January 22, 2010
As a starting point, the first step for a good portfolio manager is to identify the asset class. So exactly what is asset class? According to MPT, from a numerical perspective, an asset class differentiates from one to another wrt return, volatility of return and more importantly covariance. But merely treat asset class with respect to its numerical attributes is missing the deeper meaning of the concept and hence bounded to be misguided when choice asset classes and pursuing diversification. The basic concept of diversification is to construct a basket of asset whose return does not correlate with one another hence one factor of general environment affects a limited part of the whole portfolio. Invest benefits by trying to understand the source of value creation when analyzing their portfolio. Value can be created through a variety of ways.
Taking forest land for example, the value creation process in this case is nature biological growth of tree. The asset itself does not diminish during the value creation process, and better forestry management enhance the timber yield in a sustainable way. Other auxiliary value could be created in the process, for example, better resource management might improve the environmental quality of the surrounding area and therefore increase the desirability of property near the forest land. So roughly speaking, there are three components of value creation in this case: 1) the natural growth rate, which is the reward for planting the seed and create a desirable resource 2) direct, observable value enhancement through better management 3) indirect, hard to monetize enhancement through step two.
Taking this analogy one step way into equity market. The first layer of value creation is through accumulation of capital. As a scarce resource, capital is rewarded with approximately risk free interest rate. For putting the capital in a risky position as oppose to risk free asset, a premium is demanded which should be linear wrt to the risk assumed, this can be considered as merely enhance the return on investment through leverage, which should constitutes part of the conventional equity risk premium. Equity market as a whole wrt to debt demands another type of reward, which is for the business activities private sector going through with incorporate and organization in general sense. This part of reward(1~2%) together with the reward for assuming the capital risk constitute the equity risk premiums. For U.S. market debt ( 2% return v.s. 10% risk) is consistent with equity ( 6% return v.s. 20% ; assume 2% premium for business activities), the result is consistent with this assumption. Through better management and operation (buy out in pure sense), propitiatory technology (GOOG, 70% return v.s. 50% vol, which implies, after normalize with debt vol, 2%(capital)+1%(corp)+9%(management+prop)), the equity return can be improved wrt to benchmark.
Another source of value generation is liquidity. Due to the behavioral and capital constrain, patient investor is rewarded for holding illiquid asset over long period of time. According to Yale endowment data, the adjusted liquidity premium should be around 2% in long term. Besides, absolute return provide another source of value through enforcing market efficiency. The caveat for this two strategy is that historical data might paint an overoptimistic picture for the future. Real asset vol is normally underestimated due to low observation frequency; absolute return data normally suffer from back filing and survival bias.
Applying this conceptual framework, many diversified portfolio might not be as what investor expected. For example, Private equity (buy out and VC) in purity extract value through improving management and spotting promising prop technologies. However, if, and in most case, the main component of PE’s PnL is generate through leverage and late stage IPO financing, investor will not have much true diversification compare to boarder equity market.
Also, most traditional 70/30 equity/debt portfolio actually over weighted in capital component and over concentrated on corporation activity component. a comparison of best endowment portfolios and mean portfolio illustrate the case:
Components Yale: Mean
cap 33% 50%
corp 20% 38%
mange+prop 13% 3%
liquidity 20% 3%
absolute 16% 6%