‘Smart Money’ and How They InvestNovember 28, 2018
To many people, the success of the wealthy and how they manage their investments are likely a mystery. Do they have exclusive access to secrets and tools that most of us don’t? Can anyone follow suit and benefit from using their techniques? Affluent investors often look to emulate the principles of what is often called the ‘smart money’s’ approach to investing.
What is smart money?
The smart money is perceived as those people who have a better understanding of the market or access to information channels that a regular investor can't easily get. Market pundits, financial professionals and institutional investors, like endowment and pension funds, are examples of the smart money. And, when someone says to "follow the smart money," they are generally telling you to invest in the same ways that successful investors do.
How does the smart money invest?
The Harvard and Yale University endowment funds have taken diversification to the next level. They have been leaders in diversified multi-asset class investing for more than two decades.
The rationale for investing across multiple asset classes is supported by the modern portfolio theory. This theory shows that allocating funds among more asset classes helps reduce risk, since decreases in the value of one asset class could potentially offset increases in another. This theory is at the heart of the investment philosophy of most endowments and pension plans and is the foundation of their investment portfolios.
Many believe the success of Harvard and Yale’s investment strategy was its access to alternative assets. Alternative asset classes like private equity real estate are not selected just to improve diversification. After all, even bonds and cash can do that. Rather, the alternatives are also expected to help boost total returns.
By allocating a meaningful percentage of their assets to alternative asset classes, institutional investors like the Harvard and Yale endowments have consistently achieved attractive annual returns and have significantly outperformed a typical retail portfolio. Over the last 20 years, these endowments have achieved annualized returns of roughly 52% and 83% higher than the return a retail investor would achieve holding a traditional U.S. stock/bond portfolio (60/40) (Graph 1).
The model underlines the importance of diversification, but it also teaches that diversification should probably extend to the full array of asset classes that offer the potential for high returns. In other words, the inherent volatility in historically higher-return equities should probably be diversified not only with bonds and cash, but also with alternative instruments like private equity real estate.