The Curme-udgeon Column: When Traditional Asset Allocation Goes the Way of the Dinosaur
Although the entrepreneurs might deny it, successful venture capitalists have some things in common with successful entrepreneurs. Both species are workaholics, they focus on building great things for the future, and hopefully they have made some money along the way. From a personal investment strategy point of view, both venture capitalists and entrepreneurs have what is termed a “barbell strategy.” This means that most of our net worth is way off in the future, tied to the success of our business. At the other end of the barbell, we have our savings which are usually held in cash or short-term investments because short-term cash flow needs are hard to pin down, and we have minimal time to figure out how to effectively put it to work. So the question is, how much do we need on hand and what do we do with the rest of it?
VCs and entrepreneurs can describe at great length their strategies for their businesses, but when asked about their strategies for investing their personal assets, they are less sophisticated. Some will want to reinvest all their savings back into their business, but those with families usually want a nest egg that is “safe” and earns “reasonable returns without unreasonable risk.”Traditional Asset Allocation
The traditional approach to managing one’s savings is called asset allocation. Goldman Sachs recommends four different asset allocations, for people with differing risk/return profiles:
Balanced Strategy |
40% Equity/60% Fixed Income |
Growth & Income Strategy |
60% Equity/40% Fixed Income |
Higher Growth & Income Strategy |
80% Equity/20% Fixed Income |
Aggressive Growth Strategy |
100% Equity |
The intellectual justification for the asset allocation approach is that markets are efficient. Most equity managers cannot outperform the major market indexes over long periods of time. Over long periods of time equities outperform bonds, but when equities go down, bonds often go up. Therefore the best you can do is put your assets in a mix of stocks and bonds, the proportion of which depends on your risk tolerance, and then ignore all the daily fluctuations in the markets. You can rest assured that your retirement nest egg will grow in the long term, safe as houses.
Safety is an Illusion
The traditional asset allocation model worked pretty well twenty years ago. But it doesn’t work today. Twenty years ago the returns from stocks and bonds were negatively correlated. Today stocks and bonds have a positive correlation of about 0.8. That means that recently, they have gone up together and down together. In fact, correlations between many different types of assets have increased recently, probably a result of the massive amounts of liquidity derived from flawed central bank policy, excess savings in emerging markets, financial architecture and petrodollars. This liquidity has been recycled into all global capital markets lifting prices across the spectrum and making a truly diversified portfolio much more difficult to create.
For another thing, given the huge macroeconomic imbalances in the world, the markets are no longer efficient. Everyone knew two years ago that the housing market was in a bubble and housing stocks would go down. And astute observers like Steven Roach, Marc Faber and Warren Buffet have been forecasting the decline in the dollar for several years. Ditto for rising oil prices. These structural imbalances in currencies, household debt, government debt and commodities are threatening the nest eggs of all the savers in America. The dollar is tanking, “safe” banks and money market funds are blowing up, the equity markets are at very high valuation multiples, all while we’re about to slide into a recession. And the equity in your house is going away.
What Me Worry?
Many of those still reading will dismiss these arguments. After all, the Dow is at 13,000 and the NASDAQ is at 2,600. What’s to worry about when the market is near all time highs? Well the market isn’t really near all time highs, it just looks that way in dollar terms. The dollar has dropped over 40% against the euro since 2001. Since 1999, the dollar has dropped 69% against gold. Admittedly, the euro and gold have been strong lately, but even against a trade weighted index of currencies, the dollar has dropped 37% since 2002:
Why is the Dollar Falling?
The US Dollar is like stock in a company; in this case the company is the United States. The problem with the dollar is that the Fed has cut the rate of interest, and both the government and the consumer have been living beyond their means. In the past ten years, the national debt has risen 67%, from $5.4 trillion to over $9 trillion. Meanwhile, the U.S. consumer has been spending beyond his means:
Inflation
While stocks are up, the dollar is down. U.S. investors could ignore global currencies and global markets except for one thing: inflation. With the adoption of globalization, we live in one global economy. Prices of everything we import: energy, food, industrial commodities and manufactured goods are all set by global supply and demand. As the dollar falls, all these prices are going up. Oil and copper have quadrupled in the past five years. Wheat and corn have doubled over the same timeframe. Vegetable oil prices have all doubled in five years due to their ability to be converted to bio-diesel. The Bureau of Economic Analysis calculates “core” inflation to be 1.8% but that excludes food and energy (and many economists think that the BEA cooks the books). We have two choices with respect to our personal investments: either we expand our traditional asset allocation model to include global assets, or we can quit eating and driving when we retire.
Moving Beyond the Traditional
Since we are short on time and patience to manage our personal assets, the partners at Battery have recruited a team, headed by John O’Connor, with a mandate to exceed equity returns over a business cycle while minimizing risk and volatility. As described above, building a truly diversified and effective portfolio is a difficult task. Luckily for John and his team, the successful university endowments have laid out a road map that has worked well over many years and in our opinion will likely continue to. We think there are lessons to be learned from their investment strategies that are informative for investors of all shapes and sizes.
The main drivers of outsized returns for the successful endowments have been a few things: their willingness to diversify away from a traditional portfolio of stocks and bonds; making significant allocations to alternative investments; and operating with a much longer investment horizon, allowing them to capture premiums available on less liquid investments. We use this endowment approach with a combination of direct investments and best-of-breed external managers. Our strategy balances three points: asset allocation, manager selection and direct investment.
