Investing 2.0

We are about to enter a new and scary phase, one where there are few good answers to the question: Where should I invest my money? Risk premiums and liquidity costs are skyrocketing. Short-term Treasury yields are approaching zero and could possibly go negative, as they did in Japan during the depths of its crisis (when holding short-term government debt is akin to paying a custodian for holding a physical asset). Long stock investments likely won’t look attractive on a stand-alone basis for the foreseeable future. Long bond investments except for top-rated corporates and sovereigns will pretty much be avoided. Real estate? Commodities? The problem is exacerbated for pension and endowment managers, whose liabilities still need to be fulfilled even if portfolio returns drop. The thirst - in fact, the necessity - for identifying and capturing alpha will be even greater than it is today. So how should investors think about navigating today’s hostile environment?

My hypothesis is that the investment portfolios will begin to look like a barbell, where institutions will hold:

1. Larger pools of cash and near-cash;



2. Smaller portfolios of long-only stock and bond investments; and



3. Growing portfolios of alternative investments.

There is a concept in bond math called convexity. Positive convexity is good because it means for parallel shifts in the yield curve, portfolio value rises more and declines less than it does with less convex portfolios. And convexity tends to be maximized by creating barbell portfolios, those containing a mix of very short maturities and very long maturities and nothing in between. I see a strong analogy between this dynamic and that of Investing 2.0 portfolios, where the stuff in the middle, long-only portfolios of stocks and bonds, will be out of favor while the twin objectives of liquidity and alpha will dictate portfolio construction. And those portfolios will be barbells.

Fiduciaries of all stripes are sweating. How can we possibly achieve our return goals in an increasingly adverse investment environment? The fact is that opportunities abound for those with ample liquidity and a long holding period, and will only become greater as the market continues to work through the debt overhang accumulated over the past decade. And this purge-and-cleanse period will likely take even longer due to the lack of trust rippling through the system, where many constituencies - from employees to retirees to small and large investors across the globe - feel they were hurt by their companies, regulators and leaders. Sad, yes, but this adjustment phase will create enormous opportunities for those with the vision and capital to take advantage.

Savvy, long-term investors will use this opportunity to deploy capital in alpha-generating strategies with longer time horizons, while using their large pool of short-term liquidity to meet current obligations. As some of the gains from the long-dated portion of the portfolio are harvested, they will be redeployed into new alpha-generating strategies or used to augment the liquid portfolio.

And as I noted in Investment Banking 2.0, small is beautiful. Boutique investment banks focused on providing merger advice, general corporate strategy, private placements and alternative investments. Venture capital firms that still do real venture capital, focusing on seed stage, A and B round investments. Focused hedge funds that are excellent at specific disciplines, and haven’t diversified away the lions’ share of managers’ returns.

I also believe that classic bulge-bracket investment banking, e.g., underwriting, research, distribution and trading, is a natural oligopoly. The high fixed-costs associated with operating these platforms screams out for consolidation. The world does not need 50 of these firms; possibly not even 20. I see the middle getting squeezed, with regional and industry-specific full-service broker/dealers falling by the wayside. They simply won’t have the resources necessary to compete. Again, we will see a barbell structure, one dominated by a handful of giants enjoying scale economies and smaller, nimble, highly profitable boutiques.

One issue that needs to be addressed is capital formation between the venture-backed start-up and the $1 billion+ IPO. This is a gap the must - and will - be filled. I see a rise of alternative exchanges, like GSTrUE and Opus-5, stepping up to meet this need. Venture capitalists need exits. Companies need to diversify their investor base and gain access to new pools of capital. And investors need access to top emerging companies before they reach multi-billion dollar valuations. Innovation, as always, will rise to meet the challenge.