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Hybrid Theory (Building Better Portfolios with HPT)

Posted by VenturePopulist On June - 9 - 2009

 

linkin-park-hybrid-theory-2001There is a better way to build investment portfolios than the methods presently employed by most investors and advisors.

 

Perhaps that is hard to imagine seeing as how well we have been served by Modern Portfolio Fallacies and the Efficient Market Hypocrisies, but if you have an open mind, there is a strong chance that these portfolio construction principles will resonate with you…particularly on the heels of what we have learned from the half dozen market meltdowns experienced since ’87.

 

I know that the idea of a new asset-allocation model is intuitively tiresome…but if there was ever a time to revisit the prevailing conventional wisdom, it is now. This smarter portfolio approach places heavy emphasis on safety of principal, liquidity and income, yet simultaneously provides investors with compelling potential for capital appreciation.

 

 

I refer to it  as Hybrid Portfolio Theory (HPT) and could safely say that less than one percent of advisors have contemplated, let alone implemented such a methodology in their practice…despite its proven efficacy and how well it resonates with high-net-worth investors.

 

In HPT the investor allocates 100% of the assets into two distinct (hybrid) portfolios. The larger portfolio (A) represents 75-90% of the assets and is invested with the primary objective of liquidity, safety of principal and income. This portfolio is benchmarked against a blend of risk-free and short-term yield rates and invests predominantly in money markets, CDs, short-term muni’s and Treasuries.

 

The challenge of portfolio A is to maximize yield in bps and increase yield to the point that does not threaten the overall liquidity and safety of principal. With liquidity and safely of principal as primary objectives, that effectively eliminates allocations to high-yield corporate and junk bonds, REITs, MLPs, closed-end and utility stocks by the literal-minded HPT practitioner.

 

Why Bother with Stocks?

So, what is the source of return for capital appreciation in HPT? Not traditional equities. Stocks go up and stocks go down. That’s a symmetrical outcome that we now know empirically to be a bad bet unless you have a multi-decade investment horizon. Rob Arnott’s recent article “Bonds: Why Bother?” in the Journal of Indices emphatically settled the score.

 

 

Arnott proved that the 5% risk premium promoted by the financial services industry is at best unreliable and is probably little more than an urban legend. Starting at any time from 1980 up to 2008, an investor in 20-year treasuries, rolling them over every year, beats the S&P 500 through January 2009. Going back 40 years to 1969, the 20-year bond investor still outperforms by a marginal amount, even with the Carter-era inflation and traumatic bond market in the seventies.

 

It is not debatable. Equities have not delivered their risk premium and are simply not worthy of their risk. Rather than pursing the laughably unreliable risk premium of equities, Portfolio B is exclusively seeking higher risk–higher return positive asymmetric outcomes (PAO). The Portfolio B benchmark is in the 10-20% range.

 

A PAO is defined by its ability to generate high double-digit or multiples of return on investment, as can be achieved by successful investments in venture capital, private equity, direct (angel) private investment in start-ups, small business, private manufacturing business, private real-estate, private debt, franchises, operating cash-flow businesses, as well as, publicly-traded emerging growth companies and leveraged option strategies or highly-specialized investment strategies such as managed futures.

 

The PAO mandate is broad but should ultimately be defined by a positively skewed risk-reward ratio, as well as, the practitioner’s sector expertise and due diligence resources.

 

The investor’s overall hybrid portfolio benefits by assuring that the vast majority of assets are not exposed to a downright bad wager relative to risk-free or short-term assets, as well as, unpredictable (yet, frequent) black swan events that decimate investor portfolios.

 

HPT should be engaged and implemented as a theory, not as an absolute rigid asset-allocation model. If the portfolio manager, advisor or investor accepts that; 1) current asset-allocation frameworks cannot successfully mitigate significant market exposure and do little to protect investors from unpredictable negative black swans, 2) investors are generally over-exposed to equities in light of the proven absence of any sustainable risk premium, and, 3) investors benefit from limited but diversified exposure to investments and strategies characterized by the possibility of positive asymmetric outcomes…this is a portfolio theory that you can adapt into your other core asset-allocation principles and values.

 

When adapting HRT to your own biases, the allocator can exercise discretion with respect to;

  1. The A:B Portfolio ratio
  2. The constituent opportunity set for Portfolio A–from short-term high liquidity, lower-yielding, shorter-term instruments to Treasurys, TIPS and munis
  3. The consitutent opportunity set for Portfolio B–from private venture investments to publicly-traded emerging growth companies to specialized trading and option strategies
  4. The benchmarks applied to the A and B Portfolios

 

 

Today, investors more than ever appreciate and welcome the notions of safety and liquidity. They no longer believe in the buy-and-hope asset-allocation models and “stocks for the long run” mantras peddled by talking heads. Moreover, the coveted HNW-investor demographic that you either aspire to, or presently serve understands and accepts the risk and liquidity realities of private investment in venture and enterprise. In fact, in most cases, such investment or employment is how they generated their private wealth.

