Managing the Greatest Risk of All — What Portfolio Managers can Learn from Venture Capitalists
Just how diversified is your investment portfolio? How would you measure that? While a portfolio may be “diversified” in terms of equities, bonds, ETF’s the dependence of the world’s largest financial institutions upon each other for their solvency means that in terms of systemic risk there is often very little diversification at all.The portfolio remains exposed to the pervasive risk of institutional collapse.It is as if Google ran all its operations on a single super-computer.Google doesn’t do that for very good reasons.
Instead Google runs its business on millions of servers located in farms spread across the globe.Each server is independent of others so that if one fails the rest are unaffected.This is genuine diversification in practise.Most portfolio managers believe they are diversified like Google so that if one asset fails to perform its failure does not jeopardise the rest of assets held.However, what most portfolio managers miss is that most of their assets are “plugged” into the same system institutional dependencies.It is a single point of failure that can ruin portfolio value.
“…there is no dispute that nowadays systemic risk inseparably belongs to the main issues associated with modern financial systems…. Interdependencies among financial institutions are a hidden threat to the financial system as a whole.” Jana Procházková.
This system of dependencies has come about because the overwhelming majority of assets are derivatives in the sense that their value depends upon the value of an underlying asset.For example, the value of SPDR® Gold Shares (GLD) depends upon physical gold held in vaults in London.If access to that gold, through the failure of fund managers State Street Global Advisers,The Bank of New York Mellon as the trustee or HSBC Bank plc as the custodian the value of shares could fall to zero.
If the counterparties mentioned were financially robust and their solvency independent of each other this type of financial product would not poise a problem to a portfolio, even one invested in GLD shares.Maybe this independence among institutions was true a hundred years ago.Today the reality is that the solvency of these institutions depends upon the derivatives they hold on their books.The counterparties to these derivatives are generally other institutions.This web of dependencies spreads across the entire system.The result is that failure in any part of the system — an Italian Bank, a corporate default on debt, political tensions in the Middle East — can trigger failure system-wide failure.
“In my view derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Warren Buffet
The risk of general failure is what leaves most portfolios, however well they are managed, exposed.
How Does a Portfolio Manager Return to Genuine Diversification?
A return to genuine diversification means holding assets that have value in themselves and do not depend on large financial institutions to realise that value.The list is short but obvious:
Beyond this limited line up we have developed a new asset class called Self Managed Investments (SMIs).A form of “digital hedge fund” SMIs are specifically designed to give investors access to investment strategies while avoiding the systemic and counterparty risks of the financial system.Incidentally, unlike a hedge fund, SMIs have no fees.
SMIs function like digital currencies in that token holders give the tokens value and ownership is stored on a distributed ledger.Instead of trading assets as a hedge fund would independence from the financial system is maintained by running a simulated strategy.Trades are irrevocably time stamped to prove they were made before the event to avoid fraud.Once the trade period is complete, the simulated result is published as a “Target Price” for the tokens.As there is no reason to hold tokens except to trade them at the Target Price, investors are incentivised to do so.The result is that investors can buy into hedge-fund like investment strategies without exposure to the systemic risks of the system.All these features can be seen on the Bitcoin Enhanced website, an SMI running a long/short Bitcoin strategy.
SMI’s are likely to work best when the strategy is based on assets which themselves are independent of the fiat system.The most likely contenders are commodities and digital currencies. In these cases, because SMIs are simulating the trading of assets with stand-alone value, the performance of the strategy is unlikely to be affected by any upheavals in the fiat system.
How VCs Turn Liquidity Risk into a Benefit
Diversification.First the VC follows the same route as Google and all prudent investors through diversification.A VC does not invest in a single start-up, but in many.According to industry statistics around 60% are likely to fail.However the winners more than compensate the VC for their original investments.Like Google’s servers, VC’s expect failure — it is built into their model, and indeed it is what makes the model so successful at managing risk.
Patience. VCs realise that it takes time to build a great business.The business naturally goes through various stages from start-up to expansion phase before becoming a mature business.These stages may require new injections of capital.Even if they do not the VC realises that liquidity will not be available for some time.
Active Investing. A VC will actively work with the start-up to grow their business.While the level of active engagement varies from firm to firm, at the very least, the VC will make public its holding in the start-up.This helps to build credibility and confidence in the new business.In other cases the VC will help with expert advice and build connections for the company both with other investors and with markets.
