There are two categories of people in the world: the ones that love Packy McCormick and the ones that do not know Packy.
Howard Marks (I think) said that good stock traders are optimist while good bond traders are pessimist. I happened to to be a bond trader as part of my job just by chance but it definitely suits my innate pessimistic nature. Reading Packy substack brings a good deal of positivity back in my life. Recently he wrote a post about Equi that resonated even more with me.
Actually…that’s what I am trying to do with this blog but I never wrote a proper ‘manifesto’. So far here you can find (almost random) considerations about what caught my attention in that moment in time; if you dig deeper, you probably noticed a common underlying theme. This time I will try to make it explicit.
What is a Family Office
Once I read about the difference between the “get rich portfolio” and the “stay rich portfolio”.
The get rich portfolio usually involve a very concentrated bet, call it if you want a resonated purchase of a lottery ticket. An entrepreneur get rich investing the most of their time, and usually money, in their company; the Winklevoss twins became billionaires buying all the bitcoin they could; @jasondebolt gained millions going all-in on Tesla.
This strategy is very effective but is also very hard to accomplish: I call it a lottery ticket because the odds are against you, resonated because you can work to tilt the odds towards you. No matter the amount of work you will dedicate to it, luck will dictate your ultimate result.
Once you are rich (whatever definition of rich you have), pursuing the same strategy that got you there will most likely make you poor again: once you won the lottery, betting all the gains on the next spin of the wheel will bring you back to square one. In order to stay rich you have to take the opposite view, diversify your bets as much as you can.
A Family Office is the classic structure used by rich people to hold their diversified investments; as Packy puts it:
The way that institutional investors and Ultra-High Net Worth individuals (UHNW or the .000001%) invest is very different from the way you or I invest, even if “you” are a High Net Worth (HNW or the 1%) individual. And it’s certainly not because the institutions don’t have the ability to invest the way that retail investors do… they have a broader universe of options available to them than we do, and they mix and match those options into portfolios with better risk-adjusted returns.
Why this is relevant to you or me?
In the end, neither of us is ultra-rich. If your goal is not to become filthy wealthy but to accumulate enough assets to live a comfortable life, this strategy is the best and most efficient way of doing it. It is better than the 60/40 portfolio because it produces more gains AND lower volatility. After ten years of uninterrupted stock bull market is difficult to remember the pain of holding assets in a multi-digit drawdown. Lower volatility via uncorrelated assets buys you peace of mind.
Too good to be true? Kind of, because to reach our goal we need to find the right ingredients, mix them the right way…and get lucky. 9 times out of 10, more complex in the investing field means unnecessary costs and underperforming; is this the exception to the rule? I think so.
Diversification is the only free lunch in finance. The enhanced risk/return profile of this strategy comes from the fact that the additional elements in this portfolio are uncorrelated to stocks and bonds. Another reason is illiquidity: you get higher returns because these investments cannot be converted into cash as easily as an ETF; if your investment horizon is ten or more years, this is also a free lunch. The main risk with illiquid assets is that investors get lured by the higher yields and ‘overextend’ their allocation: when life presents them an event that they did not plan, the costs to liquidate their position more than offset past gains. You should be aware of this risk, especially regarding assets that do not produce cash flows like Venture Capital or Art.
While you can ‘set and forget’ a 60/40 strategy, this portfolio requires constant maintenance: forget about passive income. Make sure that the additional time you devote to it is worth the (probable) increase in returns. The goal of companies like Equi is to provide this strategy at a low cost so that it can be considered passive income for its clients.
How do you build a Family Office strategy?
Packy’s post includes a very interesting graph on the difference in spread performance between stocks/bonds and alternatives:
As you read in my previous post, I am a bit sceptical on how lot of people are quick to define stocks beta: is it the S&P500, a World index, a developed plus emerging markets? Do you include a value tilt to exclude periods when stocks are expensive? Whatever you define your stocks universe, getting that beta is easy: you can find a low-cost ETF and call it a day. Same thing with bonds.
The real difference between these assets and the alternatives used by Family Offices is that the latter do not have a proper beta, there are different managers that try to generate alpha out of a specific strategy and what you can observe, hopefully considering survivorship bias, is the average of their results. For example, the closest thing to Private Equity beta that I know is a strategy run by Verdad Capital using listed small caps; this is a very specific ‘financial experiment’ run by a manager, unfortunately there is no simple product out there that gives you a risk/return proxy of the average Private Equity fund. Same for Hedge Funds, even considering manager styles (Macro, Event Driven, Long/Short, etc), Venture Capital and Real Estate.
In this regard, Ultra High Net Worth investors and ‘us’ share the same problem: for each alternative category, we have to find the best manager. Since the performance difference between the best and the worst is big (and even bigger if you consider the possibility of investing in an outright scam), finding the right managers is a key component of the final result.
UHNW have an advantage in this regard but do not think that they are so far ahead. From Equi to investment proposals I receive at my office, every investment consultant in the world claims to be great in finding the best managers, while in reality no one can show empirical evidence of this ability. Despite their resources, UHNW are not immune to scams neither (Bernie Madoff anyone?) but their status definitely helps in the subsequent recovery process.
When Swensen started to allocate more and more funds to alternative strategies, he did something new. Doing something different is one of the (few) ways to generate extra returns but represents a huge career risk as well: if you are managing someone else money, is better to fail conventionally than have success unconventionally. Academic literature shows that there is a negative relationship between a manager ability to generate extra-returns and the amount of money under management: new managers have better chances than established ones; the same manager has better results early in their career. While we might not have all the same connections and relationships to access new strategies and managers, being rich can help up to a certain extent. Pass a certain threshold, too much money becomes an actual drag to performance: think about the Vision Fund and its inability to access promising start-ups too early.
