Venture Populist

Since 2002, I have been writing a monthly column on the alternative investments for Investment Advisor magazine. A couple of years ago we renamed the column Venture Populist and focused exclusively on issues the issues confronting family offices and angel investors that make direct investments in startups and early-stage private ventures.

The column generates frequent inquiries from wealth managers as to what alternative asset classes or investment strategies may provide portfolios with risk-return characteristics that are comparable to the attractive asymmetric return profile of private venture investment (PVI). The queries acknowledge that PVI is a compelling asset class, as well as, game-changing value-proposition and differentiator for their advisory firm. Yet, despite their interest, these advisors lack the access to deal flow, due diligence skills, regulatory latitude, HNW client base, or, simply the compulsory cojones to actually allocate their client capital to private ventures.

Often these advisors have embraced the progressive precepts of Hybrid Portfolio Theory yet require more accessible investment products than direct investments in private ventures to populate Portfolio B—the 15-30% of the alpha-producing portion of the portfolio that seeks positive asymmetric investment outcomes.

So, for a number of practical reasons, some wealth managers and investors searching for a substitute asset class with the same positively skewed return characteristics of PVI, but with greater accessibility and liquidity. Many investors simply do not have the investment horizon required to successfully harvest venture investments. These investors seek liquidity—not lockups.

I have always maintained that specialized managed futures, distressed, deep-value securities and out-of-the-money option strategies have the asymmetric return profiles that are required to fulfill Portfolio B’s mandate. But for many investors and advisors, these aforementioned strategies are as arcane, elusive and illiquid as investing in PVI.

Fortunately, there appears to be more accessible alternative to PVI for investors lacking leptokurtosis in their portfolios—the universe of less liquid and smaller cap publicly-traded U.S stocks.

Recent relevant research and return data indicate that there is a seemingly significant semblance between the returns of venture capital and those of less liquid, publicly-traded, small company stocks.

In 2004, John Cochrane, finance professor at Chicago Booth School of Business published The Risk and Return of Venture Capital which examined whether individual investments in venture capital projects “behave the same way as publicly-traded securities”, and which kind of securities they may resemble.

Compiling data from the 16,613 financing rounds of 7765 private companies over a 13-year period Cochrane observed similar volatilities and alphas between venture capital returns and the smallest Nasdaq stocks and concluded that “thinly-traded Nasdaq…small stock portfolios are natural candidates for a performance attribution of venture capital investments.”

More recently, the pioneering investment industry academic Roger Ibbotson got a little more granular by re-introducing his working paper Liquidity as an Investment Style which he initially co-authored with Zhiwu Chen in 2007. The work is important to adopters of Hybrid Portfolio Theory as it more narrowly defines a potential substitute for private venture investments by articulating the phenomenon of the “Illiquidity Premium”.

From 1972 to 2009, Ibbotson studied the returns of 3500 publicly-traded U.S. stocks in the context of their relative liquidity (defined by annual trading volume divided by total shares outstanding). The surprising results were that liquidity (as an investment style) was a far more effective predictor of returns than the conventional Fama-French factors. Specifically, the equities that produced the best returns during the period were the less liquid small-caps that attract distinctively less trading interest. These companies generated a remarkable 17.87% annual return over the four decades studied.

In contrast, the most liquid (and most widely held) growth stocks performed miserably at 3.3% — below the risk-free rate. The apparent performance attribution is due to the premium that most market participants are willing to pay for the most liquid securities—which, in turn, has the unintended but discernable consequences of reducing their returns.

So, the relative liquidity of a security, according to Ibbotson’s research, actually reduces its return.

Venture investors have always acknowledged the existence of an illiquidity premium and concede that they are swapping liquidity for the potential of significantly greater upside. The historical returns of the venture capital asset class prove this out. But this quantification of the role of illiquidity as a risk factor, with a risk premium, is most illuminating.

“There is a clear pattern of decreasing returns as the liquidity of stocks increase”, cites Ibbotson. There is indeed an excess return attributable to less liquid stocks and “the less liquid stocks are not necessarily more risky. Measured by standard deviation, risk seems to increase with liquidity.”

Ibbotson himself likens liquidity as an investment style to private investment such as venture capital, commenting that private securities are most appropriate for investor’s seeking even higher returns that have the luxury of longer investment horizons.

But the illustrated fact that “the illiquidity premium is positive and substantial with publicly-traded securities” offers an “Ah-Hah” moment for advisors seeking a complimentary asset class or substitute for allocations to private venture investment.

Food for thought.

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Last month I spoke on a venture capital panel at an alternative investment conference in Chicago. As the former head of alternative strategies for a well known investment management firm, I saw many old friends and familiar faces among the family offices, wealth managers and investment firms that were attendees and exhibitors.

I also picked up on a chilling consensus that was apparent among the conference attendees…that the individual investor that has been fleeing from the public equities markets for months now, is not expected to return anytime soon. They are frozen…stunned, like the “ex-parrot” in the Monty Python sketch.

