Franz served as the Chief Investment Officer of the Max Planck Foundation in Munich from 2008 to 2021. He was the first employee at the foundation and built a broadly diversified, global portfolio across traditional and alternative asset classes in both developed and emerging markets. He also established the foundation’s infrastructure and back-office operations.
In this newsletter, Franz shares with us his view on how asset allocation has evolved in a dislocated market context.
1. Is it true that the traditional 60/40 allocation model is obsolete, and a new paradigm has emerged? Why and how so?
The 60/40 model (MSCI USA/US treasuries) outperformed broadly diversified alternative investment portfolios, with the performance of US Endowment & Foundations (“E&F”) as a proxy, over the 10 years ending in June 2020 (fiscal year for E&F). It generated a 10.0% p.a. return, while US E&F generated an average return of 7.5% p.a. (source: NACUBO), underperforming 60/40 in 7 of 10 years.
This, however, happened in a period of a bull market in both bonds and equities. In June 2010, the MSCI USA forward PE ratio was at 12.5 and the 10-year US Treasury yield at 3.0%, which moved to a PE ratio of 25 and a US Treasury yield of 0.65% in June 2020. As a rule of thumb, the forward PE of 12.5 in June 2010 would have suggested an 8% p.a. return in equities, the doubling in multiples resulted in a 14.1% p.a. Today’s starting point is significantly higher with a US forward PE of 23 resulting in an expected 4.3% p.a. return (lower in the rest of the world, with MSCI Europe fwd PE of 16, MSCI EM of 13 and globally an ACWI fwd PE of 19). The same is true for fixed income, with 10-year yields negative in most of Europe and at 1.8% in the US.
This results in an expected nominal return significantly lower for the coming 10 years of around 3% from a US perspective and slightly higher for the rest of the world. A reversion to mean in valuations could lead to even lower performance.
2. How should a Family Office investor decide whether to build his or her private market exposure, as a rule of thumb?
Building exposure to private markets is a function of risk tolerance, liquidity needs, diversification aspects and available in-house skills. The two ways to go are through primary commitments to private equity funds and / or invest directly into private companies. The risk ladder goes up from committing to broadly diversified fund-of-funds to single funds to direct investments, and from mature buyouts to early-stage venture capital. Defining risk as the permanent loss of capital (instead of volatility) should be part of risk considerations.
Private Equity is a long duration asset class, and fund lives are on average 13 years, and even longer for venture capital funds. It is important to commit and invest with a vintage-year approach through cycles and avoid pro-cyclical behaviour, not investing more money and faster in boom times and less in recessionary or crisis periods. This also partly addresses the liquidity challenge, with a mature, vintage year diversified portfolio generating individual liquidity events more constantly over time.
A key consideration are the available in-house skills. Indirect and direct investments are related but require different skill sets. The higher the risk taken, the more specific the skill set required. Depending on size and organizational constraints, it is a make-or-buy decision to either build the necessary resources in-house vs. outsourcing to specialized service providers.
3. Increasing inflation is now a reality. Higher interest rates are looming. Should this impact the % allocation to PE/VC?
The impact of inflation on financial markets and investor portfolios depends on the macro regime and investment horizon of an investor. In a volatile macroeconomic environment like the 1970s and 80s, only cash and commodities provided hedging characteristics against inflation on a short-term basis. There is also an expected negative correlation between equities and inflation in periods of countercyclical inflation when supply shocks or changing inflation expectations impact the economy. When there is high expected inflation, it tends to result in higher uncertainty about growth and an increasing equity risk premium.
In periods of a stable macro regime, cash again provide a good hedge against inflation on a short-term basis. Longer-term, equities are a good inflation hedge as inflation is typically procyclical and positive inflation shocks take place within improving macroeconomic conditions.
Generally, however, the longer an investor’s time horizon is, the more most asset classes display an increased correlation with inflation, i.e., that inflation hedging properties improve with increasing investment horizons. In particular the value of alternative asset classes grows in protecting the portfolio against inflation.
