The Investment Portfolio of the Future

Bob Veres Part IV in my series on adding value through active management envisions a world where advisors are vetting a growing number of nontraditional investments for their clients.

If you were to look at 80% of Craig Martin’s client portfolios, they would be conventional and even a little boring. “Our core portfolios are invested in six passively-managed DFA funds, with an equity allocation of 60% foreign, 40% domestic,” says Martin, CEO and founder of The Family Wealth Consulting Group in San Jose, CA. “I should probably shift those allocations slightly,” he adds. “At the time we created it, the U.S. was 40% of the global market cap, but it has dropped somewhat recently.”

Wealth Consulting Group’s 140 clients have aggregate assets of $100 million, and this rather bland portfolio allocation accounts for about 89% of their investments. But 50 of Martin’s clients have invested a total of $11 million, in various percentages, in more interesting investments that include 12 managed futures and options trading funds; seven alternative income funds that include baskets of loans made to small business entities and collateralized debt; seven direct real estate investments including apartment buildings for workers in the new fracking oil fields in Williston, ND; plus 21 angel investments in non-publicly-traded startups.

What’s the point of adding all this complexity to client allocations? “Stock markets are increasingly efficient,” Martin explains. “Should I spend my time looking for somebody who can buy stocks and time the trades better than somebody else?” he asks rhetorically. “Or should I look for somebody in the alternative space who has a proven track record of outperforming their risk-adjusted benchmark by 2-3X? My answer to that,” Martin adds, “is, flat out, we are just going to buy the efficient market, allocate for risk and hold on, and meanwhile I’m going to go out there and search the alternative market like crazy.”

Diversification and capturing inefficiencies

The umbrella investing vehicle for all of these deeply-outside-the-box investments is a five-year-old invention called the Opportunity Fund: a 1940 Act 3©-1 fund structure which is typically used to create hub-and-spoke mutual funds with different share classes. “The fund allows me to put in 99 slots, so each client can customize their own portfolio,” Martin explains. “They get to choose which investments, how much and when. Everybody who is invested in the Opportunity Fund has a different portfolio.”

Beyond the opportunity to earn higher returns in inefficient corners of the investment opportunity set, Martin recommends that his clients consider some or all of these investments for diversification purposes. “During periods of high price volatility, marketable securities tend to go to a one-to-one correlation,” he says, “which eliminates their risk management potential right when you want it most.”

By adding a lot of small illiquid investments, Martin argues, an investor can attack the sequence-of-returns risk that drives a retiree’s safe withdrawal rate from the average return of the portfolio down to something less than half the average return.

“The S&P 500 can only sustain a 4% payout with any level of certainty, based on a lot of research, starting with [William] Bengen,” Martin says, adding that the most recent research might lead you to be even less optimistic. “A lower-volatility portfolio can pay out something much closer to 100% of the average return, because you aren’t getting the same losses in a bear market.”

Won’t liquid alternative funds accomplish the same thing with a lot less work? “Liquid alts are marketable securities on the public stock market,” Martin explains. “During periods of extreme market movement, either up or down, they’ll do what all publicly-traded securities do: approach that 1:1 correlation. If interest rates go up, and stocks go down and bonds lose value, my alternative income funds don’t change.” he adds. “That feels real good to clients.”

Of course, with such a broad array of potentially volatile investment programs, investors experience much more upside and downside than they would with mutual funds – leading to some interesting client communication issues.

“I met with the client last week, and we went over three pages of reports from my accountant,” says Martin. “He said, what’s the best one?

“I said, the best liquidations we’re getting are from a couple of real estate deals are averaging 25% to 35% IRRs.”

“Then he said, what is the worst one?” Martin continues. “I said, this one that just went bankrupt in November.”

Futures and income

Exactly what kind of investments are we talking about here? The four different categories are each handled somewhat differently, and are designed to not only provide asset-class diversification, but a great deal of manager diversification as well. “I would argue that as a diversified portfolio, the Opportunity Fund has less risk than bonds,” says Martin. “If we buy enough investments over a long enough period of time, the law of large numbers says we are going to approach the expected returns of those investments – which are all way above index returns.”

Start with the 12 managed futures and options funds, which come as a package – meaning that, unlike the other categories, Martin’s investors must participate in all of them or none. “I work with an introducing broker called Novus, located in East Bay [SF area], run by Don Davis,” says Martin. “Don is a Commodity Trade Advisor who runs his own precious metals fund, which happens to be the number one performer in the field over the past five years.”

Together, Martin and Davis look for managers who have good track records and also very little connection with the traditional investment markets. “I only select people who are trading precious metals, currencies, live animals and commodities,” Martin explains. “There is no stock or bond influence in my managed futures fund.” In aggregate, their composite track records would imply an expected return of 14% a year.