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Greetings!
I am pleased to announce an exciting new feature of my website - I have added the professional profiles of my Board of Advisors. Each of these brilliant, talented and deeply experienced individuals brings a specific strength to Reynolds Group, Private Investment Counselors™. Lisa Maini serves as my firm's marketing strategist and business development guru. David Schraa is a leading light in global banking and finance. John Whisnant is a profoundly experienced consultant with expertise in operations across a variety of industries. Doug Wooden is one of the most knowledgeable business strategists I know. It is my privilege to have these individuals on my team and an honor to have them associated with my firm. I encourage you to refer to their profiles.
Today's e-Newsletter introduces what may be a new concept for many - that of Opportunity Classes. Opportunity Classes help you structure your investment strategy based on risk and opportunity instead of exclusively by security type. While I am cautious about suggesting that I am introducing a new concept, I am not knowingly borrowing it from anyone. Briefly, there are five Opportunity Classes: 1) asset allocation, 2) super regional allocations, 3) manager structure and selection, 4) the use of leverage, and 5) currency. Today's e-Newsletter will address asset allocation; the four other Opportunity Classes will be discussed in more detail in the weeks that follow.
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Opportunity Classes: Asset Allocation, A Non-Traditional Approach
| Asset allocation traditionally refers to allocating investments by security type. I am going to espouse a different approach, in which assets are allocated by both risk characteristics and liquidity. Suspend disbelief, bear with me, and I think that you will find this non-traditional approach insightful and quite helpful in developing your investment strategy.
Six (6) ways to think about assets from an Opportunity Class perspective. - Liquid Resource
Liquid resources include cash as well as fixed income assets with A, AA and AAA ratings; and a duration of less than three years. The allocation that you make to these liquid resources should cover your immediate and potential needs for liquidity or cash, beyond your net compensation, for things such as personal lifestyle spending, intra-family gifts, taxes, charitable commitments, education, and involuntary transfers (e.g., judicial judgments, child support and alimony). Many financial planners suggest having enough liquid resources to cover these types of spending needs for a year.
- Assets Sensitive to Economic Contraction
The question here is what assets should you hold to protect your portfolio from an economic contraction, such as "The Great Recession from 2008 - 2010." (While not everyone believes The Great Recession is over, economists have assured us it is.) Japan too has experienced a period of economic malaise, and arguably contraction, for more than a decade.
What assets are sensitive to economic contraction? The answer has traditionally been long-term, very high quality bonds (e.g., A, AA or AAA) with a duration of 7+ years that are non-callable. Many investment advisers have more recently added gold to this list. These assets create wealth by increasing in value during a period of economic contraction. Your percent allocation of assets that are sensitive to economic contraction will depend on your views and your adviser's views about the likelihood and potential timing of an economic contraction. These periods have proven to be perilously difficult to predict; so it is essential to have an ongoing discussion with your adviser about your strategic allocation of these assets.
- Inflation Sensitive Assets
In contrast to the above, what assets should you own to protect your portfolio during an inflationary period? As I mentioned earlier, I urge you to think about your assets in terms of the set of risks you are addressing rather than by security type. Inflation sensitive investments include a wide range of assets such as bonds (e.g., in the US, Treasury Inflation Protected Securities or TIPS, and many countries offer similar bonds), equities that are focused on energy, metals, mining and natural resource companies and more exotic assets such as precious metals and commodities exposures.
Determining your allocation strategy for assets that are sensitive to inflation will depend on your views and those of your advisers. The key is to have a meaningful exposure to them prior to an inflationary period since inflation sensitive assets respond to changes in expectations about inflation. Therefore, it is vital to be way ahead of the curve by developing a long-term strategic allocation of these assets with your adviser.
- Economic Growth Assets
Assets that tend to respond most favorably to vigorous economic growth are productive assets such as operating businesses. In order to reap the most benefits from these exposures, you will want to take a long-term approach to investing in equities or funds that invest in long-only equities. You should also diversify these assets by industry sector (e.g., healthcare, technology, consumer goods, energy, financials, etc.), capitalization (e.g., large companies, medium and small ones), and style (e.g., value managers and growth managers).There is also a geographic component to building a portfolio of long-only equities that I will discuss in more detail under "super regional allocations" at a later date.
As with other asset classes, your percent allocation to economic growth assets will be influenced by your views and your adviser's views about economic growth. However, it is likely that you will want to develop a long-term perspective to ensure you participate in the strong, sometimes-concentrated, upward moves in the equity markets.
