Venture Populist

Our recent proclamations that “MPT failed” have elicited a distinctively binary response from wealth managers and investment advisors. I have both the commendatory and the castigating emails and comment board posts that prove it.

While many IAs responded enthusiastically, a seemingly larger pool of advisors continue to cling desperately to their discredited diversification dogmas hoping that investors may not have noticed the failure of their advisor’s mantras and models even as last week’s front page WSJ article (“Failure of Fail-Safe Strategy Sends Investors Scrambling”) cited more examples of prominent institutions who who likewise believe that prevailing “asset-allocation strategies are fundamentally flawed”.

Last month in this column I introduced Hybrid Portfolio Theory (HPT) as an alternative to Modern Portfolio Theory. HPT is comprised of two distinct (hybrid) sub-portfolios; the larger (say, 75%) with the primary objectives of insuring safety of principal, liquidity and income by way of allocations to money markets, CDs, municipal and government bonds, while the smaller (25%) portfolio is opportunistically allocated to make investments that have a positive asymmetric outcome (PAO) profile.

In a recent Investment Advisor Magazine-sponsored webinar I defined PAO opportunities as those characterized by positively-skewed risk/reward ratios that can be achieved via investments such as venture capital, private equity, direct (angel) private investment in start-ups and emerging private and operating cash-flow businesses, private real estate, private debt, franchises, as well as, publicly-traded emerging growth companies, (long volatility) option strategies and other highly-specialized investment strategies perhaps employed by some hedge funds, managed futures and market-timers.

This definition implies a potentially broad constituent universe that allows the investor considerable discretion in identifying PAO opportunities in the HPT sub-portfolio mandated to pursue capital appreciation. Advisor practitioners seeking to implement HPT should exercise such discretion based upon a number of factors, such as their access, due diligence skills and core beliefs with respect to the viability of certain PAO asset-classes, strategies or products. As the moniker Venture Populist implies, my PAO allocations favor private investment in private venture due to the decisive historical performance of venture capital and private equity as an asset class and its proven role of being the greatest and most sustainable source of private wealth.

But the beauty of HPT lies in its adaptability as each investor will define their PAO universe according to their own beliefs, biases, professional skills, access to product  and deal flow…as long as those investments are truly characterized by an empirical and quantifiable positively-skewed risk/reward ratio.

Private investments in venture and early-stage companies are unmistakable asymmetric upside candidates as they are often vulnerable to a 100% loss but may also return three to twenty times on capital. Publicly-traded emerging growth companies are occasionally capable of delivering outsized (Lynch’s “10-bagger”) returns, as well.

But, what about managed futures and market-timers? The manufacturers, marketers and distributers of these so-called “absolute return” products clearly position them as effective portfolio diversifiers, citing their low correlation to long-only assets during Gaussian good times, but does anyone still fall for that line in light of correlations invariably coalescing amidst ever more frequent black swan drills?

Fact is, quantitative diligence reveals most managed futures and market-timers employ zero-sum game strategies with distinctively binary and symmetrical outcomes. They can lose or gain the same amount on each trade. Even if their quantitative models impose disciplined (per trade) stop-loss provisions the aggregate sum of losing trades can equal (or exceed) the aggregate of the winners….hardly asymmetric.

MPT would not have failed so miserably if the concept of diversification was not diluted and polluted by product pushers and manipulative mutual fund marketers. Achieving true diversification requires a higher standard. Amidst the new normal and an elusive equity premium, capital appreciation should be pursued via diversified portfolios defined by their breadth of investments with the potential for positive asymmetrical outcomes.

Album:   Boom Boom Pow, Black Eyed Peas, 2009

Popularity: 27% [?]

 In my last post I introduced an alternative asset-allocation approach for investors that no longer subscribe to the discredited models of traditional (strategic) asset allocation, Modern Portfolio Theory (MPT), Efficient Market Hypothesis and what pedestrians refer to as “buy-and-hold”  investing.

This new portfolio construction approach, Hybrid Portfolio Theory, is a unique and timely portfolio construction methodology that is distinctly disparate from MPT in that it employs two distinct capital pools: Portfolio A, the larger portfolio has the primary objectives of safety of principal, liquidity and income, and, Portfolio B that only allocates to private or public investments that exhibit the potential for positive asymmetrical outcomes (PAO) via exposure to positive black swans.

Last week Investment Advisor Magazine and Ameritrade co-sponsored a webinar that allowed me to introduce Hybrid Portfolio Theory to investment professionals. The call was well attended with nearly 500 registrations.

[You are welcome to listen to the archived call and view the presentation which is hosted at this link, or, you can simply view the Powerpoint, without the audio, here.]

We cut the call at the hour mark which means that many questions from participants that were in the queue for the Q&A portion were unable to be addressed. I welcome the opportunity to address your questions, comments and critiques and would encourage you to post them on the comment boards of the Hybrid Portfolio Theory post and I will reply in that forum.

If you would like to have a direct dialogue, please reach out to me via LinkedIN and we can schedule a private conversation.

