The Allocator's Edge: A modern guide to alternative investments and the future of diversification

The Allocator’s Edge

A modern guide to alternative investments and the future of diversification

Phil Huber, CFA, CFP®

Contents

About the Author

Foreword by Cliff Asness

Introduction

Trade-Offs All the Way Down

A Two-Asset World

Three Choices

The Opportunity

How to Use This Book

Part I: The Allocator’s Dilemma

Chapter 1: Hindsight is 60/40—The Impaired Vision of Traditional Portfolios

60/40: By the Numbers

How Reliable are Bonds as a Tail Hedge?

Tastes Great? Less Filling?

The I Word

What About Stock Valuations?

Collective Error

What Does the Future Hold for 60/40?

Stop Admiring the Problem

Chapter 2: Alternatives—The Most Loaded Word in Investing

The Rise of Alternatives

A Loaded Word

The Education Gap

Buyer Beware

The Three Dirty Words in Finance

Too Rich for My Blood

Implementation Roadblocks

Unloading Alternatives

Chapter 3: How Investors Got to Now—The Evolution of Asset Allocation and the Democratization of Alternatives

The Only Constant is Change

We’re Getting Smarter

Technology is Getting Better

Part II: The Past, Present and Future of Alternative Investments

Chapter 4: Too Big to Ignore—The Usual Suspects of Alternative Investing

Private Equity

Hedge Funds

Real Estate

Connecting the Dots

Chapter 5: When Alpha Met Beta—Systematic Approaches to Alternative Risk Premia

The Erosion of Hedge Fund Alpha

What Exactly is Alternative Risk Premia?

Equity Market Neutral: The Long and Short of It

Style Premia: Pure Expressions of Classic Investment Styles

Managed Futures: Befriending the Trend

Global Macro: A World of Opportunity

Event-Driven Investing: The Science of the Deal

Variance Risk Premium: Selling Market Insurance

Too Much of a Good Thing?

ARP in a Portfolio

An Alternative to Hedge Funds

Chapter 6: The Investor as Underwriter—Natural Diversification from Catastrophe Reinsurance and Insurance-Linked Securities

Insurance as Risk Transfer

Insurance throughout History

Catastrophe Reinsurance

Insurance-Linked Securities

Internal and External Diversification

Peril Regions

Seasonality of Reinsurance

A Stealth ESG Asset Class?

Climate Change and Reinsurance

Reinsurance in a Portfolio

An Allocation, Not a Trade

Chapter 7: Keeping It Real—Cash Flow and Inflation Protection from Essential Assets

Inflation and Asset Prices: It’s Complicated

Why Real Assets?

Infrastructure

Farmland

Timberland

Implementation Challenges and Risks for Farmland and Timberland

Private Real Assets in a Portfolio

A Valuable Toolkit

Chapter 8: Extra Credit—Filling the Income Void with Non-Traditional Lending Strategies

The Trouble with Traditional Credit

What is Alternative Credit?

The Growth of Alternative Credit

The Universe of Alternative Credit

Corporate Direct Lending

Marketplace Lending

Niche Credit

Allocating to Alternative Credit

Alternative Credit in a Portfolio

The Future for Alternative Credit

Chapter 9: The Future Investable Universe—Novel Asset Classes at the Intersection of Finance and Technology

Digital Assets

Collectibles

Fine Art

Shared Home Equity Contracts

Income Share Agreements

Recurring Revenue Streams

What’s Next for Novel Assets?

The Future is Now

Part III: Building Better Portfolios

Chapter 10: Containers and Contents—Matching the Right Structure with the Right Investment

Investor Accreditation

The Investment Company Act of 1940

Liquid Alternatives

Interval Funds—the Goldilocks Structure?

Other Unlisted Fund Structures

Private Investment Funds

There’s an App for That

Due Diligence

Making the Right Choice

Chapter 11: The Allocator as Architect—Designing and Constructing Modern Portfolios

Is there a new 60/40?

