From the October 2010 issue of Investment Advisor • Subscribe!

October 1, 2010

Exits Over Outflows

Advisors should look to investment opportunities beyond public equity

Last month, I spoke on a venture capital panel at a well-attended 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 RIAs, family offices, wealth managers and investment firms that were attendees and exhibitors.

I noted a chilling consensus among the conference attendees that the individual investor has become a deer-in-the-headlights: frozen, or better, 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 investors' rampant distrust of Wall Street. Among all investor types, money is flowing rapidly out of equities in favor of bonds and cash.

The advisors I spoke with are 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 $244 billion outflow from stock mutual funds since January 2008, according to the Investment Company Institute. Perhaps under a different economic scenario, the recent 17 consecutive weeks of equity outflows would be a contrarian indicator, but Citibank's own Robert Buckland foresees trillions of additional dollars in outflows to follow and summarily declaring the "Equity Cult" to be DOA.

WHAT'S AN INVESTOR TO DO?

The stock market has become inhospitable to the individual investor. It has gone absolutely nowhere in the past 10 years and investors have no returns to point to for the risk that they have assumed.

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 investors' 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.

I would not worry about the investor. After 10 years of high volatility but no net return, two 50% bear markets and a "flash crash" ... the majority have figured it out. They are pulling out of the equity markets. But I did not get the sense that the majority of wealth managers and investment advisors have caught on. Most are still approaching their business as usual.

A couple of years ago in this column 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.

(Hybrid Portfolio Theory is outlined in detail on the June 9, 2009 post on the blog at www.venturepopulist.com.)

Sure, I have an agenda as this column specifically advocates that wealth managers and advisor embrace allocations to direct private investment as a means of increasing portfolio returns (in a manner that does not increase risk) and, as an effective differentiator that can materially distinguish any advisory practice among its peers.

But recent numbers from Cambridge Associates underscore our conviction. It is good to know that some asset class has continued to provide compelling returns over the long term. Over the past 15 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 20 years 24% for VC against 9% for both the Nasdaq and S&P.

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

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