After the call, I received dozens comments on HPT via LinkedIN. I was not at all surprised to hear from a number of advisors who had previously embraced a number of HPT core principles in their portfolios. I plan to introduce these advisors (and the manner in which they have adopted or adapted HPT to their portfolios) to VP readers in the months ahead.

Many of the comments received revealed that investment advisors were compelled by the concepts of HPT, but also had many questions about implementation and execution of the strategy at the client, portfolio and practice level.

For good reason…HPT is not as pie-chart ready as Modern Portfolio Fallacy.

Going forward, VenturePopulist posts will address issues associated with the implementation of HPT and defining the broad PAO opportunity set…with particular focus on private equity (angel investing and venture capital) investments.

Thank you for your all of your responses to HPT…the curious, the complimentary and the critical. I welcome and look forward to your comments on our boards.

Album:   What’s Next? Foster Edwards Orchestra, 1964

Popularity: 29% [?]

There 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

Popularity: 100% [?]

The Black Swan by Nicholas Nassim Taleb holds its own among the most important investment books ever written. In it, Taleb argues persuasively that any sensible long-term strategy in a world dominated by extreme and unpredictable (black swan) events has to accept, and even embrace, that very unpredictability. It is poignant and timely advice for any investor and a must-read for investment professionals.

I met Taleb for lunch at Bice in NYC one afternoon about three years ago while I was heading Alternative Strategies for an investment management firm. I was interested in exploring the idea to engage Taleb as a sub-advisor for an investment fund that we were contemplating. I found him to be personable, enthusiastic, engaging and surprisingly modest.

I had read and re-read Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life before our meeting and I was looking forward to discussing his contempt for investment managers that sell themselves on their track record…a cynicism that I shared. But Taleb had just finished his final draft manuscript of The Black Swan and directed our discussion towards his treatise on asymmetric outcomes-the central theme of the unpublished tome that he brought along with him and referenced throughout our visit.

The notion of asymmetric outcomes, “I will never know the unknown since by definition it is unknown. However, I can always guess how it may affect me, and I should base my decisions around that”, causes Taleb to advise to seek out (investment) situations “where favorable consequences are much larger than unfavorable ones.”

That is a central tenet of Venture Populism and my advocacy of committing a portion of an investor’s portfolio to private venture-oriented investments. Like Taleb, I believe that effective investment portfolios should contain meaningful (and appropriate) exposure to positive Black Swans-such as private equity investments in emerging ventures and distressed companies.

In posts to come I will expand on this premise and propose a provocative new model for portfolio construction that balances the investor’s need to mitigate the asset-depleting impact of negative black swan events with simultaneous allocations that benefit from the potential of positive Black Swans and asymmetrical outcomes.

Many advisors now concede that Modern Portfolio Theory, traditional asset-allocation and buy-and-hold investing models have failed and investors are looking for improved approaches that preserve capital and manage unexpected risks more effectively without giving up on the prospects for capital appreciation.

The Black Swan is indeed a brilliant and provocative work. As the New York Times review summed, “It concerns the occurrence of the improbable, the power of rare events and the author’s lament that in spite of the empirical record we continue to project into the future as if we were good at it.”

We expect all swans to be white and are shocked when a black swan swims by…the same way that we were lulled into complacency with flawed risk management models and were then shocked when the market fell 50% and erased away trillions of wealth.

Investors and their advisors can build better portfolios that are for the most part insulated from the impact of negative black swan events, yet have simultaneous exposure to asymmetrical risk/return opportunities.

Album:   The Black Swan, Story of The Year, 2008

Popularity: 58% [?]

In prior posts I have taken swipes at traditional asset allocation, buy-and-hold investing, the Efficient Frontier, the Efficient Market Hypothesis and Modern Portfolio Theory (MPT).

Sure, I am trying to be provocative, poke a little at advisor complacency and provoke polemic on the comment boards…but I am also sincere. MPT relies entirely on investment history for investment analysis and conclusions. These tired and discredited methods are rubbish…and have cost investors trillions.

It is encouraging to see evidence of advisor post-mortems in progress as some advisors are seeking not to repeat the mistakes of the past. I was also entertained by John C. who cracked on the comment board, “What’s over 50 years old and still considered modern?   MPT”

But pretty pie charts and Powerpoints are not so easily disposed of. As an anonymous critic incites, “The appeal of Modern Portfolio Theory in the investment advising community is its simplicity, graphic presentation value, and most of all, little or no investing judgment or skill is required; just pick, print, present, and hope; chasing efficient frontiers, hoping that investment history will somehow repeat itself, and just waiting for historical updates to generate new efficient frontiers to justify investment change.”

Nevertheless, some advisors are stubbornly standing by their man(tra).

Modern Lovers

Consider these edited comments that I received from Matthew K. in response to the Crisis = Opportunity post;

“MPT works. With the right allocation and systematic rebalancing to maintain percentages as well as in line with client’s goals, there is no lost decade. Markowitz knew what he was doing, and as an academic, he did not stand to profit…When MPT is juxtaposed with Daniel Kahneman’s Nobel Prize winning ideas on heuristics, you see how MPT does add value when used in line with client’s goals…Any classic definition of “Venture” includes the idea of risk taking. Where does that fit in CAPM or the efficient frontier?”

