Financial Literacy - Retirement income planning
Should individuals follow the smart money?

"The average over-$1-billion-in-assets endowment puts about 13 percent in private equity," says Albert Chu, chief investment officer for Wealthstone in Columbus, Ohio. Most of the minimums to get into a private equity fund would start around $500,000. If you think about a typical investor, the size of the portfolio you would have to have so that private equity makes up 13 percent of your portfolio -- you would have to be an extremely affluent investor to make sure that you have the correct mix."

As examples, let's look at the private equity holdings of two gigantic public pension funds in California. As of mid-August, California Public Employees' Retirement System, or CalPERS, the largest pension fund in the U.S., manages $191 billion in assets, with about 11 percent of that allocated to private equity. Another behemoth, the California State Teachers' Retirement System, or CalSTRS, runs about $124 billion, with a 12 percent allocation.

Portfolio holdings by asset category as of June 30, 2008

Even if individuals were able and inclined to invest in private equity, they probably shouldn't. Only the cream of the crop really pays off.

"Private equity is an institutional game and all the outperformance is created by the top 20 percent of funds," says Mebane T. Faber, author "The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets."

Chu agrees.

"The top quartile of managers represents about 50 percent of returns that are generated by private equity. So if you are in the third tier or down, you really are going to underperform because it is very manager-specific," he says.

While those kinds of strategies will only be available to accredited investors, or investors with investable assets of at least $1 million, individuals can still mimic the style of pension or endowment fund investing.

What individuals can do

Some experts believe individual investors can benefit by following these strategies:
  • Follow a broad asset allocation strategy based on your own investment objectives and risk tolerance.
  • Consider passive investing.
  • Diversify.
  • Write an investing plan, follow it and rebalance your investments.

Asset allocation strategies

If you follow a broad asset allocation strategy using noncorrelating asset classes, you're emulating exactly what institutional investors do. Rather than investing in only one type of mutual fund, for instance, large-cap value, investors should spread their investing dollars over all domestic market capitalizations to decrease the volatility in their portfolio. That means buying large-cap, mid-cap and small-cap funds -- with value and growth style biases.

"If you are going to do a strategic asset allocation, the big endowments have been the best investors over the past quarter century," says Faber.

"That means very broad diversification not just focusing on domestic assets but foreign assets," he says. "And of course paying as little for investment management as possible, and only looking for active management where it makes sense."


Consider passive investing

Pension funds, in particular, focus on passive investing strategies in large part. For instance, a large portion of CalPERs' allocation to equity is spread over passive investments, such as index funds or ETFs, rather than actively managed funds.

"All of the historical evidence comes down as that is likely to produce results. So that is No. 1," says Swedroe, a big proponent of index funds. "Today, only maybe 15 percent of individuals adopt passive investing versus about 40 percent of institutional money.

"And the trend is clearly that way. Pension plans know more about the academic evidence than individuals do, and they also have fiduciary responsibilities. And the prudent investor rule defines passive investing as the standard by which fiduciaries are judged," he says.

Individuals looking to save money on fees and expenses might consider putting the bulk of their money into a range of index funds comprising separate asset classes rather than paying for actively managed mutual funds.

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