The economics at the bedrock of our portfolio strategies are flawed. Pancake strategies wide in circumference and shallow in depth.
CalPERS, the country’s largest pension fund with $235 billion in assets under management, has given up on investing in in-state private equity and venture capital as first published by Pensions & Investments last week, and some $2.7 billion (of already massively reduced commitment) in venture capital will be taken off the table and redistributed to other asset classes.
A move I suggested (in a blog called “Dumb money, please exit here”) more than two years ago, after having studied CalPERS’ portfolio strategy in venture and having met with their executives in person on several occasions.
Experts they are not
Way back I asked CalPERS’ Chief Investment Officer Joe Dear in a 1:1 conversation the following direct question: “Why do you think that the deployment of 10 levels of bottom-heavy diversification [in venture capital] will ever generate consistent outlier returns?”, to which he then and now by virtue of his reported retreat from private equity and venture just answered: “I don’t know.”
The geniuses of Hamilton Lane, PCG Asset Management as well as CalPERS’s staff (CalPERS deployed a bilateral direct and indirect investment strategy) don’t know, given their inability to line up a viable portfolio strategy to the massive greenfield available to the underlying assets.
For years, lobbyists, statisticians, finance professors, fund-of-funds, and venture capitalists loaded with “the benefit” of the statistical performance of a bull market have sold to pension funds that their asset management strategies and participation will survive the test of time. Foolish, of course, because a demi-cartel in venture (and other asset classes) made up of colluding investors can by economic principle never scale to find outliers consistently.
But pensions funds resorted to the wisdom of modern statistical and mathematical analysis as proximity to hindsight that was supposed to deliver unique foresight. Not so much, according to CalPERS CIO Joe Dear, who openly admitted on stage at an investor conference that none of the statistical information and theories provided to him, and he said to have had access to the best this world had to offer, have worked.
Just recently, Paul Pfleiderer, as the C.O.G. Miller Distinguished Professor of Finance at the Stanford Graduate School of Business and co-founder of Quantal International hopelessly defended his stance on the Modern Portfolio Theory (MPT, from 1952) in an article on TechCrunch. Paul’s arguments of defense highlight precisely what he and other supposed experts have been missing for so long, and has led The Economist to summarize the macroeconomic problems at the top of the food-chain spot on:
Economists need to reach out from their specialized silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work.
Capital is a derivative
I rebut Paul’s arguments with a dose of practical reality:
“The problem with today’s diversification strategies deployed by Institutional Investors is that horizontal diversification (across asset classes) is chockfull of embedded bottom-heavy diversification (in each asset class), for example, at least ten levels deep in venture.
And thus, a perfectly sensible theoretical diversification strategy across asset classes is eroded by the reality of ever-spiraling fragmentation of money and risk that subsequently (and guaranteed) turns every asset class subprime. So, the theory and implementation of diversification strategies conflict with each other.
To fix asset management, we need to ensure finance is held to the same merit as the value of its underlying asset (so it can trace and support it accurately), which includes eradicating the ballooning and finite bets on itself that currently account for finance 11 times the size of production.
No asset management strategy you can design in a finance lab and sell to institutional investors can succeed with that kind of economic imbalance.”
No formula for success
The academic “porn” deployed by these economic theories is that they base their success on mathematical equations implemented at the asset manager level. Ignoring comfortably that the investments contained in the asset management portfolio are not at all created equal (not even within a single asset class) and that the risk profiles of outliers assets are, by definition, composed non-uniformly. That more than 80% of the risk of a portfolio strategy is attached to the embedded risk limited partners, have no control over nor experience assessing, and that under flawed economics, excessive bottom-heavy diversification and fragmentation have turned the asset intake by economic principle subprime. And hence, the make-up of the mathematical formulas for portfolio management is nothing more than a utopian theory that has absolutely no reflection on reality.
To make that point more palpable: it is entirely plausible to predict that if you give a group of men and women access to eHarmony, a certain amount will check each other out on a date. Is it entirely implausible to predict how many will fall in love with each other and produce children of healthy emotional and economic standing, and then extrapolate those early findings to the future?
The pancake economics deployed by asset managers exacerbates the flawed notion that mathematical computation will yield outlier portfolio returns. And would we not all deploy such theories if they produced success and thereby refute its outlier value? Or have we done just that?
Economics to the rescue
The much more straightforward answer to a successful portfolio strategy lies in the establishment of top-down economics. In the establishment of a marketplace in which the needs of investors are married with the requirements of entrepreneurs. That the rules under which the supply of, and demand for money, adheres to the guiding principles of a meritocracy and the appetite for risk and return are enforced throughout the complete financial value chain, acting as its arbitrage.
Today’s portfolio asset management strategies are a laughing-stock, in which venture capital’s general partners have admitted to me on more than one occasion that their limited partners are not the sharpest tool in the shed. One cannot breed the brightest minds and products of innovation with a financial value chain awash in endless diversification, fragmentation, and plain economic stupidity.
Zero tolerance for subprime
We can easily foresee many other pension funds and partners of CalPERS in the Institutional Limited Partner Association (ILPA) following suit, which will lead to accelerated attrition of venture capital as an asset class. And that is a good thing because we have zero tolerance for subprime investors that are responsible for attracting the massive cloud of subprime entrepreneurs that fog the faith and opportunity for prime. False negatives are currently drowned out by the enormous volume of false positives, with few limited partners seeing the forest through the trees.
Finance needs to get smarter (and simpler) if it wants to leverage the smarts of its underlying asset. And merely diminishing subprime does not increase the amount of prime. The economic fallacies of finance are already severely hurting our capacity to produce. But further attrition of the venture asset class is counter to the exploration of an 80% greenfield of technology adoption. And not just venture has turned subprime, but all asset classes will inevitably turn subprime if we do not change the economics under which our portfolio strategies operate.
The pressure is on
The economics at the bedrock of our portfolio strategies are flawed. And we better act quickly in resolving those, unless we want some nation with a steadily maturing entrepreneurial culture and a more well-thought-out economic and financial policy to eat our lunch.
Doing nothing – or not the right thing – will be all of our loss.