Recent proclamations in this column and venturepopulist.com blog posts that “MPT failed” in the crisis of 2008 have elicited a distinctively binary response from wealth managers and investment advisors. I have received commendatory and castigating e-mails and comment board posts that prove it.
While many investment advisors responded enthusiastically (having taken note of the impact and frequency that five market meltdowns in the past 22 years has had on their portfolios), a seemingly larger pool of advisors cling desperately to their discredited diversification dogmas and polished pie charts in the hope that investors may have not noticed the failure of their advisors’ mantras and models.
A July 10 front page Wall Street Journal article (“Failure of Fail-Safe Strategy Sends Investors Scrambling”) citing examples of other prominent institutions that likewise believe that prevailing “asset-allocation strategies are fundamentally flawed” has brought this debate to even a larger audience.
Last month in this column and a subsequent Investment Advisor Webinar, I introduced Hybrid Portfolio Theory (HPT) as an alternative to Modern Portfolio Theory (see Events page at InvestmentAdvisor.com to view the archived presentation). HPT comprises 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, amd municipal and government bonds, while the smaller (25%) portfolio is opportunistically allocated to make investments that have a positive asymmetric outcome (PAO) profile.
What’s a PAO?
PAO opportunities are 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 that may be employed by some hedge funds, managed futures, and market-timers.
This definition implies a potentially broad universe that allows the advisor/investor considerable discretion in identifying constituent PAO opportunities in the HPT sub-portfolio mandated to pursue capital appreciation. Advisor practitioners seeking to implement HPT will tend to exercise such discretion based on 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, I am an unabashed advocate of private investment in private ventures due to the decisive historical performance of venture capital and private equity as an asset class and its proven role of being the greatest 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, and access to product sets 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 20 times on capital. Publicly traded emerging growth companies are occasionally capable of delivering outsized returns (aka, Peter Lynch’s “10-baggers”) as well.
Managed Futures and Market Timing’s Flaw
But what about managed futures and market-timers? The manufacturers, marketers, and distributors 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 amid ever more frequent black swan drills?
The fact is that 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. Amid 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.