In a blog post on Tuesday, Damodaran laid out a four-point framework for approaching the alternative-asset boom with skepticism, challenging the assumptions that have fueled a decades-long shift toward hedge funds, private equity, and collectibles.
Even as trillions have flowed into these strategies, particularly from pension funds and university endowments, Damodaran argues the net benefit to portfolios has been “modest at best and negative at worst.” Now, as institutional interest begins to cool, most notably with Yale’s endowment announcing a selloff of private equity holdings this month, he says the focus is shifting to individual investors, often with more risk and less protection.
“Keep the following in mind when listening to alternative investing pitches,” Damodaran said, outlining four critical principles.
1. Be picky about alternatives
While alternative assets are often promoted on the basis of low correlation with stocks and bonds, Damodaran argues that this selling point is frequently overstated or misunderstood. Pricing lags, particularly in private equity and venture capital, tend to create the illusion of low volatility and uncorrelated returns, he said, masking the reality that these asset classes often move in lockstep with markets during periods of stress.
“This understatement of correlation is most acute in private equity and venture capital,” he noted, adding that both are, at the core, equity investments. While hedge funds, real estate, gold and collectibles may offer more genuine diversification, even their behavior during crises has become more synchronized with public markets.
“Correlations should guide investor choices,” Damodaran advised, and not the outdated idea that all alternatives inherently reduce risk.
2. Avoid high-cost and exotic vehicles
One of Damodaran’s sharpest critiques is aimed at the high fees and opaque structures that dominate much of the alternative investing landscape. From private equity to hedge funds, fee models like two-and-twenty, a 2% annual management fee and 20% of performance gains, have persisted even as performance has stagnated.
“At the risk of drawing the ire of some,” he said, “I would argue that any endowment or pension fund managers who pay two-and-twenty to a hedge fund, no matter how great its track record, first needs their heads examined and then summarily fired.”
Damodaran further warned against strategies that are so complex that neither the seller nor the buyer has a clear understanding of what’s happening under the hood. “Alternative investments that are based upon strategies that are so complex… should be avoided,” he said.
Even as fees come under pressure, Damodaran maintains that “these costs represent a significant drag on performance,” and erode whatever marginal alpha may exist.
3. Be realistic about time horizon and liquidity needs
Damodaran stressed that while alternative investments might suit investors with long horizons and stable cash needs, such as pensions or endowments, real-world pressures often make this assumption fragile.
“Much as investors like to believe that they control their time horizons and cash needs, they do not,” he said. During market crises, both institutional and retail investors often find themselves scrambling for liquidity, precisely when alternative assets are hardest to exit.
Yale University’s decision this month to sell billions in private equity holdings underscores the point. Long held up as a model for alternative investing success, Yale is now recalibrating after years of underperformance in the space. Damodaran views it as part of a broader institutional rethink, writing: “Even savvy institutional investors… are questioning whether private equity, hedge funds and venture capital have become too big and are too costly to be value-adding.”
4. Be wary of correlation matrices and historical alphas
Damodaran’s most fundamental warning is about the data itself, the glossy marketing charts showing non-correlated returns and high Sharpe ratios are often backward-looking, constructed under ideal conditions, and rarely hold up in crisis periods.
“If there is one takeaway from this post,” he said, “it is that historical correlations, especially when you have non-traded investments at play, are untrustworthy and that alphas fade over time.”
Damodaran points to a long list of research—including work by Richard Ennis, Nicolas Rabener and others, showing that hedge funds and private equity have delivered diminishing returns in recent years. In hedge funds, he noted, alpha had dropped to zero by 2009. For private equity, returns that once beat public markets in the early 2000s have now converged with broader benchmarks.
“As the number of funds and money under management in these investment vehicles has increased, the capacity to make easy money has also faded,” he said. “The average venture capital, private equity or hedge fund manager is now no better or worse than the average mutual fund manager.”
Even the few top-performing managers who do outperform, Damodaran said, are difficult to access, and their alpha is quickly arbitraged away by passive replication strategies like ETFs.
Also read | Aswath Damodaran explains 3 reasons why Moody’s ratings downgrade of the U.S. didn’t impact market
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of the Economic Times)
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