How Harvard Beats The Market, and How You Can Too

Dec. 16, 2011— -- When investors are getting beat up by the markets, it's not without some envy that we look at the strong performance of the investment portfolios of Ivy League universities such as Harvard.

From 2001 through 2010 — a period known as the lost decade — the average annual return of the S&P 500, by some measures,was only about 1.7 percent. But while the S&P 500 languished, the Harvard University endowment achieved an average annual return of about 7 percent during the same period.

After this year's wild ride in the stock market—currently on track to end up right about where it began—you may be looking for new investment strategies, such as those that Harvard endowment managers used to save their decade. Their methods, distinctly different than those used by many professional investors, make sense because they account for long-term changes in the rewards of different asset types relative to the risks they pose.

You probably don't think for a minute that you could mimic these methods. After all, these professionals have access to many types of investments that aren't available to individuals, right? Not exactly.

Increasingly, the same kinds of investments the endowments use are becoming indirectly accessible to individual investors through mutual funds and exchange-traded funds (ETFs). These are securities whose price is linked to an index. (Unlike mutual funds, the price of ETFs can vary throughout the trading day, just like stocks.)

To go the endowment route, start by reconsidering how much of your portfolio should be in stocks and bonds. Compared with institutional portfolios, those of many successful university endowments have astonishingly low holdings in these traditional investments.

Harvard has done quite well by reducing its investment in stocks from 65 percent in 1980 to only about 20 percent in the past five years — less than half of what many advisors recommend for the average middle-aged investor.

Harvard's domestic bond holdings during this period have shrunk from more than 25 percent to 8 percent or less — this year, about 4 percent. Instead, Harvard and many other successful large university endowments have gradually increased their holdings in what are known as "alternative investments."

These are not your father's investments. They include commercial real estate, inflation-indexed U.S. government bonds and commodities, along with many investments that most individual investors have never heard of. Alternative investments are generally regarded as a good way to strengthen portfolios against market downturns because they add all-important diversification, spreading risk over different areas, and because their prices may consequently move in different directions than those of stocks and bonds. Most of these investments also generate income, which can help keep returns steady.

Where endowment managers part company with many pros is by putting far more of their assets into alternatives and using a much more varied array of them. The traditional view is that alternative investments carry too much risk, yet these managers assemble portfolios that provide steady, long-term returns while avoiding big hits.

Many analysts are predicting paltry annual returns from stocks and bonds over the next few years, so this might be the time to take a page out of the Ivy League playbook. Here are some alternative investment strategies you might want to consider, now that many of them are available through mutual funds and ETFs.