Liquidity Event. The end goal of the VC business model is the generation of a liquidity event where they can realise the returns from their initial investment.This is usually in the form of a trade sale or IPO.Generally it is at this point where there is enough liquidity for the VC to cash out if it chooses to do so.
What Can Portfolio Managers Learn from VCs to Reduce Catastrophic Risk?
The Venture Capital model is very successful.Over a 20 year period the Cambridge Associates US Venture Capital Early Stage Index returned 9 times more than the S&P 500.
The benefit for a portfolio manager of the VC approach is that it demonstrates a proven method of managing an asset class with low initial liquidity and where the success of asset cannot be guaranteed.But what does the VC roadmap look like when applied to SMIs?
Roadmap to Investing in an SMI
Diversification. There is no guarantee that a particular SMI will be successful.This suggests that investments in multiple SMIs would be prudent — a strategy that genuine portfolio diversification has always advocated for sound investing.As the SMI class is new there may initially be only a handful of SMIs to choose from.However if other assets of independent value such as property, commodities and digital currencies are included in the mix, then the goal of diversifying away from the systemic risk of institutional failure can already make significant headway.This inclusion also has the benefit that many of the other independent assets are already established and so have good liquidity.
Patience. Like the VC model patience is an attitude more than a particular time period.Some SMIs may establish themselves in the matter of months.Others may take years.Digital currencies can give some indication of the time required to achieve significant liquidity.Bitcoin started trading across multiple exchanges in decent volume in 2013, 4 years after inception.After an initial spike transactions in Monero began to provide credible liquidity in October 2016, two and a half years from inception.
Active Investing. It is hard to over-estimate the effect a top VC firm like Andreessen Horowitz can have on the fortunes of a start-up it has invested in:
And at the firm’s executive briefing centers at headquarters and in a New York satellite office, Andreessen Horowitz staff played matchmaker, enticing big corporations and government agencies with the prospect of seeing cutting-edge tech, then lining up relevant portfolio startups to present to the visitors. GitHub, the open-source-code repository the firm backed in 2012 before it was acquired by Microsoft for $7.5 billion, found the briefings so lucrative-good for $20 million in new recurring revenue in 2015 and 2016-that it posted a junior staffer to hang around the Andreessen Horowitz office full-time, its sales chief says. Consumer startups like the grocery delivery unicorn Instacart (a 2014 investment that now has a $7.9 billion valuation) scored partnerships with national retailers and food brands. (Source: https://www.forbes.com/sites/alexkonrad/2019/04/02/andreessen-horowitz-is-blowing-up-the-venture-capital-model-again/#4109cc097d9f)
Early investors may also have the opportunity to take equity stakes in the issuing company.This act is likely to re-enforce the confidence message sent to the market. It also has the beneficial effect for the portfolio of an early source of return.This is because the issuing company earns its revenue from the sale of tokens.By holding an equity stake the portfolio manager can participate in this revenue in the form of dividend from the company.Once all tokens are sold there is no further revenue stream for the issuing company and the portfolio can now realise the full extent of its investment through the liquidity provided by the circulation of all tokens.
Liquidity Event. Unlike the VC model where there is in most cases a defined liquidity event in the form of a trade sale or IPO, liquidity for an SMI is more akin to that of digital currencies: sufficient liquidity is simply the presence of buyers willing to purchase tokens on the digital exchanges where the SMI is listed.A fund manager may therefore be able to exit a portion of their investment in relatively early stages when demand for tokens is still limited.They may also be able to exit their entire holding well before all tokens are sold.In other words, while the end goal of both the VC investing in a start-up and portfolio manager investing in an SMI is liquidity, the definition of such an event for a SMI is more flexible, depending on factors such as how limited is token supply (generating demand), how many tokens remain to be sold and the size of the holding the portfolio manager wishes to cash out.
Summary — Relief for the Headache
SMIs exist to help solve a serious dilemma for investment managers — lack of genuine portfolio diversification in the face of the singularity of the financial system.They do this being stand-alone silos where the value of the digital tokens is conferred by token holders.Their built-in risk is lack of liquidity at inception and the possibility of failure later.These risks have been negotiated by venture capitalists for decades.The success of the VC model shows that, when managed properly, the ability of an SMI to fail is precisely what makes the model so successful.Portfolio managers who are flexible enough to adopt a VC’s approach not only have the opportunity invest in a new asset class, but one that can help solve a very large headache.
Originally published at https://www.zerohedge.com.