Six Myths of Portfolio Construction, Part II

Myth #4: Private Equity is the Place to Be
It’s getting harder and harder to get killer deals in private equity. There are so many PE shops scouring the globe that getting the right thing at a bargain price is wishful thinking. If the price is a bargain, it’s that way for a reason. Private equity is becoming more and more like public equity. The Internet is making this asset class more efficient every day.

One exciting development for people in private equity is that we’re learning much more about how to run companies than we ever knew before (and than they still teach in business school). By becoming lean and agile, most companies will become far more efficient and innovative, able to better keep up with today’s increasing pace of innovation. I have written a book about this and have a web site dedicated to business agility. Since most PE fund managers have very little operational experience, they should seek out people who can help them increase productivity, employee satisfaction, and customer wow using the principles of business agility.

Myth #5: Smart Venture Capitalists Beat the Markets
According to the Kauffman Foundation’s excellent report, We Have Met the Enemy, and He is Us, venture capital is a poor asset class. The people who think they can pick the winners are fooling themselves, as we have seen above. This article from CB Insights shows that, even though all the VCs think they can pick the billion-dollar companies beforehand, the data shows otherwise. In fact, recent studies have shown that venture capitalists have a strong bias toward funding good-looking white males.

It’s important for investors and venture capitalists to understand that a venture capital fund is not a machine that generates either companies or profits. A VC fund can only do so much. One thing they can do is get cash to entrepreneurs who probably can get it from other sources (they rarely fund companies that don’t look tasty, trendy, and backable). Another thing they do is give advice that the entrepreneurs can probably get from other sources. And a third thing the VCs do is help them find exits that are good for the fund (the sooner the better). Any venture capitalist who thinks he can steer his fund into the top quartile of returns, above the dividing line between 1st and 2nd quartile, doesn’t understand statistical variance. Once again, 25% of funds HAVE to be above that line, by definition, and several funds have found themselves above that line several years in a row, but cause and effect is dubious at best. It’s likely that in ten years of venture investing a fund will be able to point to two or three deals that contributed to most of the profits, and if you look at those deals carefully you’ll see that timing and luck had a huge amount to do with the outcomes. Bessemer Ventures has published a list of companies they passed on, any one of which would probably have outperformed their entire portfolio.

Believe it or not, there are ways to make money in venture capital, but not the way most VCs do it. You need to harness the power of convexity – making small investments that have big payoffs, capturing beta, rather than alpha. A few funds are already on this track, and a couple of them actually have the statistical understanding to make it work. More on that in a minute.

Myth #6: The Future Looks Like the Past
The next five years in investing are going to be nothing like the last five years. Mark Spitznagel has a compelling argument for our current stock market situation being another house of cards, ready for a significant correction. Why do we keep falling for the rosy scenarios when things are good and then believing the world is over every time markets collapse? Neither is true. Mean reversion is more powerful than prediction. If you believe in mean reversion, then you must admit that the road ahead is extremely risky. It’s impossible to predict the future, but it’s very likely that some huge corrections are in store, somewhere, at some time in the next several years. There is almost zero percent chance that the next five years will look like the last five. There is hidden inflation that isn’t reflected in the official numbers (we’re not really measuring inflation correctly to begin with). There is hidden unemployment. There are dangers in the increasing gap between ultra wealthy and middle class. In short, it’s the unknown unknowns that often show up as black-swan events and trash portfolios, even portfolios based on MPT.

Modern Portfolio Theory has disappointed many of its customers, and that’s because we don’t live in a world with normally distributed events. We live in a world of black swans, complexity, emotion, and surprises. Perhaps the biggest myth in portfolio construction for the past twenty years has been the belief that modern portfolio theory models the world and its uncertainties accurately. It doesn’t. It’s best to remember that all models are wrong – it’s a matter of how wrong – and we don’t get to find out until later.

To put these myths into a larger perspective, Doug Hubbard, author of The Failure of Risk Management, explains:

In response to the 2008 financial crisis, several of the major consulting firms and standards organizations have charged in with a variety of “solutions” for risk management, none of which is better than consulting astrologers. The worldwide financial system remains as interdependent, fragile, and poorly understood as ever.

Investor alpha is largely an illusion, a story told by people who have gotten lucky. I believe one should hope for the best but be prepared for the worst, taking the growing list of human cognitive biases into account.