Asset Allocation – this is the most critical step in the process. It is very important to have a sound top down view of macroeconomic conditions in order to assess opportunities and valuations in many global capital markets. For example, investing in a mediocre China-or India-focused manager three years ago was probably a great decision. Given the current “bubble like” valuations, investing in a top tier one now may not be. We determine our asset allocation using proprietary modeling, our very good access to research, and our deep understanding of what our external managers are seeing in their respective investment universe.
Manager Selection – this is also very important and time-consuming. As a result of high management fees, there is no shortage of hedge funds and other asset managers. The key is determining the “edge” the manager has as it relates to his/her investment mandate and whether it is a repeatable process. The good managers usually have fairly high minimums and periodically pretend they are closed, but our relationships usually allow us to get around those hurdles.
Direct Investments – An advantage to the endowment model relative to a pure fund-of-funds is that we have the ability to invest directly in areas where we don’t believe active management can add much value. Passive investing — or indexing — is a very effective and cheap alternative to active management in highly efficient markets such as large cap U.S. equity or long only commodities. We also use direct investments to build out long-term thematic based exposures where we do research ourselves. It is very important to know what you know and what you don’t know.
A typical endowment strategy might look something like this:
Another way to look at it would be by investment style, which would look something like this:
Allocation Driven by Macro Investment Trends
The final piece to successful portfolio construction is evaluating the likelihood that it will accomplish your return and risk objectives under scenarios that can be hard to anticipate. Many investors evaluate their portfolios based on what happens if the stock market goes up and what happens if it goes down. That’s fine. But a successful portfolio manager will also analyze the impact of underlying trends such as rising energy prices, the dollar continuing to weaken, inflation, deflation and stagflation, war, etc. A portfolio cannot truly be market neutral and still make you money. You need to consider what you believe will happen over time, and then develop a core strategic allocation that will provide some downside protection. And don’t be afraid to make material tactical adjustments as the markets and your outlook change.
Our Current Favorites
To illustrate our grand theory outlined above, we will share a few of our favorite investment themes:
Water – there is a global shortage of potable water resulting from accelerating population growth and migration to urban societies. Currently less than 1% of the world’s water is usable for drinking or farming. The situation could become particularly dire in India, China, Latin America and the Middle East. Agriculture requires a significant amount of clean water, and in addition to feeding people, agricultural products are being consumed in large quantities for alternative energy sources. There are many new promising technologies in filtration and desalination. These products, along with general utility services, should become increasingly valuable to our growing globalizing world.
Uranium – currently there are 439 operating nuclear reactors generating approximately 15% of the world’s electricity. According to the Uranium Information Center there are another 33 reactors under construction and 316 planned or proposed. The nuclear renaissance is primarily due to the fact that carbon-based fuels have gotten very expensive, come from hostile countries, and emit tremendous amounts of greenhouse gases.
The accidents at Three Mile Island and Chernobyl put the uranium industry in a bear market for almost 30 years. The Uranium mining industry was essentially put out of business as there was only one profitable mine in the world. Current demand significantly outstrips new supply. The shortfall has been made up by using excess inventory and blending down Russian nuclear weapons, but both of those sources are rapidly coming to an end. As a result, the price of uranium increased from $7 per lb in 2000 to $138 at the beginning of the summer as speculators drove the price up. It has since dropped to $90 per lb as many of the speculators left the market. Even at these elevated prices the marginal cost to produce electricity does not increase dramatically as most of the cost is in the construction of the reactors.
As a result of the price increase there has been significant investment
in finding new sources of uranium, but production delays at three of the
major mines have caused 2007 production to fall below estimates, even at
historically high prices. If only some of the planned reactors come online
in the next five to ten years, we believe there will be a structural
supply/demand imbalance that will cause the price of uranium to
increase further. We think the largest producers are currently the safest
way to capitalize on this trend as their revenues per pound are significantly
lower than current spot prices, and as their delivery contracts are modified
in the future their revenues will rise rapidly. Eventually the companies
that have expertise in engineering and constructing reactors will also benefit.
Russell 2000 – during the 90s large cap stocks significantly
outperformed small cap stocks. This trend reversed in 2000 and small
cap stocks have been in the lead ever since. The out-performance of small
caps has likely been aided by massive inflows of capital into hedge funds,
which tend to focus on smaller companies where they can gain an information
edge. The result has been that small caps trading at 30x current earnings are
now significantly overvalued relative to large caps. Furthermore, small cap
companies are more dependant on domestic revenue and cheap sources of financing.
We believe that better growth opportunities exist overseas and that large multinational
underleveraged companies will outperform small caps for the foreseeable future
and recommend underweighting small caps.
China – we’ve done well with our China investments so far, but recently we’ve become quite bearish on the market. Like the Shanghai index, the Hong Kong Hang Seng index has more than doubled in the past two years, and its chart looks like the NASDAQ in 1999. Many of our China friends are predicting a sharp correction in the Chinese markets in the next twelve months, as rising interest rates pop the Chinese housing bubble and non-operating earnings from cross-held shares fall as stocks unwind.
Summary
As a wise man once told us, it’s never easy to make money because other people don’t want to give it up. That’s especially true with financial investing; entrepreneurs and venture capitalists can make money through innovation that makes the economy more efficient, but with financial investing, it’s close to a zero sum game. Fortunately, by finding smart investment managers who work extremely hard, our nest eggs will thrive and we can focus on helping entrepreneurs build the future.
© 2007 Battery Ventures. All rights reserved.