A Postmodern Permanent Portfolio

“Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.”

-   George Soros

Takeaways:

·        A modified permanent portfolio approach should yield exceptional risk-adjusted returns in the coming years  

·        Since the 2007-2008 financial crisis, wealth creation has been generated almost entirely on the back of declining interest rates and systemic debt assumption, two un-repeatable dynamics

·        Looking forward, credit-influenced volatility and liquidity expressions, rather than asset class allocation, is the optimal framework for constructing balanced portfolios

·        Less-liquid, under-leveraged assets should outperform more-liquid, over-leveraged assets

·        Assuming the tech is able to scale, and with a total unleveraged market cap of less than $150 billion today, digital assets (both distributed networks and venture equity) should outperform established financial assets by a wide margin

·        Blockchain assets are a high-impact portfolio diversifier

 In 1982, Harry Browne created the permanent portfolio, which consisted of equal parts U.S. growth stocks (25%), long-term Treasury bonds (25%), gold (25%), and T-Bills (25%). The all-weather portfolio was meant to provide ample growth during periods of expansion, recession, inflation and depression.

According to Investopedia, a hypothetical permanent portfolio would have generated annual returns of 8.65% from 1976 to 2016, while a basic 60/40 (60% stock, 40% bond) portfolio would have generated 10.13% over the same period. [1] However, the standard deviation of Browne’s permanent portfolio was 7.2 vs. 9.6 for the 60/40 portfolio, meaning it actually outperformed in “risk-adjusted terms” (assuming asset volatility equals risk).

Looking forward, the absolute real performance of both 60/40 and Browne’s permanent portfolio will unlikely be repeated because: 1) interest rates cannot decrease (bond prices cannot increase) as much as they did from 1976 to 2016; 2) significantly rising interest rates would greatly reduce the value of all assets, including stocks, bonds, real estate and most collectibles; and 3) asset values as a percentage of the broader economy are nearing their 2000 peak.

As it stands, ongoing access to credit that promotes asset inflation determines “risk-on” or “risk-off” appetites across established asset classes. Were the Fed and other global central banks to again drop funding rates to zero (and negative) in an attempt to add credit to the system and boost confidence, it would unlikely be as impactful as it was from 2009 to 2017. Balance sheets have already been refinanced at rock-bottom rates. (See Figure 2, below.) This state of affairs is troubling.

The alternative asset market, which began to scale in the nineties, was supposed to provide access to uncorrelated assets, strategies and returns. The 60/40 portfolio was modified to some variation of 50 (stocks)/30 (bonds)/20 (alts). Since the financial crisis, however, the credit-funded rise in stock and bond prices (beta) left risk-adjusted investing in the dust. Under-performance and higher fees in the alt space greatly reduced acceptable uncorrelated, alpha-seeking strategies and managers.

Against this backdrop, how should investors construct a balanced secular portfolio to accommodate potential growth, inflation, hyper-inflation, deflation, contraction, recession and depression?

 Credit => Asset Liquidity => Asset Values :: “Good vs. Bad Volatility” 

Let’s be logical. Asset liquidity is derivative of ongoing credit availability. If access to credit determines the ongoing sponsorship level and direction of market-priced assets (our premise), then market priced assets (including real estate and anything else directly or indirectly priced off of increasing or decreasing credit conditions) must compete as destinations for that credit. The more an asset class relies on credit, the more likely it is to suffer if systemic credit generally slows or contracts, or is re-directed away from it. The opposite is also true: the less an asset class relies on credit, the more likely it is to benefit if systemic credit generally increases or is re-directed towards it.

Further, asset volatility generally occurs when prices that have been at equilibria (where supply meets demand) suddenly break from equilibria. Prices may break higher or lower, depending upon myriad inputs. In theory then, asset volatility can help or hurt performance in equal measure. However, most investors have been conditioned to equate volatility with risk and not with reward because a sudden increase in price volatility is usually applied to assets directly or indirectly leveraged and trading at or near equilibrium levels. So, a portfolio that is 100% exposed to relatively stable volatility will suffer.