 

Assuming the proper resources, advisors that embrace Hybrid Portfolio Theory (for appropriate investor portfolios) your advisory practice would benefit by;

  • Delivering the services, results and sensibility that desirable HNW investment clients are actually seeking from advisors,
  • Protecting your client’s assets and portfolios from incurring significant losses from exposure to unpredictable black swan events,
  • Strengthening advisory-client relationships by developing a unique and connected client community within your practice, and,
  • Competitively distancing your practice from the vast majority of investment advisory firms that can provide no evidence of a discernible value proposition.

 

 

I understand that this sounds provocative considering what investors and advisors have come to believe in after years of over-attentive care and feeding by the financial services industry. Yet, if you acknowledge the historical data,  the frequent and unpredictable impact of negative black swans and the notion of investing for positive asymmetric outcomes ,you should not be questioning the virtues of HPT as much as the critical issues of; access to the opportunity sets, due diligence, implementation and execution of the strategy.

 

Stick with us as we intend to tackle those issues in coming posts.

A more detailed Powerpoint presentation and audio webinar on HPT is available here.

 

Album:    Hybrid Theory, Linkin Park, 2001

 

 

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20 Responses to “Hybrid Theory (Building Better Portfolios with HPT)”

  1. derek says:

    Jeff,

    Funny, I was re-reading Gerald Loeb’s ‘Battle for Investment Survival’ yesterday and he discussed keeping most of reserves liquid but taking 10% to shoot for stocks that double. I thought it was right on, as is your idea.
    Of course, I’m personally reluctant to invest OPM in illiquid situations, no matter the upside. Personal money, I agree. The happy medium for me is heavy fixed income in short duration, with a few bets on asymmetric outcomes using long calls.
    Great proposal…

  2. Quant This says:

    Very interesting. This is very similar to what we do. Most of our holdings are in fixed income product where we try to get the best duration adjusted return, we then use the coupons collected to invest in riskier assets. These assets are divided into small company PE investments, quantitative trading strategies (of the mathematical persuasion, not factors) and special situation equity investments. There is a 10% allocation that is invested in these portfolios at the beginning and then as coupons are collected, an amount to cover inflation is put back into the fixed income portion and the remainder flows over to the yield enhancement portion of the portfolio. Much much better than the EMH BS. I wish they would stop teaching it in business schools and the CFA program.

  3. great detailed write-up thanks for sharing. Was unfamiliar with your site so look forward to reading!

  4. Mark says:

    Hmm. Good post. It made me think. The whole investing in 20 year Treasuries strategy is an interesting one. See Gary Shilling on this — http://www.forbes.com/2009/04/22/treasury-deflation-stocks-personal-finance-guru-insight-gary-shilling.html — he repeats it elsewhere.

    Whoever adopted this strategy has been able to benefit from a more than two decade long trend of declining interest rates. Using zero coupon bonds and rolling them over to keep capturing declines in interest rates has accounted for huge capital gains over the period. Rates on the long bond decreased from 15% to 4%. 1100 basis points.

    Do you believe that current investors in zero coupon bonds can earn similar returns? Will interest rates drop 1100 basis points from 2009-2037, 28 years from now? To ask the question is to answer it: hell no. Future investors in Treasuries have more limited upsides, and (possibly dramatically) worse downside risk.

    As for focusing 10-25% of your portfolio in higher risk/lower liquidity investments, I suppose that makes sense. In my business, I can make investments that return 100% per year. So we make the high-return investments, and keep moving. But I believe that those sorts of opportunities are pretty closely held, and are pretty small-scale. Any kind of extended super-returns attracts competitors, and drives down returns. If I knew of a number of such fantastic, high-return, modest risk sorts of investments, I would load up on them. If they are highly PAOs, why would you want them to be a greater percentage of your portfolio — like 50%?

    In another vein, Larry Swedroe, a personal finance writer and financial adviser, uses smallish investments in DFA mutual funds to achieve high value and small cap loadings, while keeping the bulk of his portfolio in Treasuries. So this concept is out there.

    But again, if I had sure bets on huge returns, I would take as many as I could. Highly PAO, indeed.