Sizing and Sourcing Alternatives

Modern Portfolios in Action

How I Invest My Money

Alternatives and Liquidity

Alternatives and Market Timing

Alternatives and Taxes

Alternatives and Costs

Alternatives and Due Diligence

The One Job of Asset Allocators

Chapter 12: Sharpening Your Edge—Cultivating the Client Experience Through Courage and Communication

The 60/40 Security Blanket

Edges in Investing

Defining the Allocator’s Edge

Harnessing the Allocator’s Edge

Establish Principles

Set Reasonable Expectations

The Fox and the Hedgehog

Setting the Record Straight: Diversifiers vs. Hedges

Make the Unfamiliar Familiar

Prepare for Long Winters

Jobs to be Done

Incremental Upgrades

There is No Perfect Portfolio

Know Your Clients

Taking the Leap Forward

Appendices

Appendix 1: Investment Options by Category

Alternative Risk Premia

Insurance-Linked Securities

Real Estate and Real Assets

Alternative Credit

Registered Private Markets Funds

Private Alternative Investment Platforms for RIAs/Wealth Management

Appendix 2: Research Rabbit Hole

Asset Allocation

Inflation

General Alternatives

Private Equity and Venture Capital

Hedge Funds

Gold and Commodities

Real Estate

Real Assets

Alternative Risk Premia

Insurance-Linked Securities

Alternative Credit

Digital Assets/Cryptocurrencies

Novel Asset Classes

Interval Funds and Other Unlisted Investment Structures

Appendix 3: Investment Principles

Acknowledgments

Publishing details

If everyone is thinking alike, then no one is thinking.

— Benjamin Franklin

We cannot solve our problems with the same thinking we used when we created them.

— Albert Einstein

For my wife, Christie, and our daughter, Hannah.

You are my world.

To that, there is no alternative.

About the Author

Phil Huber, CFA, CFP®, as both a wealth management practitioner and an investment industry thought leader, is uniquely qualified in understanding the merits of alternative investments as well as the myriad challenges that accompany their use in the portfolios of wealthy individuals and families.

Phil is the Chief Investment Officer for Savant Wealth Management, where he helps oversee the firm’s investment and portfolio-management related functions. As co-chair of the firm’s Investment Committee, Phil leads the research efforts that he and his team perform on asset managers, investment strategies and portfolio construction techniques.

Phil has been featured in a number of notable media outlets, including The Wall Street Journal, The New York Times, InvestmentNews, CityWire RIA Magazine, and Bloomberg TV. In 2018, 2019, and 2020, he was named one of Investopedia’s Top Financial Advisors. He also produces his own investing blog, bps and pieces (bpsandpieces.com).

He has been involved in the financial services industry since 2007. Phil joined Savant as part of a merger with his prior firm, Huber Financial Advisors, where he worked for twelve years and last served as the firm’s Chief Investment Officer. Prior to his days at Huber Financial, Phil was employed at a global asset management company where he worked closely with financial advisors to develop investment strategies for their clients.

He holds a bachelor’s degree in finance from the Kelley School of Business at Indiana University and is a CERTIFIED FINANCIAL PLANNER™ professional. Phil also is a CFA® charter holder and a member of the CFA society of Chicago.

Phil and his wife Christie live in the northwest suburbs of Chicago where they enjoy reading, yoga, and spending time with their daughter Hannah. He is also a lifelong, diehard professional wrestling fan.

Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark, and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Foreword by Cliff Asness

It is hard to write an unbiased non-self-serving foreword to a book when a) you already think quite highly of the author, b) you think the author thinks quite highly of you, and c) the author’s recommendations line up fairly well with your own (with an admitted nod to Upton Sinclair). Luckily for me unbiased is not a requirement for a foreword and I will thus make no attempt to temper my praise with manufactured critique added solely for credibility. Be forewarned.

My summary of Phil’s wonderful book can be broken into three parts.¹

What’s the situation?

What do you do?

Why is doing it hard and how might we make it less hard?

