If you were to read any thoughtful book on investing there would be a chapter devoted to the importance of asset allocation. In all likelihood, the author would state: “Asset allocation determines 95% of investment performance and manager selection determines the balance.”
Yet, how does one determine an appropriate asset allocation? How should one consider risk, volatility, and liquidity in constructing an asset allocation plan? How do you incorporate the appropriate indexes, managers and assets?
In simple terms there are only two asset classes: you can be an owner (equity) or a lender (debt). Long-term you want to own assets, be they businesses, real estate, natural resources (energy & minerals) , agricultural assets, etc. On occasion you get adequately compensated to be a lender. However, in most instances, you will be better off as an owner.
Importantly, in periods when all asset classes are over-valued, holding cash in anticipation of attractive investment opportunities is most sensible.
Characteristics
Each asset class has its own special characteristics. These characteristics need to be well understood and carefully and thoughtfully integrated into an asset allocation plan. For example, we believe investors should recognize that private equity and hedge funds are not separate asset classes to be treated as “alternatives”. Private equity and venture capital are investments with a particular set of characteristics that include illiquidity, high fees, longer holding periods and various partnership risks. Returns from private equity are closely correlated with public equity returns, though they offer distinct opportunities for outperformance if one can identify and access the top tier partnerships.
Hedge funds are investment partnerships with both an asset management fee and a profit allocation to their managers. Hedge funds pursue a wide variety of generally uncorrelated strategies. Distressed assets, merger and capital structure arbitrage, currency trading, emerging market and long/short equity are distinct asset classes, each with its own unique risks and returns.
Risk Mitigation
We analyze investment partnerships with a focus on understanding the principle activity and risks. Occasionally, these non-traditional asset classes require a well informed, educated investor to remain “under-invested” at certain points in the investment cycle. Thoughtful asset allocation is critical to earning good long-term investment performance; investors must achieve real, not just perceived, diversification. Finally, knowing your managers well is far more important than searching for the highest return.