Putting Theory Into Practice
To effectively deal with the challenging environment, advisors should utilize alternative investments, as sources of growth and income, as tools to dampen volatility, and as a means of hedging the impact of inflation. These valuable and versatile tools are now available to a broader group of investors, at lower minimums, with lower fees, and more flexible features, as I described in articles in the January-February Investments & Wealth Monitor and the May issue of Financial Advisor.
As the chart below illustrates, institutional investors have allocated to an entire spectrum of alternatives in a diversified fashion. Public and private pension funds, sovereign wealth funds, and endowments and foundations have all committed significant capital to private equity, private debt, hedge funds, real estate, and infrastructure.
The largest institutions often allocate most of their capital to a diverse set of alternatives. For example, the target alternative allocation for Yale’s endowment is more than 78% as of June 30, 2020, with specific target allocations to venture capital, leveraged buyouts, real estate, natural resources, and absolute return strategies.1 The target allocation to U.S. equities is a mere 2%. We’re not suggesting that advisors follow the Yale allocation with their HNW investors; we’re using the example to illustrate how one of the most successful endowments allocates capital.
Let’s consider the following case study.
Jim and Mary Smith are both 60 years old and have three children—Jamie 25, Jackie 21 and Joanie 18. Jim is a successful attorney and Mary is a schoolteacher. They both plan to retire at 65 years old. The Smiths have been able to save $5 million ($3.5 million in their personal accounts and $1.5 million in their IRAs). Their current income is approximately $650,000 per year (Jim’s salary is $500,000, Mary’s salary is $75,000, and they have $75,000 in portfolio income). They have no debt, no immediate cash flow needs, and they have experience investing in alternative investments. The Smiths are focused on capital appreciation over the next 10 years and have a healthy appetite for risk.
Based on the Smiths’ wealth and income, their experience with alternative investments, and their long time horizon, they are good candidates for alternative investments. But what types of alternatives? How should their allocation in their personal and retirement accounts differ?
Personal Accounts. Because they are primarily focused on capital appreciation, and have no immediate cash-flow needs, the Smiths can afford to lock up capital for an extended period of time. Their allocation would be as follows: private equity 10%, private real estate 5% and equity hedge 5%.
Retirement Accounts. Because the Smiths will be retiring in the next five years, they will need a combination of growth and income, and will want to buffer market shocks. Their allocations would be as follows: private real estate 10%, private credit 5% and relative value 5%.
The case study is designed to illustrate how to allocate capital for a sophisticated investor with significant wealth and income. Advisors should determine the appropriateness and amount of capital to allocate using several factors, including investor eligibility, risk profile, cash-flow needs, sophistication, time horizon and the goals they are trying to achieve. For private market funds, advisors should determine each client’s liquidity needs, as these funds should be viewed as long-term investments (seven to 12 years).
Conclusion
We can learn a lot by observing how institutions allocate capital. We adopted the 60/40 portfolio because we wanted to follow the institutional approach. As institutions have evolved their approach over the years, they increased their allocations to alternative investments to meet their portfolio needs—growth, income, defense, and inflation hedging.
Product evolution has helped democratize these once-elusive investments by making them available to a larger group of investors, at lower minimums and with more flexible features. Advisors should use these versatile and valuable tools to achieve their clients’ goals.
Tony Davidow, CIMA, is president and founder of T. Davidow Consulting LLC.
1. Andrew Bary, “Yale Endowment Has Just 2% In U.S. Stocks. Don’t Expect Major Changes Under The New Investment Chief,” Barron’s (September 2, 2021), www.barrons.com/articles/yale-endowment-only-2-percent-u-s-stocks-51630535033.