The Traditional Investment Portfolio Turned on Its Head (w/ Danielle DiMartino-Booth & Chris Cole)
DANIELLE DIMARTINO-BOOTH: You put venture capital and private equity into your 70% slice of the pie. Explain that. Because I don't think that if you went down to Texas teachers, for example, I don't think that they would say that-- they would say it would be at the opposite end of the spectrum, and it would be a diversification strategy against publicly traded equities. CHRISTOPHER COLE: So one are the concepts on doing this paper is I wanted to find a asset allocation that is a solution. What asset allocation can work over 90 years that can protect you against the deflationary elements of the left wing of the hawk and the reflation three elements of the right wing of the hawk? That led me to a very big conclusion, and it ties into the question about private equity. Most people think that excess return-- that you want to take to asset classes that both have solid returns, and bring them together, and that you'll get a better result from. That they prioritize the search for yield and prioritize excess return. And what I found is that, actually, what people should prioritize is secular diversification. And what that means is that you should look to large asset-- look to asset classes that can perform on the left or the right tail, and boldly size them in your portfolio. That means boldly sizing countertrend asset classes that perform when stocks and bonds don't. DANIELLE DIMARTINO BOOTH: So gold's not like the little 10% just in case? CHRISTOPHER COLE: That's right. Gold shouldn't be 1% or 2%. It should be 20%. Volatility should be 20%. Commodity trend should be 20%. And then stocks and bonds can make up the other remaining 20 and 20. Well, so private equity-- DANIELLE DIMARTINO BOOTH: That stands the conventional wisdom on its head. CHRISTOPHER COLE: It does, where many individuals have big problems trying to even allocate 3% of their portfolio to gold. Well, this gets back to the private equity VC question. Now, these are relatively new asset classes. It's tough to see their performance going back 100 years. But Cambridge has fantastic data going back a good 20 years, 20, 30 years. DANIELLE DIMARTINO BOOTH: When I was at DLJ, we had a merchant bank. Private equity was this cottage industry. Leon Black used to walk the halls. This was way before-- what, they've got $4 trillion? CHRISTOPHER COLE: Yeah, it's massive. DANIELLE DIMARTINO BOOTH: Massive. CHRISTOPHER COLE: Massive. Well, it becomes very clear from looking. You can just look at the return data from private equity NVCs to see that these asset classes are secular growth asset classes. They are correlated to the business cycle. DANIELLE DIMARTINO BOOTH: So they move in concert with publicly-traded equities. CHRISTOPHER COLE: They move. Sure, you might get some excess return, but they are correlated to equities. They will lose money in the event that there's a widescale recession. Well, I should say, they have historically lost money when that has occurred. I cringe when I hear leaders of very large-- and I've heard this. Leaders of very large pension systems, huge, huge systems that have a lot of money, and they say that private equity and venture capital are diversifies because they're lagged. This doesn't work with the data in view. DANIELLE DIMARTINO BOOTH: I've been harping on this issue for years and years. When we went into the crisis, the baby boomers were still an actuarial accounting assumption you could fudge with. Heading into the next downturn, they're going to be a cash flow issue for pensions. And when you factor in the illiquidity aspect of the alternatives, it just makes no sense. CHRISTOPHER COLE: No, it does not. And this is what we've seen. So I put about a post on Twitter. And I had three asset classes. And they were just sine wave graphs. The two asset A and asset B were highly correlated with one another, and they were slightly offset from one another. And asset C, the last asset, was a countertrend asset. It was an asset that didn't make any money, but made money when all the other assets lost money. DANIELLE DIMARTINO BOOTH: Did it lose? Lose money? CHRISTOPHER COLE: It lost money, actually-- lost a little bit of money. It was flat. DANIELLE DIMARTINO BOOTH: A little-- OK, critical words. OK, continue. CHRISTOPHER COLE: And I posted to Twitter. I said, which of these would you combine. You can choose two assets to have the optimal portfolio. And of course, everyone says, well, we're going to choose the high returning asset and the countertrend asset because that's going to result in a dramatically better risk adjusted return as opposed to combining the two assets that have similar return profiles, which results in bigger gains, but bigger losses. So Twitter got that answer correct. 80% of people chose the trend and the countertrend asset. But what's interesting is that the big institutions around the world are doing the exact opposite. They're taking equity exposure, and then they're layering on more and more private equity exposure, and more VC exposure, and more high yield credit exposure, and short volatility exposure, and you name it, all because they have to reach the 7.25% return target. And at the end of the day, what you have is a portfolio that is tilted to secular growth. Will perform in secular growth, but in the event that we have any regime change, any period of secular change, either on the left wing of the hawk with deflation or the right wing of the hawk with reflation fiat devaluation, that portfolio will struggle and struggle terribly.