” more often than not failing to act in the best interests of beneficiaries.

“There are significant agency problems with the CIOs and the OCIOs, the investment consultants,” Ennis contends. “They can make more money running very complicated investment programs in which people get paid a lot of money. And politicians are responsive to contributions and lobbyists” — a game index funds can’t compete in, he said.

“Almost everyone that has anything to do with institutional investing is conflicted. None of the asset managers, consultants, CIOs or OCIOs would dare criticize the beast that feeds them,” he said.

In that regard, Ennis said he’s in a privileged position to exercise what he termed a lifelong, constitutional aversion
to “BS.”

“I’m retired, above the fray ... I’ve got the credibility to say this stuff and make it stick, and the Boy Scout in me says this is a story that should be told,” he said.

For the past three years, in papers such as “The Failure of the Endowment Model” and “The Fairy Tale of Alternative Investing,” Ennis has argued that none of alternatives strategies’ supposed charms for institutional portfolios — from dampening portfolio volatility, to offering uncorrelated sources of diversification, to delivering outsized returns — stands up to scrutiny today.

Ennis’s latest paper, released Sept. 21, concludes that U.S. endowments — perhaps the world’s biggest consumers of alternative strategies — have likewise been hurt proportionately rather than helped by those exposures over the 13 years following the global financial crisis through 2021.

The paper, “Endowments in the Casino: Even the Whales Lose at the Alts Table,” based on data from the National Association of College and University Business Officers, shows annualized returns for six successive size cohorts of U.S. college and university endowments trailing passively investable benchmarks constructed using returns-based style analysis by an annualized 1.2 to 2.5 percentage points for that period.

The smallest, with average assets of $25 million and relatively small alternatives allocations of 10.4%, trailed their benchmarks by 1.2 percentage points a year — the same gap Ennis’ research showed last year for U.S. public pension funds, another group of avid alternatives investors.

At the other end of the spectrum, endowments with more than $1 billion in assets and allocations of 59.1% to alternatives lagged their passively investable benchmarks by an annualized 2.2 percentage points, modestly better than the 2.5 percentage point gap for the next largest cohort: endowments with assets of $501 million to $1 billion and average alternatives allocations of 43.4%. Ennis speculates that the biggest endowments, with their own chief investment officers and investment offices, may simply be better positioned to pursue labor-intensive opportunities than smaller funds, dependent on investment committees and boards of trustees working with consultants.

At the end of the day, however, those billion-dollar endowments were simply losing less, vis-a-vis their benchmarks, as opposed to winning, Ennis wrote.

Meanwhile, the paper showed bigger endowments enjoying better returns than smaller ones — an annualized 7.8% for the biggest cohort, compared to between 6.4% and 6.6% for the smallest three cohorts — but no size-related advantage apparent when it comes to Sharpe ratios, measuring returns per unit of risk. Sharpe ratios for all six cohorts bounced around in a narrow range between 0.51 and 0.60.

The punchline? “Large endowments earn more because they take more risk,” Ennis wrote. Effective equity exposures, he noted, ranged from a low of 66% for endowments with less than $25 million to 83% for endowments with more than $1 billion.

Alternatives have been a significant source of underperformance for endowments across the board, he concluded.

The key reason for that underperformance is the exorbitant management fees alternatives managers charge, which, for a diversified portfolio of alternative strategies he pegs at roughly 300 basis points of allocations, about 10 times the fees asset owners would be facing for a traditional mix of stock and bond strategies.

That, he said, is an “utterly and insanely impossible burden, given the extent of market efficiency and the penchant of institutional fiduciaries to diversify.”

Ennis said he doesn’t want people who review his work of the past few years to conclude that he thinks there’s anything wrong with alternatives as investments.

“When I put my hat on, I think about cash flows, borrowing and lending, buying and bidding and all that sort of thing,” he said.

“The thing about alternatives is what people pay for them,” and if everyone woke up tomorrow to find fees for private equity and other alternative strategies halved, Ennis said he’d have a considerably more positive view on their potential role in portfolios.

At present, however, with segments such as private equity and venture capital acknowledged to have betas of their own largely in line with publicly listed equities, institutional investors with heavy alternatives allocations will end up with portfolios that behave just like ones with stocks and bonds but with very costly diversification, effectively leaving their buckets with a hole in it, and significant money leaking out into the pockets of managers of leveraged buyouts, hedge funds and real estate, said Ennis. “That, I think, is the downside,” he added.

For critics, the key question is whether Ennis’s conclusions are timeless or specific to a post-global financial crisis period where extraordinary monetary policy support deployed to ward off economic disaster levitated valuations for U.S. equities and bonds alike — both sides of a traditional 60% stock/40% bond portfolio.

Richard Nuzum, Mercer’s executive director, investments and global chief investment strategist, who counts himself as an admirer of Ennis, said “I think the statistical analysis (in Ennis’s endowment paper) is well done, state-of-the-art, return-based analysis … but I reach very fundamentally different conclusions” about the future.

While it’s factually correct that investing in private equity, real estate, hedge funds and others didn’t add value for a 13-year period where U.S. stocks outperformed every other asset class, “asset owners can’t buy the past,” Nuzum said.

And, he added, there’s a case to be made that those alternative asset classes can provide smoother, more diversified returns going forward.

By contrast, Nuzum said, if investors had been able to read Ennis’ paper and dump their alternatives exposures at the end of 2021, just as U.S. stocks and bonds were poised to suffer their biggest declines in a decade in 2022, they would have lost out on a year when alternative strategies performed so strongly that a major concern became the “denominator effect,” where crashing stock and bond valuations left asset owners with alternatives weightings exceeding their targets, he noted.

A veteran institutional chief investment officer, who declined to be named, likewise warned that Ennis’ conclusions could ultimately prove “time specific.”

If the more than decadelong stretch Ennis covered through June 30, 2021, is extended through June 30, 2022, wouldn’t Ennis have had to reach the exact opposite conclusion, asked the CIO, concluding “I would rather have underperformed the equity markets a little … knowing I had diversified.”

But, Ennis counters, the supposed strengths alternatives provided for public pension and endowment portfolios when public equity and bond valuations collapsed in 2022 were essentially a mirage, reflecting the year or two required for private markets strategies to be marked to market.

Even as public equities suffered double-digit declines for the 12 months through June 2022, public pension funds were reporting double-digit gains for their private equity holdings, owing to that lag in PE pricing, Ennis noted.

While this “pumped up their reported performance” by roughly 9 percentage points, “no one in their right mind would have taken those assets off their hands at those valuations,” Ennis said. A year later, as of June 2023, that outperformance on paper had shrunk by roughly half, Ennis estimated.

For big endowments, meanwhile, Ennis estimated their return numbers as of June 2021 were inflated by roughly 10 percentage points.

Ennis said the argument that extraordinary monetary policy enhanced the attractiveness of U.S. equities relative to alternative pillars such as private equity needs further examination: “Why wouldn’t the ‘printing press’ also inflate the value of LBOs, venture capital, private market real estate and net-long-U.S. equity hedge funds,” he asked.

The unsatisfactory results of alternative strategies in the post-financial crisis era are the result of negative alpha, not the absence of beta, Ennis added.