The current situation is more complex due to the global pandemic and its impact on economic activities and supply chains. Short-term inflation is influenced by base effects, a strong increase in oil prices and pandemic induced supply chain disruptions. Services inflation did not fall due to subsidies, as would have been the case in a regular recession, and goods inflation increased significantly due to changed buying behaviour of durable goods. These should, at least partly, correct over the course of 2022.
Mid- to long-term, a peak in global trade, which has been flat since 2010, and increased onshoring as a learning from the pandemic, tighter labour markets and big government are all inflationary forces.
On a longer-term horizon, Private Equity has the ability to provide good inflation hedging properties. It, however, also depends on industry specifics, as those with more inelastic demand like e.g., healthcare should have better inflation protection compared to other sectors.
4. Tech disruption is everywhere, and the rise of tech companies is impossible to ignore. How can a private investor best take advantage of it, for optimal risk-adjusted return?
The predominant vehicle for technology exposure are venture capital funds. The US share of global venture capital funding is about 45%, followed by China with ca. 40%, with Europe representing ca. 10%. The US has close to 2,000 VC Firms, compared to ca. 14.000 in China and less than 1.000 in Europe. The asset class is most developed and liquid in the US, with the Nasdaq as a proxy having a market cap of $24.5trn, MSCI China Information Technology Index of $3.3trn and the MSCI Europe Information Technology with a market cap of $0.8trn. While the US is the place to be, both in terms of breadth and liquidity, China is a relevant market but significantly more difficult to diligence. Europe has had positive developments over the last few years, but still lags other markets.
Know-how and required skillsets are specific and difficult to build inhouse. Commitments to Venture Capital Funds, however, come with the hurdle to have access to the best funds. The return dispersion between a top and bottom quartile fund in Venture Capital is by far the widest of all Private Equity sub-strategies. Access to preferred funds is a key parameter to investing, as an investable “venture capital beta” is not available.
The same is true for direct investments in venture companies. Unless dedicated technology and investment skills are inhouse, the recommended route would be to choose a specialist third party for sourcing, due diligence and investing.
Finally, one must be aware about the long duration of the asset class. The average venture capital fund has a life of 15-20 years, despite the usual 10-years communicated in a fund’s offering documents. Holding periods for venture capital companies have nearly doubled over the last 10 years, as ever more capital available allowed to stay companies private for longer. A disciplined vintage year approach and committing through cycles is important in executing a venture investing program.
5. How strongly do you rate diversification, by sector, region and stage, but also in terms of Fund v Direct investments?
The below numbers are illustrative for the mean reverting characteristics of financial markets. The same applies for regions, countries and currencies, in particular in emerging markets.
The S&P 500 weights for the largest sectors experienced meaningful changes over the last 20 years:
· Information Technology had a 20% weight in 2000, 17% in 2010 and 26% in 2020
· Communication Services at 6% / 8% / 15% in the years 2000 / 2010 / 2020
· Financials were at 19% / 16% / 10% in the years 2000 / 2010 / 2020
· Consumer Discretionary with weightings of 5% / 8% / 12%, in the years 2000 / 2010 / 2020
An important point to keep in mind when thinking about regional allocations is that regional returns are driven by sectors dominating these regions. The performance of USA vs. Europe can be expressed by the biggest relative sector over-/underweights. As of June 2020, the MSCI USA had an allocation of 28% in Info Tech and 11% in Communication Services, while Europe had 7% and 4%, respectively. In Financials, the USA had a 10% weight while Europe was at 15%. A long “MSCI World Information Technology Index” / short “MSCI World Banks Index” trade mimics the performance of MSCI USA vs. MSCI Europe, consequently. A similar relationship exists between developed and emerging markets, with the latter underexposed to Health Care and overexposed to commodity producers.
Currencies tend to mean revert in the major currency pairs but can be very volatile in emerging markets with a significant impact on performance.
Investors can deviate from benchmarks and over-/underweight certain sector and regions. These decisions should be documented and serve as the basis for regular review, especially if the decision is detracting performance.
Diversification between fund vs. direct investments depends on size / AUM, risk profile and skill set. Volatility and losses will be lower / higher with fund / direct investments, but the latter can compensate with higher returns. Ideally, direct investments complement fund investments, the magnitude in one’s asset allocation depends on the criteria above.