So, what’s the situation? Well, I won’t rehash all the evidence Phil presents (or people like me have been screaming about for a while!) but valuations on both stocks and bonds are very expensive today. That means (almost but not quite by definition²) that they have done really well for a while, but sit at substantially lower expected medium- to long-term expected returns right now. That doesn’t mean it’s a certainty they’ll underperform their historical norms going forward. Expectations are just that—they aren’t ex post realizations. And it’s not without controversy. I have colleagues who’ve written papers on the difficulty in statistically proving³ this as you just don’t get enough non-overlapping long-term periods.⁴ But, the point estimates (i.e., if you had to make one guess from the data) go the way intuition would suggest. That is, more expensive starting valuations lead to lower expectations of future return and vice versa. Again, it’s difficult to prove that beyond a reasonable statistical doubt, but it has been historically true and fits our economic intuition (at least mine)—two things that are enough for me to give it serious consideration.

What’s more, one thing that makes today fairly unique is both stock and bond markets are very expensive versus history at the same time. That means that portfolios (e.g., like the classic 60/40 stock/bond portfolio) of U.S. or global stocks and bonds taken together are actually more expensive than their component parts. In the past when one of these was quite expensive (e.g., stocks in the 1999–2000 technology bubble) the other (e.g., bonds in the 1999–2000 technology bubble) was often cheap, and thus the portfolio, even without any tilts or timing towards the cheaper one, was not as extreme as today. Today, both major asset classes have done very well versus history for quite a long time, leaving both of them quite expensive, and thus the portfolio of stocks and bonds even more expensive vs. history. As a result, at least in Phil’s and my opinion, the expected going forward return on this diversified portfolio of stocks and bonds is extremely low versus history.

Phil then shows that it doesn’t seem that most real-world investors actually believe this! Rather, their estimates for the future currently seem higher than historical experience. To those seduced by Phil’s (and my) reasoning, that may appear backwards (and we think it is!). However, for many, having experienced at least a decade of superb returns on both stocks and bonds (with some big bumps along the way of course) the intuition runs the exact opposite way. They expect the good times to continue to roll on and on.

So, what do you do? Well, I really should say what do you do if you believe Phil and Cliff? but let’s consider that implied from now on. Well, you’re faced with substantially lower expected return on traditional assets today vs. history. Many organizations and individuals have return goals, and financial obligations, that makes this a real problem looking ahead. One thing you could do is just accept it. Stay the course, realize you’ll likely make less than-hoped-for for a while, perhaps quite a long while (the alternative is making a ton less for a little while but that’s kind of scary), but not make any big errors. Not a crazy plan but Phil (and I) are interested in how we can perhaps do better.

One option is to stay with traditional stocks and bonds but add a ton more alpha than you used to assume you could, either through security selection or market timing. Nice work if you can get it! This isn’t a screed about perfect efficient markets and the impossibility of either of these attempts. That would be pretty hypocritic of me. But it is a warning that both of these are a zero-sum game that you were, I assume, already engaged in if you believe in it. Why anyone can suddenly get much better at this now that traditional assets are offering less is anyone’s guess but it doesn’t seem like the best plan to us.⁵

So, Phil lands on the recommendation to diversify away from traditional stocks and bonds. OK, that sounds great. But into what? Phil goes through multiple options that all can fall under the rubric of alternative. Some have done even better than traditional markets (e.g., crypto), some have kept up, but many (e.g., liquid alts that put significant weight on the value factor—something I know a bit about) have lagged what seems like an ever upwards, ever anti-cheap assets stock and bond market. Phil is non-partisan across these. If they pass a basic reasonableness test, including that they are getting more investable for more people all the time, he likes them, at least for a small part of the whole. He advocates a broad portfolio of many different types of alternatives, and taking a slice of what’s normally allocated to traditional stocks and bonds and allocating it to that alternative portfolio. We all might do it slightly differently. I for one am more cynical than Phil about privates (e.g., the dampened reported volatility might make them look better than the really are), more clueless about crypto (I’m kind of cynical, but not in a knowledgeable way, more in an old-man harrumphing kind of way), even more clueless about farmland (like House Greyjoy my family sigil might be we don’t sow⁶), and even more bullish than he on liquid alts which have taken a pounding for a while leaving many of them the rare things that look cheap not expensive today versus their history (massive Upton Sinclair alert). No matter. As a whole, it’s hard to argue with Phil’s non-denominational diversified portfolio of diversifiers. I’ll leave the details to Phil (you do have to read the book!) but he shows that such a portfolio of diversifiers has great potential to help the situation that investors in a more traditional portfolio find themselves in.