There is a finite amount of opportunities that can be exploited in these investment categories: as I described in my post “Yields will go down” about p2p, the more a strategy has success, the more it attracts new funds, the more future results will get compressed, or totally disappear.
Here some examples of alternatives I consider good opportunities for a retail investor based in Europe; some of them have been already discussed in this blog, other will be part of future post. While I will describe them in general terms, as said before there is nothing ‘average’ in this part of the investing world: your gain or losses will depend on your ability to find the best managers.
Peer-to-peer
This category includes various sub-themes: consumer, business, real estate and invoice lending. Each of them has its own characteristics and correlation to stocks. As demonstrated by the recent Coronavirus-lead bear market, some platforms proved to be really uncorrelated to stocks while others went belly up. It is difficult to define an average return because of the high risk of scams: your ability (or luck) in dodging them will have more impact than any single platform-advertised yield. Pros: easy to access, easy to diversify. Cons: less historical data, scams.
Royalties
I wrote a post about the SONG fund listed on the London Stock Exchange; this fund buys rights on popular songs and collect a fee every time a song is played, streamed or used in a show. Royalties can be a good investment because they are uncorrelated from the stock market; any Intellectual Property can generate royalties and I bet in the future there will be more investment opportunities for retail investors. Average yields are around 10%, if you consider income from fee and rights price appreciation. Pros: steady income, strong uncorrelation. Cons: High fees, final return depends on manager ability to buy at the ‘right’ price.
Farmland
At the moment this is one of my favourite themes. Returns are stable and they also offer a good protection against inflation. Farmland has been a major source of wealth throughout history and unlike stocks and bonds, chances that your investment will go to zero are pretty low. Unfortunately, the only investment vehicle I found so far is a stock called…LAND; I also invest in HeavyFinance, a p2p platform that lends to agricultural business in Europe. Average returns are in the high single digit. Pros: inflation protection, steady income. Cons: difficult to invest if not accredited investor, climate change.
Art
In this category I consider any type of respectable collectable: if you have a passion, it will turn the necessary research from work into fun. I use art because of my personal interest, others might be more into wine or classic cars. Since nothing in this macro-group has any intrinsic value, is difficult to draw a line between a temporary fad and a real store of value. In the past years, multiple platforms have started to trade to offer users fractional ownership of a particular asset: this means that if in the past only millionaires could buy a Picasso or a vintage Ferrari, now everyone can have a piece of it. I use Masterworks and so far I like it. Average returns are in the low double digit. Pros: the owner gets value outside the pure financial side. Cons: no income, very low liquidity.
Crypto
No matter your personal opinion, it cannot be denied that crypto markets have become an established form of investing. So much so that there are now ‘risk-free’ opportunities outside the classic buy Bitcoin and wait. I call risk-free strategies that arbitrage prices between different exchanges or lock-in premium between spot and future markets; these strategies are not 100% risk free because you will always have a counterparty exposure but their risk/return profile is fundamentally different from a long-only asset. They are not simple to implement and maintain, ideally they would require some coding so that you can monitor risk even when you are away from your laptop (remember that crypto markets trade 24/7); this video provides a nice example, I will write a post as soon as my experience with Kraken reach a good level. Average returns can be as high as 18 / 20%. Pros: risk-free returns. Cons: not really risk-free, requires constant monitoring.
Venture Capital
Recently I wrote a post about my experience with Seedrs, there you can find my approach to Venture Capital from a European retail investor point of view. As for professional VC, average returns strongly depend on how many 10x or more you catch; if you manage to build a very diversified portfolio you should get at least a return comparable to a small cap fund. This asset class is more correlated to the stock market compared to other alternatives: expected returns increase if you invest when the market is down 20% or more (there is less competition for deals and start-ups are more focused on becoming profitable). Pros: if you get access to the right names, returns can be life-changing. Cons: the typical exit happens after 5 to 7 years; not only you do not get income, you have to invest additional capital in subsequent rounds if you do not want to get diluted too much.
ETFs and Leverage
There are multiple ETFs that mimics hedge fund strategies, from long/short to risk parity. Unfortunately they are almost all listed in the US: you can buy them only if ‘you have a strong MiFid’, as one of my friends put it. Leverage, if managed correctly, is a good tool to achieve a very diversified portfolio even if you do not have the means (yet). The easiest example is a 2X ETF on S&P500: you get your desired exposure to large stocks with 50% of the money, so you can use the other 50% to buy other assets described in this post; I strongly suggest you to buy income generating assets though, because you have to rebalance your portfolio more often or risk to get nasty surprises during a drawdown. I wrote about leverage here, here and here.
Conclusion
This is all folks. The main issue to reach the goal of a better performing portfolio is that it requires a lot of due diligence on every category you decide to add. It is not impossible but you have to do your homework, I personally prefer it to stock picking as a way to increase your returns. By definition a mass market product cannot achieve massive extra-returns: if you wait to invest only when something has become mainstream, be aware that the best results are most likely in the past.
I consciously did not touch Real Estate: the unlevered version has a risk/return profile similar to a mix of of stocks and bonds, the levered one (i.e. you buying properties with a mortgage) is like 60/40…with leverage, plus a strong idiosyncratic risk and headaches from your tenants. You can find plenty of success stories on YouTube, here you can find the other side of the coin.
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