Asset Allocation with Shadow Assets

Abstract

The wealth of most investors contains both financial assets as well as nonfinancial assets. The author defines shadow assets as (mostly) nonfinancial and nontradable assets that are exogenous to the investor’s asset allocation decision, such as human capital, nonfinancial sovereign assets (e.g., underground oil reserves), the present value of future alumni contributions for university endowments, or the nonlisted family business for the client of a family office.

Ignoring shadow assets is unfortunate, as it is the existence and nature of shadow assets that distinguishes private investors, university endowments, sovereign wealth funds, and family offices and hence leads to different demands for risky securities. Shadow assets influence the outcome of asset allocation decisions via their covariance with financial assets and their effect on total wealth. Adding shadow assets has two effects on investors: It makes investors more aggressive and can create demand for hedges. Investment advice in the client’s best interests needs to incorporate shadow assets as well as shadow liabilities, as optimal allocations differ considerably when shadow components are properly accounted for