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

Do you wish you had a yuan for every time you heard the inaccurate reference that the Chinese symbol for “crisis” is the same as for “opportunity”?

How often will we have to hear this nonsense from pontificating pundits, investment advisors and portfolio managers out ballyhooing the pending stock buying opportunity of a lifetime?

The equation above is only applicable when something is actually learned from the chaos and behavior is changed. The common definition of insanity–the behavior of people who keep doing the same thing, yet expect different results–is likely more relevant.

So far, I see little evidence that investment advisors have learned anything from their vanishing assets-under-management, despite irrefutable evidence that:

• Stocks have plummeted more than 60% in real terms since the market peak in 2000. They have performed no better than 20-year Treasuries for the past 40 years and certainly have not delivered their risk premium.
• Bonds may be the next bubble (according to Warren Buffett) as unprecedented spending, ballooning deficits, risk of a devalued dollar, and inflation could prompt foreign investors to dump Treasuries.
• Modern Portfolio Theory, traditional asset-allocation and diversification models, and buy-and-hold investing have been materially discredited over the past 80 years.

Will investment advisors revisit their mantras or continue to tout the same traditional asset-allocation models that have so dutifully devastated their investment portfolios?

Empirically, investor returns on private investments constitute the single largest source of private wealth in America. All stages of private venture investment (early/seed through mezzanine and later) have dramatically outperformed traditional equity indexes over the past five, 10 and 20 years.

Investment advisors should educate themselves to become more familiar with best practices in evaluating and ultimately embracing private investment opportunities for investors. Prudently implemented, private investments can materially benefit your client’s portfolios, and, in turn, your investment advisory practice.

By “private investments” we are referring primarily to investments in private enterprise. (But Venture Populist will address the wider range of private investment strategies, including angel investing, private equity, venture capital, venture debt financing, private placement offerings, and private investment in public equity (PIPEs).

Walk the Walk

True, sustainable wealth is rarely generated through traditional investment or employment. It is the consequence of inheritance, windfall (lottery), illegal activity, or private enterprise. Contrary to the widespread, pedestrian misconception, inheritance is not the major source of private wealth in America. Rather, it is entrepreneurial success or investment in private enterprise.

According to Drs. Thomas Stanley and William Danko’s research published in their book The Millionaire Next Door: The Surprising Secrets of America’s Wealthy–80% of today’s American millionaires are first-generation rich. More than half never received as much as $1 in inheritance, and 91% never received as much as $1 from their previous generation’s ownership of a family business.

The same was true a century ago per Stanley and Dankos’s citation of a 1892 study of the 4,047 American millionaires…”84% were nouveau rich, having reached the top without the benefit of inherited wealth.”

The highly-coveted high-net-worth and ultra-HNW investor knows this better than anyone, because, as probability has it, they very likely accumulated their own private wealth through entrepreneurial activity or investment in private venture. When investment advisors are speaking with HNW investors about private investment opportunities in start-up ventures or emerging companies they have their attention, and do not show that glazed look of disinterest that a lecture on the Efficient Frontier evokes. The HNW may not be familiar with the specific product, service, or technology that the venture you may be discussing is engaged in, but they do understand business, private enterprise, and their potential for wealth creation.

Advisors should become more receptive to learning to speak the language of their desired target market, rather than continuing to subscribe to the defiled dogmas and outmoded portfolio fallacies (like Modern Portfolio Theory) that have so wantonly wasted wealth and invalidated their perceived value proposition.

Album:   Crisis, Mike Oldfield, 1978

The Future of Investing: Evolution or Revolution? (Pension & Investments, Bill Gross)

A must read. Gross ponders the impact of global de-leveraging, deregulation and the reverse of globalization on long-term equity returns…

Treasury-Bubble Trouble? (Forbes)

In a recent letter to shareholders Warren Buffet cautioned that “the U.S. Treasury bond bubble … may be regarded as almost equally extraordinary” as other recent bubbles.

Album:   Read All About It, The Newsboys, 1988

A March 6th Bloomberg story, “Bonds Beat Stocks in ‘Earth-Shattering’ Reversal“, danced on the freshly dug grave of my prior post that rhetorically questioned the Death of Equities. In fact, as the chart illustrates, the patient passed away back in October of 2007 which was the peak for global stocks.

Album:   The Best of Gary U.S. Bonds, Gary U.S. Bonds, 1990

 That’s the prediction from Bill Gross.

Recently, from his perch atop $700 billion in bonds at PIMCO, in addition to advising the U.S. on its $500 billion fund to buy mortgage-backed securities and $250 billion commercial paper program, Gross sounded the death knell for common stock.

Yes, according to venture capitalist Peter Cohen of Peter S. Cohen & Associates, who cornered the bond king for the exclusive interview, “the current economic contraction is killing the animal spirits that drive risk taking and that’s contributing to the death of equity capitalism as we’ve come to know it.”

The Gross outlook is very grim for those who expect stocks to ultimately regain their historical performance advantage over bonds. “Things will never be the same. Risk taking has been destroyed…asset classes will be readjusted for that outlook. That is — stocks will be more of a subordinated income vehicle as opposed to a ’stocks for the long run’ growth vehicle.”

Common shareholders are seeing their values eroding because of their subordinated position relative to debt in the liquidation hierarchy, because when a company files for bankruptcy, all of the other stakeholders — such as bondholders, lenders, and preferred stock holders — get their money before the common shareholders see a dime.

That may be the case for some time to come, but as sure as Truman defeated Dewey, common stock returns will eventually trump bonds. But in the indiscernible interim lies the rub…inflation, interest rate and default risk has not been greater in years. Bonds are about as unattractive as stocks for the intermediate-term.

So where will growth-minded investors find compelling asymmetric return opportunities amidst the new world disorder?

Gold is probably the next bubble. Commodities are too correlated to the economic cycle. Managed Futures quant models are a black swan breeding pond, and Hedge funds? Well, that brain is drained for now.

Private Investment in Private Ventures

That’s right. This may not be intuitive to the remaining fossils that still subscribe to dogmatic asset allocation models or efficient market hypocrisies, but prudent and appropriate allocations to private investments in; your own business, start-up and early-stage ventures, mezzanine opportunities, distressed real estate and other forms of private equity are about the only remaining viable and proven means of wealth that is truly non-correlated to the whatever remains of your investment portfolio.
Every credible study into the origins of wealth has verified that the vast majority of family fortune has been generated through business ownership or investment in private enterprise. Affluent investors already know this…because that’s how they became affluent.

The counter-cyclicality of venture investing is counter-intuitive to most investment professionals. Yet, the VCs that have experienced the salad days and the soup lines will tell you that many of the most disruptive and most profitable new companies have emerged from the ruble of past downturns (Exxon, Microsoft, Google, Ebay and Skype, to name a few).

Pending breakthroughs in alternative energy, power distribution, privatized education, medical devices, non-invasive healthcare, genetic disease prediction, processors, nanotech, wireless communication, cloud computing, and so on, are agnostic to the vicissitudes of investor psyche and economic cycles.

Ultimately, the job and wealth creation that will restore our economy will emerge from the confluence of investment capital, entrepreneurship an innovation.

This is our debut post. Though Venture Populist is an unabashed advocate of private venture investing, we intend to bring you the good, the bad and the ugly of private investment. From the agonies of angel investors to the victories of VCs, we will examine the sourcing, diligence, deal terms, risks, returns, liquidity and exits associated with the various stages, structures and sectors of private investment.

Album:    For the Whole World to See, Death, 1975