Tight Credit / Low Liquidity / High Volatility

Each quadrant should be populated with assets that would flourish for each quadrant’s credit/liquidity/volatility scenario. Basically, assets in the top two quadrants would generally benefit from stable markets while assets in the lower two quadrants would benefit from change.

The obvious challenge, almost forty years into a secular credit expansion, is to find enough assets that would benefit from tighter credit conditions and rising volatility. By definition, such assets would have low market caps today. But that should not dissuade investors.

Sophisticated gamblers and financial asset speculators may be familiar with the Kelly Criterion, which seeks to quantify how much to bet on an outcome given its odds of success. Generally, the longer the odds of an outcome occurring, the greater the payoff if it comes to pass, and the less one needs to bet on it. Applied to portfolio construction, the more volatile an asset may be, the less its portfolio weighting must be, and vice versa. This implies that instead of equal weights for the top (short-volatility) and bottom (long-volatility) quadrants, investors need only define the potential impact (payoff) of each. 

Potentially high octane assets with asymmetric return complexions should populate the bottom two quadrants. In theory, there is no asymmetry of returns on unlevered (i.e., fully-paid for) assets. In reality, however, an asset that has not been sponsored by credit, but that may be in the future (i.e., it is “leverage-able”), may rise with great volatility. Therefore, the allocation decision for the bottom two quadrants comes down to which un-levered assets have fundamental economic merit.

Blockchain Assets => High-Impact Portfolio Diversifier

With less than $150 billion in total un-levered market cap, blockchain digital assets (distributed networks and venture equity) have the potential to outperform established financial assets by a wide margin. Their success or failure will come down to their economic merit, which may be further reduced to whether the technology advances to the point where various use cases can scale.  

A critical assessment of the blockchain scaling issue may be found in this McKinsey report, which seems to capture the general skepticism overhanging the space; basically: “the technology has not yet seen a significant application at scale, and it faces structural challenges…” [4]  

We believe such skepticism is more than fully-discounted in the valuations of certain digital assets. In our informed opinion, the tech (specifically, networking solutions) will advance sufficiently in the next few years to allow substantially more throughput capacity across use cases, in turn allowing certain digital assets to scale and take significant market share from incumbent businesses with huge current market capitalizations. (Please see Joey Krug’s recent thesis.)

Blockchain businesses with equity cap structures that provide scaling solutions and cheaper and easier on-ramps for blockchain applications should generate substantial ROIs in the coming years. We believe financial and commercial blockchain applications that become operable and popular as a result of upcoming scaling innovations are currently trading at one to ten cents on future dollars (potentially 10x to 100x returns with 40% to 200% ROIs). Further, the rate of innovation in the underlying blockchain tech is uncorrelated to economics and traditional capital markets, and therefore may become operable and very profitable at a time when beta financial markets suffer.  

Blockchain exposure puts the “alt” back in alternatives. Is there a 0% chance the tech will scale (i.e., a 100% chance the tech will fail)? We don’t think so. In fact we see a clear path to scalability, and that is the opportunity. A 0% weighting to blockchain today is as imprudent as a 50% weighting would be.

Paul Brodsky

[email protected]

[1] Investopedia; https://www.investopedia.com/terms/p/permanent-portfolio.asp

[2] Advisor Perspectives; https://www.advisorperspectives.com/dshort/updates/2019/01/03/market-cap-to-gdp-an-updated-look-at-the-buffett-valuation-indicator.

[3] McKinsey & Co; https://www.mckinsey.com/industries/financial-services/our-insights/a-decade-after-the-global-financial-crisis-what-has-and-hasnt-changed.

[4] Mckinsey; https://www.mckinsey.com/industries/financial-services/our-insights/blockchains-occam-problem.