- Hedge Funds
Hedge funds are known as marketable alternative assets (a bit of a mouthful!). The term 'alternative' is important because it reminds you that hedge funds are an alternative to long-only equities. They are not however, an alternative to liquid resources, assets that are sensitive to economic contraction, or inflation sensitive assets.
Broadly speaking, there are three (3) types of hedge funds:
- Funds that buy stock in profitable companies (seeking to gain when prices rise) and sell short stock in companies they think will do poorly (seeking to profit when prices fall).
- Funds that invest in assets that will benefit from the completion of a transaction (e.g., a merger of two enterprises, the spin-off of a division of a company, the work out of a Chapter 11 bankruptcy). The return streams from these funds, also known as absolute return funds, are meaningfully less correlated with the returns of well-known equity benchmarks, (e.g., the S&P 500).
- Funds that invest in commodity, currency, stock index and interest rate futures. Their returns are driven primarily by the trading skills of their managers vs. the underlying returns of any asset class. These funds are also known as managed futures funds.
Well run hedge funds should offer equity-like returns with less volatility. However, hedge fund returns are typically lower than long-only equity returns over the long-term. This is because hedge funds have a reduced exposure to equity markets and typically charge higher fees in exchange for reduced volatility. Properly selected and properly used, hedge funds are a risk management tool. If you are sensitive to volatility, hedge funds may have a role in your portfolio. Most investors I know are indeed sensitive to downside equity market volatility.
Buyer Beware: five cautions about hedge funds:
- Hedge funds offer constrained liquidity (i.e., you may only be able to withdraw your capital quarterly, annually or less frequently, depending upon the funds you choose).
- Small to moderately large investors typically gain adequate diversification via a fund-of-hedge-funds, which implies another layer of fees.
- Hedge fund managers tend not to be tax-aware since many of their investors are non-taxable entities such as endowments and pension funds. Further, year-end tax reports (K-1s) are usually late, which will prevent you from filing your tax returns in April.
- Manager selection is hugely important, but the research required to select the best manager is not generally available. Long-Term Capital, Ameranth, Bayou and more recently Mr. Madoff taught investors this lesson in a dramatic way.
- Many managers are not yet Registered Investment Advisers and disclosure, including fees and terms, may be imperfect.
- Non-Marketable Alternative Assets
Non-marketable alternative investments by definition have no public market in which you can sell them in order to get your money back. They are also sometimes called draw-down funds, because you commit a given amount to the fund's manager who decides when and how much to invest based on their expertise. Further, the fund manager (not the investor), dictates when you get your investment and profit back, which can take 5 - 15 years. Given the characteristics I have described above, you can see why these investments are typically referred to as a liquidity class, rather than an asset class. To further clarify, these assets are typically comprised of real estate, timber, venture capital, buyouts, energy, natural resources, farm land and mining enterprises.
You might be wondering why someone would tie their money up for a long time without being able to control their liquidity. Their mission is to achieve greater returns in exchange for reduced liquidity. Does it always work? No. By way of example, returns on venture capital have been disappointing for more than a decade. On the other hand, as you can imagine, returns on many energy and farm land funds have been gratifying.
A bit of good news followed by a word of caution:
- Non-marketable alternative assets tend to be very tax-friendly. The returns from investments in this liquidity class tend to be tax-friendly, long-term capital gains. That said, K-1's are typically tardy and investors seldom file their final tax returns in April.
- As with hedge funds, only the largest investors build direct programs. Others typically use funds-of-funds, which carry another layer of fees.
- Further, manager selection is of paramount importance and yet, the requisite information and research is highly proprietary and hard to come by.
Summary
I have proposed a new way to think about asset allocation; one that focuses on risk and opportunity vs. security type. I hope that my approach is helpful and I am keen to receive your feedback and Letters to the Editor. Please let me know what you agree/disagree with, as well as your own priorities for asset allocation. Click here to shoot me a note, and with your permission I will publish your Letter to the Editor.
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| Letter to the Editor: Personal Use Assets -- Art | | I received several 'off the record' calls and emails from art professionals who thought that my definition of art as a personal use asset vs. an investment was too narrow. They believe that a professionally advised approach to acquiring art should be thought of as a part of a diversified investment program (given reasonable diversification and quite a long-term horizon). I very much hope that one of my readers will submit a Letter to the Editor, offering their views in their own words. |
About Us
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Reynolds Group, Private Investment Counselors, LLC helps high net worth individuals, families, private foundations and charitable trusts enhance risk adjusted investment returns, drive operational efficiencies and optimize adviser effectiveness.
email
Jack at RGPIC dot com
617.945.5157
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"You have done a much more thorough job than other advisors in how to think about and manage personal use assets. I really enjoyed reading some of your tips."
- Senior insurance professional advisor
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