So, it’s simple right? No it ain’t. In fact it’s ridiculously hard. Phil discusses why it is so hard and how might you make it less hard.

Here I picture Phil as Colonel Nathan R. Jessup screaming at us all You can’t handle diversification! OK, more accurately, though not as pithy, he’s (not screaming but politely explaining) that diversification, particularly away from assets that have (note the tense, people assume have is the same as will way too much in investing!) done great, is in fact much harder to handle than those in an ivory tower might think. Of course, he has some concrete ideas how to help get there (and stick there which is also very hard!).

At one point Phil says Most allocators intuitively like the idea of uncorrelated returns, but most balk at the actual experience of owning uncorrelated return streams. This certainly fits my experience! As Phil discusses, diversification is, by definition, being different than the norm. When the norm does very well, being different will, also mostly by definition, hurt you, at least relative to your normish peers. That’s not easy to live through! It’s not easy even if you’re doing it precisely because you strongly believe it will lead to doing better than the norm long term. When it doesn’t work it’s going to hurt, and hurt more than many anticipate when and if they allocate to these alternatives to begin with. Diversifying away from the norm means almost by definition you’ll be trailing when most people you know are doing great. You’ll have your moments, including hopefully the most important one (the long term). But, it’s really hard to stick with through the lean years. And I do mean years with a plural. Everything in investing seems to go on longer than we all expect, and it seems (and this is probably a tautology in some equilibrium fashion) many of us throw in the towel at exactly the wrong time. We suffer for years and then can’t take it, leaving (in my case sometimes within minutes of the low!) at the near exact point it finally starts to work and work and work. If that’s going to be the case it is truly better not to have diversified at all but, rather, have simply accepted the lower expected returns on traditional assets and held the line there.⁷

Of course Phil is not without suggestions on how allocators can weather these difficulties and actually see diversification through. I won’t spend a lot of time on them here. Again, you have to read the book! But one thing Phil says that I particularly love is Great investments (and by extension great portfolios) are nothing if not paired with equally great investors. I think that’s just staggeringly true.⁸ An example (where the portfolio creator and the investor are one and the same) is Warren Buffett (isn’t he an example of everything?). My colleagues wrote a paper on Buffett’s investing success.⁹ They found his success came a large part from picking the right investing styles over his career (for those keeping score at home it’s buying cheap, high quality, low volatility/beta stocks) and, taking advantage of the lower volatility/beta, applying modest leverage. But they also found one other thing that’s really neat. A big part of his success came from not backing off during some periods of tremendous relative or absolute difficult performance. And he did that when he was plain old Warren Buffett not the WARREN FREAKING BUFFETT THE GOAT we know today. It’s just one example where doing something ex ante good, like the styles Buffett tilts towards, must be paired with staying power. I can’t promise you Phil will turn all us readers into Warren Buffett but if you read his book I think it helps you at least move in that direction.

In summary, Phil tells us stocks and bonds have done great, but are now poised to do less great over the next X years, just when people now expect them to do even greater. He tells us we should diversify into some alternatives and makes a very reasonable recommendation about which to include. Perhaps most importantly, he coaches us about how hard it’s going to be, how important it is to stick with it, and offers some concrete ideas how to make it happen. He offers a mantra for the whole project—SHARP. It stands for sensible + humble + autonomous + resolute + persevering. Personally, I think he’s forcing it a bit with resolute and persevering being pretty similar, and he wussed out on adding an E to make it SHARPE, but it’s really great stuff!¹⁰

Phil tells us diversifying properly is vital, today more than ever. But, that sticking with it is a harder battle than you might think, yet a battle worth waging, and when it comes to waging it he’s got your six.

Read the book.

Cliff Asness

Managing and Founding Principal, AQR Capital Management

1 By the way, Phil starts each chapter with a great set of quotes, all implicitly about investment but rarely explicitly about investing. Please make sure you glance at them as you read the book as they are both fun and informative.

2 It doesn’t have to be so for stocks. For example, you can get to a very high P/E by price going up or earnings falling through the floor. So it’s theoretically possible to be at very expensive valuations without having had abnormally high returns. But that’s not the case today. Stocks are very expensive versus history and have indeed done very well.