Beyond this sallow assessment, these investment pros were not particularly optimistic about the near-term. Wealth managers and investment advisors are hardly the beneficiary of todays investor’s prevailing distrust of Wall Street. Among all investor types, from retirees to HNW, money is rapidly flowing out of equities in favor of bonds and cash.

Today, the key asset management industry metric of AUM (assets under management) more aptly refers to assets under mattresses. Investors have lost faith in the integrity, as well as, the opportunity of the public equities market.

The advisors I spoke with were not prescient…merely perceptive. The evidence is hard to ignore. A recent CNBC/AP poll cited widespread investor distrust of the stock market with 61% of investors declaring that the market’s recent volatility has made them skeptical about participating in the market.

The radical shift in stock market investor confidence has resulted in a net $250 billion outflow from stock mutual funds since January 2008, according to the ICI, $48 billion in the past four months alone. Perhaps under different a different economic scenario the recent 21 consecutive weeks of persistent equity outflows would be a contrarian indicator, but Citibank’s own Robert Buckland cites these menacing metrics as support for his theses foreseeing trillions of additional dollars in outflows to follow and summarily declaring the “Equity Cult” to be DOA.

Some of these credible voices are even stronger. For example, sports mogul, billionaire investor and modesty magnate Mark Cuban initially declared that the “Stock Market is for Suckers” back in January 2006. He has frequently revisited and reiterated his meme on his Blog Maverick site since. Cuban recently called out the conventional wish-dom of Buy & Hold to be “the second most misleading marketing slogan ever, after the brilliant rinse and repeat message on every shampoo bottle”.

I guess that’s why the mutual fund company swag has been such slim pickings at investment conferences lately. There probably is not a lot of interest in those tired old laminated Ibbotson “Stocks, Bonds, Bills” charts anymore.

The stock market has become inhospitable to the individual investor. It has gone absolutely nowhere in the past ten years and investors have no returns (rather, for the most part…losses) to point to for the risk that they have assumed.

Nothing seems to work. Forget about investing in an individual company’s security based upon its specific fundamentals and outlook. The price movements of individual securities are now dictated by larger global macro themes such as the economy, interest rates, currencies, commodities and geopolitical considerations. Individual stocks are no longer priced on their own fundamentals. Hedge funds, index funds and speculators drive price action.

Adding to the investor’s frustration is the fallibility and futility of popular, traditional and even alternative approaches to extracting returns from the stock market. Buy-and-hold, day-trading, Modern Portfolio Theory, diversification, sector rotation and even the majority of alternative and absolute return strategies have come up short.

After 10 years of high volatility but no net return, two 50% bear markets and the May 6th flash crash (apparently was the result of one massive computer-triggered sell order)…they majority of investors have it figured out. Mass exodus time. They are pulling out of the equity markets in droves.

But, I did not get the sense that the majority of wealth managers and investment advisors have caught on. Most are still approaching their asset-allocations as usual.

A 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 client’s capital as the primary objective while simultaneously pursuing the opportunity to achieve double-digit annual returns at the portfolio level.

Hybrid Portfolio Theory is unique as it eschews equity exposure in favor of allocating the majority (75-80%) of the assets into fixed income such as Treasurys, munis and TIPS (portfolio A). A second portfolio (B) holding the balance of the assets is mandated to pursue investing opportunities that have a positive asymmetric return profile such as investment into private early-stage private companies or small businesses, public emerging growth companies, real estate, or, specialized trading strategies that employ options or managed futures.

Of course I am biased. Venture Populist advocates that wealth managers and investors more frequently embrace allocations to direct private investment as a means of increasing portfolio returns in a manner that does not increase portfolio-level risk.

But recent numbers from Cambridge Associates underscore this conviction as the venture asset class has continued to provide compelling returns over the long term. Over the past fifteen years the U.S. Venture Capital Index has returned 38% annually against 7.4% for the Nasdaq and 7.8% for the S&P. Over the past twenty years 24% for VC against 9% for both the Nasdaq and S&P.

Exposure to private enterprise has historically been this countries greatest single wealth producer. Progressive wealth managers would be well-advised to adapt their core competencies to embrace more diverse and opportunistic investment opportunities outside of the public equities markets.

Some of their client’s certainly are…as Mark Cuban recently posted, “The stocks I own for the most part I have owned for a long, long time and I have more in gains than I want to pay taxes on. But in total, I have been a net seller of stocks for more than a year. The only investments I am making are small buys into private companies.”

Entourage fans, for the record, those “small buys” do not actually include an investment in “Turtle’s tequilla“…but considering the past decade of stock market performance, and the forward prospects, a spirits investment may not be a such a bad alternative.

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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.

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This presentation introducing Hybrid Portfolio Theory was introduced in a 6.17.09 webinar hosted by Investment Advisor magazine and sponsored by Ameritrade that was attended exclusively by investment professionals.

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.

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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.

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