I cannot rebut a hopeless romantic, so let’s engage Matthew K. in a virtual volley with interlaced quotes excerpted from a FT article and a McKinsey interview with the especial epistemologist, Nassim Nicholas Taleb. Taleb is the author of two true investor instant classics and must-reads, Fooled By Randomnes and The Black Swan.

Taleb has a strong opinion on the matter of MPT and modern finance…and he is no modern lover:

MK- MPT works. With the right allocation and systematic rebalancing to maintain percentages as well as in line with client’s goals, there is no lost decade.

NNT-We learn from crisis to crisis that MPT has the empirical and scientific validity of astrology, without the aesthetics…In 1990 William Sharpe and Harry Markowitz won the prize three years after the stock market crash of1987, an event that, if anything, completely demolished the laureates’ ideas on portfolio construction….I would ban portfolio theory immediately. It’s what caused the problems…Portfolio theory simply doesn’t work. It uses metrics like variance to describe risk, while most real risk comes from a single observation, so variance is a volatility that doesn’t really describe the risk. It’s very foolish to use variance.

MK-Markowitz knew what he was doing, and as an academic, he did not stand to profit…When MPT is juxtaposed with Daniel Kahneman’s Nobel Prize winning ideas on heuristics, you see how MPT does add value when used in line with client’s goals.

NNT-Academic economists are no more self-serving than other professions. You should blame those in the real world who give them the means to be taken seriously: those awarding that “Nobel” prize… Every time I have questioned these methods I have been abruptly countered with: “they have the Nobel”, which I have found impossible to argue with. There are even practitioner associations such as the International Association of Financial Engineers partaking of the cover-up and promoting this pseudoscience among financial institutions. The knowledge and risk awareness we are accumulating from the current subprime crisis and its aftermath will most certainly not make it to business schools.

Thanks, (virtual) Nassim. I will take the next one.

MK-Any classic definition of “Venture” includes the idea of risk taking. Where does that fit in CAPM or the efficient frontier?

VP-Of course, venture implies risk-taking… they are nearly synonymous. A venture investor is knowingly acknowledging and accepting an implicit and quantifiable serving of risk that is decidedly less than a range of positive (asymmetric return) outcomes. Perhaps investors would have been better served if their notion of the risk that they were assuming in their efficient frontiers was not muted (and implied to be mitigated) by the marketing machinations of MPT. CAPM is a future-oriented model yet it essentially relies on historic data to predict future returns. The Efficient Frontier? I have seen the inputs, I have seen the outputs…and I have seen the results…the efficient devastation of unsuspecting portfolios.

Album:   The Modern Lovers, The Modern Lovers, 1976

Popularity: 47% [?]

An opinion poll that is currently posted on Investment News asks advisors, “Do you think the market downturn has created a lost generation of investors?”

It is a thought-provoking question as investors of all ages (and ironically, of all risk tolerances) have seen portfolios reduced by as much as one half of their peak value. Have these investors lost a generation of opportunity that they can never recover?

The answers tallied thus far are as provocative as the question and may suggest a lost consciousness among many advisors. Surprisingly, approximately half of the respondents thus far disagreed with the notion of a lost generation of investors despite the fact that some of their own clients have incurred substantial losses that are not likely to be made up prior to retirement.

These advisors are naively optimistic, in denial or merely oblivious. Either way they are doing a disservice to their clients and their practice. By ignoring the mistakes of their recent past they are destined to repeat them. In the past dozen years they have seen several black swans with their own eyes yet they still manage assets as if all swans were white.

A slight majority of advisors are indeed aware of the irrevocable nature of some investor’s losses. As one advisor posted on the opinion poll’s comment boards with respect to a hypothetical 68 year-old investor losing half of their portfolio’s value;

“Based on the annualized returns of a 60/40 portfolio over the past 15 years (5.44%) it will take your client ~13 years to recover what he/she had 18 months ago, IF the annual average return was to resume at 5.44% tomorrow. IMHO it’s quite likely that John or Jane will NOT return. And if you use the 0.19% annualized that a 60/40 has returned over the past 10 years, try explaining to your former client that it will take more than 365 YEARS to get back to where he/she was.”

Advisors whose practices will prosper going forward are those (50%) that are revisiting the buy-and-hold, asset allocation and diversification models that have failed so miserably. Same old, same old will simply produce the same results.

Album:   The Sly, Slick and Wicked, The Lost Generation, 1970

Popularity: 38% [?]

Leave the Capital Gains Tax Rate at 15% (Seeking Alpha)

Entrepreneurship and private sector investment should be encouraged in order to accelerate our economic recovery.

Ten Principles for a Black Swan-Proof World (Taleb, FT)

I am a big fan of Talebs, and principle #1…“What is fragile should break early while it is still small.”

Album:   Huey Lewis and the News, 1980

Popularity: 22% [?]