How the very rich invest their wealth

Private equity and hedge funds may be all the rage, but a study shows that many millionaires prefer more traditional strategies. Fortune's Katie Benner opens the accounts of the super wealthy.

By Katie Benner, Fortune reporter

NEW YORK (Fortune) -- There's no question that hedge funds and private equity investments have dominated the business headlines for the last year. But does that mean that individuals are actually flocking to these high-risk, high-return funds?

Not as much as you might think. A recent study shows that 40 percent of millionaire investors surveyed had no allocation whatsoever in alternative investments, including private equity, hedge funds and commodities. Those who shy away from the investments say the products are too complex or that the risks associated with these investments are too high, says the report from Northern Trust, which provides financial services to high net-worth clients, including 22 percent of the Forbes 400 Richest Americans.

Instead, domestic equities dominate the portfolios overall, representing 43 percent of their assets, up from 41 percent in 2005. Millionaires reduced their exposure to real estate to 8 percent from 13 percent; and international investments increased to 10 percent from 8 percent.

About half of the high-net worth investors who do put money into alternative assets allocate 10 percent or more, and they told Northern Trust that they are attracted to the higher returns and diversification that these riskier investments hope to deliver. "Private equity funds are really investing on behalf of institutional investors - and that means the pension funds for teachers, firemen and police officers," says one private equity insider.

And he's not just spinning a Mr. Nice Guy image for his own industry. Wealthy families accounted for 11 percent of the $154.3 billion raised by U.S. private equity firms in 2005, according to Dow Jones Private Equity Analyst. More than 70 percent of private equity capital came from public and corporate pension funds, insurance companies, endowments, foundations, and funds of funds, specialized vehicles that combine the assets of many small investors.

Additionally, Dow Jones said that U.S. investors accounted for 77 percent of the capital raised by private equity firms in 2005. With the bulk of private equity's money coming from pensioners, universities and insurers, the actions of these cash-happy funds are of genuine importance to the comparatively cash-strapped masses. And the deep participation of such institutions may also explain why some politicians and regulators have been fighting for more industry scrutiny.

Among wealthy investors who did give money to alternative assets, Northern Trust found some striking generational differences. For example, 27 percent of GenX millionaires (i.e. ages 27 to 41) have exposure to the higher risk vehicles, compared with 17 percent of baby boomers, and only 11 percent of millionaires ages 61 and older.

"Alternative asset class investments, particularly hedge funds and private equity, often have lock-up provisions and other limitations on liquidity," says Northern Trust chief investment officer John Skjervem. "Younger investors, presumably still working, can afford to invest a larger proportion of their portfolio in an illiquid, non-income producing asset class."

Lest we believe that the wealthy are throwing all their cash at high-risk, high-return investments, respondents overwhelmingly described their risk tolerance as "moderate." But among the "deca-millionaires," meaning households with more than $10 million in investable assets, 22 percent say they are aggressive investors; and younger, male investors claimed higher risk tolerance levels than older, female investors.

Moreover, millionaires are optimistic about the future, with 62 percent expecting annual market gains of 6 percent or higher. Only a tiny minority said they were bearish on the market, despite spirit-dampening trends like the worsening international crisis, growing budget deficits and the declining dollar.

"Despite a discernable slowdown in U.S. economic growth in the second half of 2006 and a continuing steady stream of often disconcerting geopolitical headlines, investors continue to embrace risk across equity, fixed income and alternative asset classes with remarkable calm and tenacity," says Skjervem.

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