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Invest Well. Live Well: How does big money invest?

In recent years, institutional investors such as university endowments, pension funds and sovereign wealth funds have shifted their asset allocation away from standard investment classes like stocks and bonds into alternative investments like private
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In recent years, institutional investors such as university endowments, pension funds and sovereign wealth funds have shifted their asset allocation away from standard investment classes like stocks and bonds into alternative investments like private equity and hedge funds.

This suggests they either believe that alternatives can earn a higher return, have lower risk or provide diversification benefits.

According to nacubo.org, as of 2016, the top three endowments -- Harvard, Yale and Princeton -- have in excess of $74 billion -- yes, billion -- and have an average exposure to hedge strategies of 20 per cent. The portfolio allocation of most college and university endowments in the United States are voluntarily reported to the National Association of College and University Business Officers.

In 2016, more than 800 members reported the following average asset allocation: o Cash: 4% o U.S. stocks: 16% o Fixed income: 8% o Foreign stocks: 19% o Private equity: 11% o Hedge funds and alternative strategies: 42%

Hedge funds have a wide range of strategies, from conservative to aggressive, and often make use of advanced investment strategies, including options, futures, currencies, leverage, stop-losses, shorting and many other tools that mutual funds typically cannot employ.

This tends to increase their risk. On the other hand, hedge funds are less regulated and only accessible to accredited investors or through a licensed portfolio manager. There are several definitions of an accredited investor. For financially sophisticated individuals or couples, it usually requires a certain amount of investible assets, income or net worth.

Often, a hedge fund will set an absolute return objective, for example, a five per cent return objective in all market environments. The goal is to deliver positive returns throughout various market conditions. Given the 2008 financial crisis, large investors are continually looking for alternative ways to invest by attempting to reduce risk and protect the downside. Hedge funds can be a good addition to a portfolio, depending on your investment objectives and risk tolerance.

On the other hand, some hedge funds are more aggressive and will borrow (also referred to as using leverage), thereby enhancing or significantly detracting from their results.

As for costs, the norm in the industry is to charge a management fee plus an incentive or performance fee. Costs can seriously detract from what ends up in the investor's pocket.

Many strategies have higher minimums and liquidity restrictions where you might have wait up to a year to get your money out. Hedge funds, while sometimes difficult to assign to specific categories, tend to fall into one of the following: o Long-short: long-favourable companies and betting against those with poor fundamentals; o Market-neutral: hedging against up or down movements; o Event-driven: "quick-trigger" decisions to attempt to capitalize on anticipated news; o Macro: betting on overall market trends; o Arbitrage: looking for mispricing of securities, possibly in merger situations; o Distressed: purchasing potential insolvent or bankrupt securities.

For all the reasons mentioned above and more, the alternative space and hedge funds are incredibly difficult to navigate.

We strongly recommend investors work with an experienced advisor or portfolio manager to determine the best fit for their wealth within their comfort and to ensure that they understand the potential rewards and risks associated with this type of investment.

Until next time, Invest Well. Live Well.

This document was prepared by Eric Davis, vice-president, portfolio manager and investment advisor, and Keith Davis, investment advisor, for informational purposes only and is subject to change. The contents of this document are not endorsed by TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc.-Member of the Canadian Investor Protection Fund. All insurance products and services are offered by life licensed advisors of TD Waterhouse Insurance Services Inc., a member of TD Bank Group. For more information, call 250-314-5124 or email Keith.davis@td.com.