60/40 No Longer? Building an investment portfolio for the 21st Century
On Productive vs Speculative Assets
The biggest headline from the legendary Berkshire Hathaway annual meeting a few weekends ago was about a company that Warren Buffett is not an investor in: Robinhood.
One topic that was top of mind for Warren Buffett was the speculative nature of trading apps. Buffett and his business partner, Charlie Munger, criticized the “casino-like” nature of stock trading apps because they encourage individual investors to participate in speculative trading behavior rather than long-term investing based on the fundamentals of a business.
In many respects, Buffett certainly isn’t wrong. Investing and trading, particularly options (heard of the Greeks, anyone?), are two very different things. And can result in very different return outcomes for investors over the long-term (not to mention, tax impacts).
Buffett is a big fan of productive assets, which he favors over speculative assets because of their capacity to produce goods or services, and thus create cashflows for a company. In fact, he’s often eschewed the opportunity to invest into speculative assets because productive assets, such as stocks, can produce dividends. Productive assets also provide a company with capital to invest into operations, expand, acquire other productive assets, all of which could result in further profits, increased cashflow, and dividends back to investors (it’s worth noting that the stocks that investors can trade on Robinhood are theoretically productive assets even if investors on Robinhood are not investing in them as such — they are companies, which in many cases, have cashflows and dividends).
The purpose of this post, however, is not to discuss the merits of Buffett’s comments about Robinhood encouraging speculative investment behavior. But Buffett’s comments do shed light on an interesting aspect of the rise in interest in alternative investments.
In a low interest rate environment, how should investors — particularly those who have been shut out of accessing many investment opportunities that have been available to a select few institutions and individuals — build an investment portfolio for the 21st Century?
Some investments in the alternative assets space that are currently being democratized for the individual investor are certainly speculative in nature.
Does this mean that investors should not invest into these assets because they are speculative assets rather than productive assets?
A place for productive and speculative assets in an investment portfolio
Rather than take a prescriptive view that investors should only invest into productive assets, particularly if they can’t afford to lose what they invest, I’d argue that (1) there’s a place for both productive and speculative assets in an investor’s portfolio and (2) investor may actually have deep knowledge or understanding of some of these speculative assets, giving them a unique insight into that investment opportunity.
Should the investor who is an expert in sports and knows everything about sports cards not invest into a sports card just because it’s a speculative asset?
Should the investor who studied art in university and worked at a top art gallery not invest into art as an investment just because it’s a speculative asset?
We’ve had a number of guests on the Alt Goes Mainstream podcast who have said that the 60/40 portfolio (60% stocks / 40% fixed income and bonds) is dead.
60/40 no longer
For many institutional investors and ultra-high net worth investors (UHNW) the 60/40 portfolio has actually been dead for quite some time.
Many institutions and UHNW investors have long had quite a large asset allocation to alternative investments — which has often driven much of their returns. Endowments like Yale and Harvard have performed well over the years in large part due to their allocation to top tier private equity, hedge, and venture funds.
If done right, allocations to alternative investments can drive outperformance in an investor’s portfolio — either generate alpha, albeit with correlation to public equities (venture and private equity), or provide returns with uncorrelated exposure (like commodities, cryptoassets, sports cards, and other collectibles).
Furthermore, UHNW portfolios have often included speculative assets for years. UHNWs have long invested into art or other collectibles that can generate meaningful returns on an uncorrelated basis to equity markets.
Democratization of access to alternative assets also means democratization of the investment portfolio for all investors.
Now that the ability to invest into virtually anything is being brought to the masses, we need to create ways for investors of all types to be able to gain exposure to these assets in a thoughtful, measured way.
Creating a safe, accessible environment for investors
What can we do to create a safe, but accessible environment for investors to invest into alts irrespective of whether or not they are HNW?
Education is key: Educate investors on the merits of the assets they are looking to invest into — and how it fits into overall portfolio construction. Investment platforms that invest heavily into investor education will win by becoming trusted venues for investors.
Wealth managers can also commit to learning about alts in order to provide guidance to their clients. They can leverage educational platforms like CAIA to better understand alternative assets. Initiatives like AltsEdge, iCapital’s educational partnership with CAIA, is a fantastic development for the alts space and for advisors who are looking to allocate to alts.
Moreover, learning about alts is just good business for a wealth manager. A 2020 Nerdwallet study found that almost 60% of Americans are interested in investing into alternative investments, with significant interest in alts coming from Millennials and Gen Z. There is also data that indicates that 66% of next gen clients switch advisors when wealth is transferred from their parents. So, wealth managers should be highly motivated to learn about alts, particularly so that they can attract and retain the next gen client.
Platforms must focus on quality control and product innovation: Investment platforms must think hard about quality control so they only attract high-quality assets to their platform. All investors deserve access to institutional-quality investments, so this means platforms must invest heavily into origination and diligence functions.
Investment platforms would be remiss to not think about product innovation so that investors can access these assets in a variety of ways. Platforms that create structured products, like index funds or multi-product / diversified asset funds, will appeal to the widest audience of investors. Some investors may want to be more self-directed and make asset-level investment decisions, but there are many more investors who will want to get broad-based exposure to a number of alt assets within a platform. A diversified investment product, akin to what Republic has done with their Autopilot product, may be a better fit for them.
Platforms can also help to create mechanisms for investors who may require liquidity. Now, it’s not always best to sell illiquid assets, as sometimes these are the assets an investor wants to hold due to potential compounding effects, but there are times when an investor may need liquidity for life events. Platforms should seek to create ways to give investors liquidity on either a structured basis (i.e. quarterly liquidity via trading windows) or through a secondary market.
Regulators can help too: Regulators can play a role in both helping to unlock access for individual investors while also protecting them from the pitfalls of investing into speculative assets.
Regulators have done well to help usher in the era of democratized access to private markets. Recently, the SEC increased the maximum amount that can be raised through a Regulation Crowdfunding Offering from $1.07M to $5M.
The SEC also increased individual’s investment limits in certain cases. They removed the limit on the dollar amount that accredited investors can contribute in crowdfunding campaigns. And, while non-accredited investors have investment limits on the amount they can invest into each private offering, they can now use a different calculation to determine what they can invest. Individual investors with an annual income or net worth less than $107,000 can contribute either $2,200 or 5% of their annual income or net worth. The old rules limited them to the lesser of those two numbers. And investors with annual incomes or net worth greater than $107,000 can contribute up to 10% of the highest number.
Regulators will also have to strike a balance with enabling access and protecting investors. Admittedly, this is more difficult in the world of social media, where platforms and online communities like Twitter, Discord, and Reddit can be used by influencers who have large followings to promote certain investments — or worse, pump and dump schemes. Regulators will have to try to keep up with the pace of technological innovation to be able to help investors since many people look to online communities — either public, like TikTok or Twitter, or private, like Discord channels —for financial advice and ideas.
It’s not productive to speculate about an investor’s portfolio
It’s great that we are starting to see access to alternative investments unlocked to all investors. Now it’s time to start thinking about how all investors can construct a portfolio for the 21st Century — and it wouldn’t be productive to speculate that investors shouldn’t include both productive and speculative assets in their portfolio, much like the UHNW investor has been doing for years.