  5. Just_Math says:

    Ok so let me get this straight. If I hypothetically have $100,000, I invest 90% in “a blend of risk-free and short-term yield rates and invests predominantly in money markets, CDs, short-term muni’s and Treasuries.” Let’s say this earns me 5%. Then I take my remaining $10k and let’s say I make 30%. Wowiewowzers!! 7.5% return overall?! AMAZING! If we pretend inflation doesn’t exist, this is a very good return!

  6. VP says:

    Mark, thanks for your comments. I believe the primary value of HPT is that it is a theory (that values the principles of liquidity with simultaneous wagers on positive asymmetric outcomes) and not a model.. That distiinction highlights the asset-allocators four discretions in impementation that were identified, the tactical choice of underlying vehicles that best acheives the A and B portfolio objectives (in the allocator’s opinion) based on market fundamental’s and the investor’s risk profile.

    I share your outlook on interest rates and would predominantly populate portfolio A with TIPS and a laddered short-term CD portfolio. Low yields, yes…but certainly in line with the “new normal” that Gross has recently referred to.

    On the other hand, with respect to portfolio B…you and I have a different take on that. PAO bets are characterized by the uncertainty of their outcome. Consequently. that portfolio needs to be diversified with smaller bets. IMO, you don’t need Portfolio B to achieve 100% or 50% returns, for that matter. Moreover, loading up on B violates the other fundamental objective of HPT…safety of principle.

    Increasing the Portfolio B allocation beyond the 10-25% range simply swaps equity market risk for PAO underwriting, outcome uncertainty, principle exposure and liquidity risks.

    Your two points are worthy of a followup post. Thank you for continuing the dialogue.

    Jeff

  7. VP says:

    Just Math–Your question implies to me that you may have not chosen the best handle for yourself.

    But yes, you have it straight. In your example, you adopted a 90:10/A:B Portfolio ratio, (as opposed to 80:20, for example) which implies that you are referring to a more risk adverse investor that prefers the benefits of safety of principle to the uncertain potential for upside. For that investor, “wowiewozers!!” should be the investors response. That 7.5% would be an exceptional return for any conservative investor.

    You must be still drinking the Kool-Aid…a member of that diminishing camp that still belives a 10% return is an investors birthright (and, that 10% is easily achievable). I have news for you my friend–it isn’t. If you want and expect a conservative investor to acheive returns in excess of 7.5%, then you are part of the problem.

    btw…I would assume that your conservative (90:10, A:B) investor would be benchmarking the A Portfolio to 4% and the B Portfolio to 15% returns (as opposed to A/5%, B/20% returns that you stated)…so the composite (A:B) portfolio targeted return would be 5.1%…still a very respectable return for any conservative, risk-adverse investor.

    But, you can do the math.

  8. derek says:

    After reading your outstanding reply about the Kool-Aid, I realize even more how much you’ll enjoy Loeb’s book. Another of his recurring themes is breaking the “Myth of the Ideal Investment”. One would think 12 years of zero returns would eliminate the need to convince people of the inherent risk in markets, but I guess there are more to be converted in the years ahead

  9. Russ (aka, TheRTTrader) says:

    Hi Jeff- more people need to read, ponder and read your recent post on failed portfolio theory and the pathetic returns, or lack thereof, and how it has hurt the average person, just not the rich who can “absorb” it better.

    Your basic ideas and the concept of being a large part in low yielding cash makes perfect sense not only as an asset class but as a volatility dampening agent, if you were. So-called professionals just have no clue what to do to manage risk, other than “diversification” which is the two edged sword of limiting returns, and does not control much of anything in market swoons.

    Pity though that you have given up on stocks. Forget stock investing in the classic sense and look at stocks as a trading vehicle for making money. To use stocks in your part B – exactly what we do, has a great advantage over the other asset classes you propose – one always knows exactly what those assets are priced at, and of course ease of entry and exit at a cheap cost. The way we do it revolves around stock picking and of course timing, i.e. short term position trading and a limited portfolio of 4-8 positions, never more than 12.

    However, the reality is that great returns are all about risk control. Below explains my major points of view on risk-

    “I am a very risk adverse chart pattern break out trader with a system that clearly defines the risk in a trade before it is made (entry-minus exit prices.) Knowing the risk per share allows me to calculate how many shares to buy such that the total risk of the trade to total equity equals whatever percent I want to control. Currently, and for the past year, that risk is ca.0.2% of total equity at risk per trade.

    I also control total portfolio risk to total equity by limiting the total number of trades I place in a day and the total number of trades I keep open. That controls the total dollar risk to whatever percent of total equity I deem appropriate at any given time, based on market conditions. Cash is a great dampener of volatility.