3 Proving here means a really small chance you’re wrong. Sadly, you never really prove anything in statistics you just reduce the chance you are mistaken.

4 For one paper on this statistical difficulty see J. Boudoukh, R. Israel and M. Richardson, Financial Analysts Journal 75:1 (2019).

5 Admittedly, some of Phil’s suggestions to come, like liquid alts, are a form of indeed pursuing more alpha going forward.

6 Actually my family did officially vote on a motto about 15 years ago. For those curious it was are you going to finish that?

7 Phil notes in the book that alternatives also often get a shorter leash than other investments. First, I’m here to testify that is true! Second, while true, it’s perhaps also why there’s the most to gain here. Doing things that are easy rarely leads to a long-term edge. For instance, easy makes them easy to arbitrage away. Doing things that are hard is not sufficient for generating such an edge (there can indeed be hard but stupid things) but does seem necessary.

8 And it makes me a very thankful man for the investors I’ve (mostly) encountered in my career.

9 A. Frazzini, D. Kabiller and L. H. Pederson, Financial Analysts Journal 74:4 (2018).

10 This coming from me who prefers my own acronym MAGFANTs (Microsoft, Apple, Google, Facebook, Amazon, Netflix, and Tesla) to the more well know FANGs. It’s my foreword and I’ll be a hypocrite if I want to be.

Introduction

Trade-Offs All the Way Down

For as long as I can remember, I have been fascinated—nay, obsessed—with asset allocation.

I know what you’re thinking—this guy needs more hobbies.

And you’d be right, but that’s neither here nor there…

My infatuation with asset allocation stems from my strong conviction that diversification—true diversification—is indistinguishable from magic. I mean, think about it. To put different investment ingredients together in a blender and have the resulting smoothie taste great and be less filling than the sum of the parts?

The direct parallels between asset allocation and our everyday lives captivate me. Whether in markets or in life, we continually walk a tightrope of trade-offs in the decisions that we make. Want to be physically fit? You need to balance the trade-offs between a healthy diet and exercise against your desire to watch TV and eat the things you enjoy. Want to have a successful career? You need to balance the trade-offs of a higher salary and recognition from your peers against your willingness to work long hours and spend time away from your loved ones.

This brings us to the myriad trade-offs we must make as investors: return objectives, risk tolerance, income needs, liquidity preferences, tax considerations, and so on and so forth. The deeper you go, the more you realize that it’s trade-offs all the way down.

For the last several decades, traditional asset allocation techniques have proved sufficient in helping investors achieve their most important financial goals. It is my belief that while the conventional core building blocks of portfolios—stocks and bonds—will still be necessary going forward, they are no longer sufficient.

To that end, I have spent an inordinate amount of time over the last decade-plus of my career researching modern approaches to asset allocation and leading-edge portfolio construction techniques. I believe that most investors have historically been limited in terms of the types of diversification they can access, but that is changing.

My raison d’être with The Allocator’s Edge is to reach other forward-thinking financial advisors and investment professionals involved in the asset allocation process who believe we can do better than the status quo. Some will be resistant to change, while others will keep an open mind. Either way, I’m confident those who bring an unwavering commitment to doing what’s necessary to improve their clients’ odds of achieving their most important financial goals will walk away from this book more confident than before in that very possibility.

The road to success in this new era will not be paved with the familiar and comfortable. It is no secret that old habits die hard. But excellence in asset allocation requires a continuous evolution of ideas. We now live in an era where alternatives can stand on equal footing with stocks and bonds as a third pillar of diversified portfolios. The evidence and rationale are too compelling to ignore.

Writing instructor David Perell encourages authors to write at the intersection of what they know, what excites them, and what others want. I’m confident I’ve got the first two covered and it is my hope that in picking up The Allocator’s Edge you possess the third intersection of this Venn diagram.

When I set out to write this book, I had four main priorities with the end reader in mind. I wanted it to be:

Interesting

Accessible

Comprehensive

Actionable

If after reading The Allocator’s Edge you feel that all four of those boxes have been checked, that’s about the best compliment