Savio,
I totally agree on the importance of the covariance matrix, but it's absolutely crucial to note that we're talking about the TRUE covariance, not the MEASURED covariance matrix. I think that the biggest reason for the very unfortunate growth of investing in illiquid assets (especially private equity) is that their illiquidity "forces" (permits) the use of valuation measures that disguise their true volatility and their true covariances with other assets, thereby making them appear to provide greater portfolio diversification benefits than they really do. That doesn't help the beneficiaries at all--but unfortunately it often does help the people who should be exercising better fiduciary responsibility on behalf of the beneficiaries!
Larry,
Great post, especially your discussion of #2. Thank God for Franzen!
--Brad