How do the most sophisticated institutions invest their money? How do their asset allocation models look like? Before we look at that, let’s examine what traditional asset allocation models look like.

The traditional asset allocation models split up your assets mainly between bonds and stocks. It ranges from the most conservative capital preservation model (25% equity, 75% fixed income), income model (55% fixed income, 45% equity), income and growth model (10% cash, 40% fixed income, 50% equity), growth model (35% fixed income, 65% equity), aggressive growth model (20% fixed income, 80% equity).

For very high networth individuals, you could add more diversification by putting a portion (normally 10%) of your portfolio in alternative asssets. These include hedge funds, private equity, venture capital and real estate partnerships.

However, the most sophisticated institutions have asset allocations that is totally alien to mainstream asset allocations. In yesterday’s Financial Times, there was an article on how Yale University allocated their endowment fund into the various asset classes.

This is how they do it :

“Only 4 per cent is in fixed income. And only 27 per cent is in public equities. All the rest is in alternative assets, which are not readily marketable: 25 per cent is in “absolute return” hedge funds, which attempt to generate returns uncorrelated to the market; 17 per cent is in private equity; and 27 per cent in “real assets” – property, oil fields and forestry.”

David Swensen, who took over the endowment in 1985 (when it had just $1bn), has easily beaten the S&P 500 with much lower volatility. The endowment fund last June stood at $18bn.

The strategy is now coined “core satellite strategy” in private banking circles. It involves having a “core” bond and stock strategy (even indexed), but investing in alternative assets which have very low correlation with traditional assets and greater potential returns. A friend of mine (who is a private banker) says that someone with about $2mm in investible assets would probably be able to invest in hedge funds and maybe some private real estate deals. However, to truly invest like Yale, you need investible assets of at least $10mm (in some cases $25mm).

For the rest of us, being “well diversified” has a different meaning. Take a look at the article here. Diversification will never mean the same thing to you as it did before!

This entry was posted on Wednesday, June 13th, 2007 at 03:37 and is filed under Personal Finance & Frugality. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.