    The third way I control risk is through a working hedge. When I take a long position I do not hedge it, nor do I hedge the entire portfolio. However, at times, when my exposure to market risk is high and the markets turn suddenly, as they often to do, to dampen risk of loss, as well as protect profits, I will place an estimated beta neutral hedge using -2x short index ETFs. The ramifications of that strategy, how it works and when it works and fails is a long discussion. The net is that it added 17% of the profits in 2009.

    And it goes without saying staying away from any risk one can mitigate – e.g., no positions on when earnings are announced, no biotech which is always subject to huge loses from unfavorable FDA rulings, etc.

    My belief is that managing risk is THE ABSOLUTE most important part of ANY type of program. The bottom line is that our program accounts did NOT lose money in 2008 and were at all time new highs for June 2009.

    Russell Mascieri

    General & Managing Partner
    RTT Growth Partners, L.P.
    (contact via LinkedIN)

  10. VenturePopulist says:

    Russ,

    Thanks so much for your post.

    With respect to your comment, “Pity though that you have given up on stocks. Forget stock investing in the classic sense and look at stocks as a trading vehicle for making money“…please note that we are in agreement…stocks can have a role in Portfolio B.

    Public equities have a distinct place in portfolio B if they can be allocated to in within a quantitative model that maintains and insures a postively-skewed risk/reward ratio (where, I might add, there is no discretionary overlay)

    The powerpoint deck on Hybrid Portfolio Theory contains the following definition of investments that are characterized by their potential for a positive asymmetric outcome

    PAO is a positively-skewed risk/reward ratio that can be achieved via investments such as venture capital, private equity, direct (angel) private investment in start-ups and emerging small businesses (PVI), private manufacturing businesses, private real estate, private debt, franchises, operating cash-flow businesses, as well as, publicly traded emerging growth companies, leveraged (long vol) option strategies, and highly specialized investment strategies employed by managed futures and some hedge funds.

    A properly executed strategy like that you are referring to can certainly be a candidate for the B portfolio.

    Thanks again for your comments.

  11. very interesting post..

    this is what Taleb had proposed in his black swan book..this was even corroborated by a Professor of Boston University I happened to meet and listen to his presentation at the FPA conference at Boston last year..He in fact had been personally investing using this hybrid portfolio model..

    cheers
    partha

  12. Interesting conversation here. I think we are all looking for ways to manage risk in our clients portfolios. I have been doing my DD on systems like Dorsey Wright and VPM partners in search of a system that I can implement in my practice.
    Want to talk shop with other successful, independent, forward thinking advisors? Check out http://www.advisorconnect.groupsite.com

  13. Arzu says:

    very interesting post..

    this is what Taleb had proposed in his black swan book..this was even corroborated by a Profsssor of Boston University I happened to meet and listen to his presentation at the FPA conference at Boston last year..He in fact had been personally investing using this hybrid portfolio model..

    cheers
    partha;

  14. Kamchako says:

    This strategy is essentially what we’ve been running for a few years now. Essentially we run three model strategies at 70%A, 80%A, and 90%A, and for the B portfolio we blow it out shooting for the moon. Frontier markets, leveraged etfs, micro caps, and opportunistic trading utilizing etf’s for simplicity. No complaints here.

  15. [...] the mindset should embrace private venture investments–for the benefit of their client’s portfolios, as well as, their practices. Yet, the majority of independent wealth managers should best leave [...]

  16. winstongator says:

    Why wouldn’t you put all (or most of) your money on the B strategy? Obviously the volatility is not for the faint of heart, but if you’re counting on that to increase your rate of return, you’re assuming that B will deliver at least the low-risk rate, long term.

    Part of the problem is that B-strategy investments are not always available. What would you have invested in around 2006-2007? Gold? Shorts of housing or stocks? It is safer to keep liquidity and then pour into the B-types when they come along. Keeping a constant % of the portfolio (vs. time) liquid doesn’t seem to make sense.

  17. winstongator says:

    Let’s consider a 401k illiquid, but you also keep a cash fund. When times are good you put into both, when times are bad, you pull out of your cash fund, and try to keep funding your 401k. Your relative % in illiquids should track as it should.

    A lot of this portfolio theory can be answered by ‘how big a rainy day fund do you need?’

  18. [...] couple of years ago I introduced and advocated Hybrid Portfolio Theory as an alternative asset-allocation approach for the progressive advisor that held preservation of [...]

  19. [...] these advisors have embraced the progressive precepts of Hybrid Portfolio Theory yet require more accessible investment products than direct investments in private ventures to [...]

  20. Jeffs Daughter says:

    Awesome blog dad!

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