With a rip-roaring bull market underway, talk about alternative investments, aside from venture capital, has been scarce. Which is why Phil Huber’s new book The Allocator’s Edge: A modern guide to alternative investments and the future of diversification is a breath of fresh air.
Phil is the CIO of Savant Wealth Management and the author of the well-regarded blog bps and pieces. Most importantly, Phil is fellow IU graduate. In service of the book Phil has been on a podcast tour. Some recent stops include The Compound & Friends, The Long View, the Meb Faber podcast and The Long Term Investor.
I had to the pleasure to ask Phil some questions about the book. Below you can find my questions in bold. Phil’s (unedited) answers follow. Enjoy!
AR: Despite the benefits, diversification often feels like a raw deal to investors. How does diversifying via alternatives alleviate or exacerbate this issue?
PH: Diversification is a double-edged sword. We know it’s the only free lunch in investing, so we want to eat a lot of it. But as my good friend Brian Portnoy is fond of saying, “diversification means always having to say you’re sorry.”
The more line items you have in a portfolio, the more likely at any given time there will be something in your portfolio you want to own less of (or none at all). As counterintuitive as it may be, if everything in your portfolio is up at the same time, odds are you’re not diversified enough.
Earning the benefits of diversification over time requires accepting the fate that you will lose more battles, despite having a higher likelihood of winning the war.
AR: In the book you talk about the past and future of the 60/40 portfolio. Interest rates have been in secular decline for four-plus decades now. How does this affects our views on investing, in general, and alternatives specifically?
PH: The phrase “past performance is not indicative of future results” comes to mind. I think we need to be sober about the long-term expected returns for all asset classes, but particularly for fixed income. The math for bonds is a bit more straightforward than it is for stocks.
Investors’ collective need for balance in their portfolios is not going away. While bonds can still serve a meaningful role, their ability to do the heavy lifting we’ve grown accustomed to as the “40” in 60/40 will be limited going forward. Core fixed income can still play a meaningful role in a portfolio, but allocators should strongly consider expanding their investment palette and diversifying their diversifers.
AR: There is really one-stop vehicle for alternative exposure. Why do you think that is? Do you think we see target-date funds up their exposure to non-traditional asset classes any time soon?
PH: A one-stop shop for alternatives is a tough nut to crack for allocators, despite the obvious convenience benefit it would provide if feasible. I think the reasons are two-fold. First, the universe of alternatives is vast, and the label tells you more about what something isn’t rather than what it is. There are a wide range of objectives and risk profiles within the alternatives landscape, so a one-stop shop for one investor might be inappropriate for another. Second, many allocators prefer to have some degree of control over how to best mix and match alternatives. A single fund solution eliminates that flexibility.
I do think that we will see an increasing number of target-date funds embrace additional diversification beyond stocks and bonds. It might surprise some people to know that even Vanguard has included material alternatives allocations in some of their multi-asset strategies. It wouldn’t be much of a stretch to assume that one day they’ll include them in their target date funds as well.
AR: You mention in the book that high (and rising) inflation is ‘kryptonite’ for traditional asset classes and the 60/40 portfolio. What has the recent bout of inflation taught us about this observation?
PH: If the last decade-plus has taught us anything, it’s that inflation is incredibly difficult – if not impossible – to predict with any sort of consistency. The re-emergence of meaningful inflation this past year has demonstrated the corrosive effect it can have on bond performance, especially in real terms. While the stock market has been relatively unscathed so far, the sticker inflation ends up being – which is anybody’s best guess – the worse off traditional stock-bond portfolios are likely to be.
While we can’t predict inflation, we can prepare for it. A variety of alternatives exist that can either add inflation-sensitivity or inflation-neutrality, potentially adding value where stocks or bonds might fall short. One example would be trend following, which research has shown to provide strong relative returns in high and rising inflation environments.
AR: One of the biggest trends of the past couple year has been hedge funds getting into the growth fund investing game. What does this tell us about the prospects for hedge funds and venture capital?
PH: The lines between public and private market investing have become increasingly blurred in recent years. The hedge fund landscape has become more and more competitive as it has matured. Where alpha was once plentiful, it is now relatively scarce. As such, it is not that surprising that hedge funds have been exploring new terrain in potentially less efficient asset classes than public market stocks. What we do know is that too much money chasing too few quality deals will eventually lead to some poor outcomes.
AR: The late David Swensen helped popularize the so-called ‘endowment model’ of investing. These trends seem to have been played out. Do you see a successor model out there for institutional investors?
