How Diversified is Your Portfolio? The Unpalatable Truth, Meeting Fiduciary Responsibilities and What You can do about it.

How diversified is your portfolio? Really?  Are you willing to take another look?  When the Titanic struck ice no one panicked.  It was just inconceivable that a ship that size could sink.  At 00:45, 15th April 1912 the first lifeboat was rowed away from Titanic with 28 passengers on board, despite a capacity of 65.  The enormity of the situation simply could not be comprehended.

The challenge for most assets in most portfolios is that they now share a single point of failure – the fiat system itself.  Institutional counterparties and liquid markets are required for the value of most assets to be realised.  If the institutional counterparties fail markets cannot operate.  Liquidity dries up and portfolio assets dependent upon the fiat system have effectively no value.

Now, it is easy to be Chicken Licken and run around shouting “the sky is falling, the sky is falling”.  So do not take my word for it.  Listen people who should know what they are talking about:

Ray Dalio, Bridgewater Associates
Donald Amstrad, Aberdeen Standard Investments
Jeffrey Gundlach, DoubleLine Capital

What makes the analogy with the Titanic so compelling is the sheer number of people who should know what they are talking about saying the same thing.  As long as their job does not depend upon professing all is well with the fiat system, all is clearly NOT well whoever you wish to listen to. 

That is to say the fragility of the fiat system is no secret.  Nor is the failure of monetary policy in the form of interest rate cuts and the expansion of money supply (Quantitative Easing) to remedy the situation. 

When the Titanic struck ice on her starboard side six of her sixteen compartments were opened to the sea.  Titanic had been designed to stay afloat with four of her forward compartments flooded but no more.  Whatever passengers believed, the ship was going to sink.


"The ship will sink." Image credit: Titanic 1997 movie Paramount Pictures.
 

So we are not dealing with a lack of facts or warnings when it comes to the risk of major disruption, if not collapse of the fiat system.  Instead we are dealing with incredulity – how can a portfolio manager conceive of this happening?  More importantly what can they do about it?

The Employee Retirement Income Security Act of 1974 (ERISA), although it applies specifically to pension fiduciaries, provides a primary source of statutory guidance for all fiduciaries because of the large dollar value of assets invested in pension funds. The Act requires managers to exercise a standard of reasonable care (prudence) in managing the portfolio.  Empirical studies showing that long-term investment performance depends primarily on asset allocation policy support the total portfolio approach to measuring prudence.

The bedrock of prudent asset allocation has always been diversification – having a diversity of assets so that the failure of any one does not jeopardize the value of the entire portfolio.   However, as most assets in a portfolio now share a common point of failure – the fiat system itself – diversification within the portfolio has all but disappeared.  I suggest this presents a big challenge for portfolio managers seeking to meet their fiduciary responsibilities.

What can be done?

First is to acknowledge there is a problem.  Because the fiat system is now a singularity, assets whose value depends upon the system share a common risk.  This common risk has caused diversification to evaporate.  The problem is not with the concept of prudence based upon asset diversification.  The fundamentals of good investing have not change.  It is the fiat system that has morphed.

Second, measure the extent of the problem within your portfolio.  A few asset classes are not tied to the fiat system for their value.  These assets are valued in themselves.  Hence they do not require access to underlying collateral or institutional counterparties to realise that value.  These include:

·         Property, owned outright

·         Commodities, owned outright and preferably physically held

·         Digital Currencies, such as Litecoin, Monero and Bitcoin

·         Self-Managed Investments (SMIs), a digital form of hedge fund.

The exposure of a portfolio to the risk of systemic collapse can be calculated by subtracting these independent assets from the whole.  The result is the risk exposure the portfolio has to the fiat system.

For example, CalPERS, the largest retirement fund in the United States, serving 1.9 million people, has the following asset allocation:


CalPERS portfolio mix.  Source: https://www.calpers.ca.gov/page/investments/asset-classes/trust-level-portfolio-management/investment-fund-values
 

 

Of these Real Estate, an asset class of independent value is 8.7% of the portfolio.  Forestland, also of independent value is 0.35% of the portfolio. Infrastructure may also be a contender, comprising 1.13% of the portfolio.  In total CalPERS holds 10.2% of its portfolio in assets whose value does not depend upon the effective functioning of the fiat system.  To put this another way 89.8% of the CalPERS portfolio is exposed to a single source of risk. Would Google plug 89.8% of its servers into a single power supply?

Is the CalPERS portfolio diversified?  No.  Not by any usual use of the word.    However this simple process at least gives the CalPERS investment team an idea of the scale of the problem they face.

Once exposure has been quantified the next step is to take practical steps to reduce the risk.  This entails returning to the source of sound portfolio management with Genuine Portfolio Diversification. 

CalPERS can restore diversification by shifting its allocation to include more of the four asset classes of independent value mentioned above.  Each class does not depend upon the fiat system to realise the value of the asset.  At first glance this may look like a loss of diversification until one remembers that all the other asset classes, including global and private equity, should now be treated as a single class as they share a single source of risk.

Self-Managed Investments (SMIs) are the new asset class specifically designed to aid this return to genuine diversification by giving portfolio managers access to a range of long/short hedge-fund-like strategies without the counterparty and systemic risk associated with them.  SMIs do this by simulating trading rather than actually trading the asset in the markets.  Value of the digital asset is self-generated by token holders by tracking the “Target Price” of the simulated returns. A long/short Bitcoin strategy, Bitcoin Enhanced is the first of the class commercially available. Others, including a long/short Brent Crude and long/short Natural Gas strategy are likely to be the next on the market.

SMIs share a risk profile with early-stage VC investing.  Both lack early liquidity and both carry the risk that any particular SMI or start-up company may fail.  VCs have built an effective business model for managing these risks.  The result has been one of the top performing asset classes over the last 20 years.  By emulating the VC approach in respect to SMIs portfolio managers win on a number of fronts.  First they have an asset class that not only provides genuine diversification, but also has the potential to meet the return targets of the portfolio to ensure its obligations are funded.  Second, the VC model demonstrates how the risks of SMI’s can be effectively managed. 

Because they combine return potential with zero exposure to the fiat system, SMIs may provide a valuable impetus for action.  The reason is this: what if the fiat system remains in tack?  In that case the portfolio manager has lost nothing.  SMIs enable portfolio growth irrespective of whether the risk of fiat collapse comes to pass or not.  In the meantime however, the portfolio has been restored to genuine diversification as the bedrock of sound portfolio management and the portfolio manager is once again fulfilling their fiduciary duties.