Wednesday, June 10, 2009

Asset allocation - introducing "Hybrid Portfolio Theory"

Interesting article out from the  Venture Populist on what they term as Hybrid Portfolio Theory - forget about the name, but the content is worth reflecting on.

In short, they suggest heavily weighting a portfolio (something like 75% to 90% of assets) towards capital protection, liquidity and income - being treasury bills or the equivalent  - with the balance invested in assets with a high potential for capital appreciation - venture capital, private equity, emerging listed companies, and hedge fund type strategies.

The rationale is primarily based on the poor relative performance of equities as an asset class versus long dated treasuries - both on an absolute basis and on risk adjusted returns.  They conclude that the risk premium for holding equities just doesn't actually exist.

One line in particularly tweeked my aging synapses..."I refer to it  as Hybrid Portfolio Theory (HPT) and could safely say that less than one percent of advisors have contemplated, let alone implemented such a methodology in their practice…despite its proven efficacy and how well it resonates with high-net-worth investors."

In my experience, it is true that high-net-worth investors adopt this kind of strategy.  Variations on a theme exist as you'd expect given we are all individuals with different stories to tell, but generally if someone has significant wealth accumulated they tend to segregate their wealth into these two risk classes.  The pattern I came across was that risk capital is typically confined to the business - seeking to generate returns of at least 20% year in year out - while capital that has been released or realised from the business is parked in bank bills.  This was the same whether the individual was a property developer, liquor retailer or internet guru.

Come to think of it, this is the same investment model that an insurance company will 'typically' adopt (there will always be an AIG or HIH or FAI to muck things up).  QBE's investment parameters are almost identical (95% in highly liquid, high quality credit with average duration of 6 months - with the balance in equities).  

So what is the conclusion?

I'm open to the idea that capital should largely be protected from the vagaries of the equities market.  So having a strong tilt towards income, liquidity and capital protection makes sense.

Also, I agree with their skepticism that equities as an asset class will simply outperform.  Once again it has been made clear by this latest stock market seraglio that most companies are managed by self interested and less than inspiring individuals.  Our task then is to find those few companies that have growing business models that are well managed by quality individuals.  They are likely to be companies that will generate returns of 20% per annum.  They are out there, its a 'wood for the trees thing' - and the good thing in this market is that the rotten trees are all falling over.


  1. I imagine you're read Black Swan by Nassim Nicholas Taleb. What your post mentions is somewhat similar to the investment style he advocates: 90 to 95% or so invested in safe assets (like US treasuries) with the remaining 5 or 10% in deep out the money puts and calls. You then just wait for the inevitable Black Swan to waltz on over and earn you a knockout return. Apparently.

    I guess it has merit, but you could wait a long time for your OTM calls or puts to payoff...

  2. Read something yesterday rubbishing the Black Swan theory of investing (you look good for 5 minutes but its a longtime between drinks). I agree with the sentiment...

    By way of explanation, part of the reason for writing this blog is to think about portfolio construction under different assumptions (the implicit one in this one is that there is a critical mass required to investing part of a portfolio in treasuries)...