PH: I’m not so sure there is a clear successor today to the endowment model in the institutional world. The endowment model is but one of several attempts over the years to improve upon asset allocation and portfolio construction. Others include GTAA and Risk Parity. No asset allocation construct is perfect, but they each contain attributes that allocators – both institutional and financial advisors – can take cues from.
As the wealth management industry looks to the future to build better portfolios for their clients, they will increasingly borrow the best attributes from Risk Parity, GTAA, and the endowment model. This will allow for greater diversification, more dynamic risk management, and higher allocations to less liquid and uncorrelated return streams.
AR: When it comes to alternatives you mention using the ‘Lindy effect’ as a guideline. Can you define how the Lindy effect plays a role in your thinking and how does it specifically apply the area of digital assets, like Bitcoin etc.?
PH: Many alternatives, even ones that have been around for a while, are novel to the average individual investor. The Lindy effect essentially states that the likelihood of something failing decreases with age. A better understanding of the long history of asset classes like farmland, credit, and reinsurance might help investors gain confidence in them as strategic components of their asset allocation.
An asset class like Bitcoin, while still in its relative infancy, continues to gain broader adoption each time it avoids death and survives yet another deep drawdown. While still a teenager in asset class years, the odds off Bitcoin – and crypto more broadly – going to zero are shrinking by the day.
AR: As you note in the book, ‘containers’ matter a lot when it comes to alternatives. It is simplifying things too much to say alternative investments are strategies that require a container that is not traded on an exchange or available in a open-end fund?
PH: I don’t think it is quite as cut and dried as that. There are a handful of alternatives that can be implemented quite effectively in daily liquid, ’40 Act vehicles. Others, not so much.
What’s interesting today are a variety of fund structures, one example being interval funds, that provide a middle ground between mutual funds/ETFs and truly illiquid LP private funds. This opens a handful of less-liquid asset classes to investors that are seeking additional diversification but prefer to avoid private funds for operational, tax, or liquidity reasons.
AR: One of the themes you touch on in the book that any investment, or investment strategy, is only useful if it helps an investor reach their ultimate goal(s). As you see it, how do alternatives help an investor, or their advisor, accomplish this?
PH: Relative to their specific goals, I think investors want a portfolio that gives them the greatest odds of success across a wide array of potential (and unknowable) futures. Most investors are seeking some semblance of balance between meaningful returns and prudent risk management.
The classic 60/40 served those tradeoffs quite well for many years. I think it’s less equipped to do so going forward. The silver lining is that as the investable universe continues to evolve, allocators have a broader toolkit with which to build more durable and resilient portfolios. It just requires the conviction and courage to step away from the 60/40 security blanket that has comforted us for so long.
AR: Some of the newer asset classes available to investors, like art, collectibles, NFTs, have an affinity aspect to them. Is there a danger that investors can let their interests override their finances?
PH: I have mixed feelings on these categories. And in full disclosure, I have dabbled myself on platforms like Rally and Otis, albeit in very small doses.
On one hand, there is natural appeal for assets where investors can marry their passion(s) with the potential for profit. Some might even go as far as to think they have an edge in [fill in the blank] collectible niche because of how attached they are to it. However, these assets lack cash flows and are difficult to assess from a value standpoint. In essence, you’re betting that at some point in the future someone will gladly pay a higher price than you’re paying today based on some combination of scarcity, aesthetics, nostalgia, and cultural significance.
What’s clear is that any allocation to these areas should be within an investor’s speculative bucket and sized appropriately. But there’s nothing wrong with having a “fun” bucket in your portfolio so long as you’re disciplined with your “serious” bucket. And there may be some long-term diversification benefits to various collectible and culture-based assets.
AR: A bonus question, If an investor with a balanced, globally diversified portfolio of index funds (equities, bonds) came to you asked for the one alternative asset they should consider adding to their portfolio to achieve better risk-adjusted returns, what would you advise them?
That’s a bit like asking me to pick a favorite child. But I guess that would be easy for me since I only have one!
In all seriousness, if I could only add one diversifying alternative to a traditional balanced portfolio, it would probably be catastrophe reinsurance. It checks all the boxes one would want from an alternative to improve overall portfolio efficiency: an intuitive risk premium, a return stream that is structurally uncorrelated to both stocks AND bonds, and a history of positive risk-adjusted returns. And today, this asset class is accessible to most investors in ways that it wasn’t a decade ago.
AR: Thanks Phil for your time. Good luck with the book!
*Full disclosure: Phil was kind enough to send me a review copy of his book.