These investors earn more return, with lower volatility. But it is not by magic. The key to their strategy lies in not limiting the scope of their investment universe. They take positions in asset classes worldwide, including niche and less liquid assets in private equity, real estate, hedge funds, and private debt markets. By diversifying broadly and accepting lower levels of liquidity, they are able to earn high returns. We believe some of the principles of this approach can also be successfully applied by many private investors.
An endowment-style approach, if applied by private investors, could be used as: i) a source of ongoing cash flow to fund expenses, ii) a long-term portfolio to reach goals 10 or more years into the future, or iii) an intergenerational portfolio that can secure capital growth across generations.
So, how does it work? The key building blocks, in our view, are some assets from public markets (bonds ranging from the safest government bonds to sub-investment grade bonds, and equities), and some assets from private markets (hedge funds, private equity and debt funds, and real estate). Endowment-style allocations typically have a much heavier weighting in private market investments than most traditional allocations held by private investors. This mix of assets meets the key criteria of income and purchasing power protection: income is provided by diversified streams: dividends from public equities, distributions from private equities, rents from real estate, and interest from a variety of fixed income instruments.
Meanwhile, purchasing power should be protected by cap- turing additional sources of return. In addition to the traditional “risk premiums” that can be earned by investing in public markets, the high share of private market investments means that investors can also capture returns from exposure to less liquid and less well-followed markets.
An additional benefit that may be realized by private investors is protection against behavioral biases that a largely illiquid allocation can cause. Overtrading based on emotion is a major source of underperformance for private investors – less liquid investments and a long-term time frame can help avoid temptation.