Last week I celebrated my birthday, and this week I got to enjoy one of my birthday gifts – Warriors tickets (NBA basketball). My in-laws sweetened this gift by also volunteering to watch our kids, so my wife and I could go together.
The drive from home to the arena is modest in miles and daunting in drive time – LA traffic. I laugh in hindsight, but I was fumbling to find directions, as I kept asking Siri to pull up directions based on the old name of the arena. I’d ask to be navigated to “Staples Center” and Siri kept trying to direct me to the local Staples office supply store. I had forgotten that the name was changed at the end of 2021 to the “Crypto.com” arena (no comment).
Eventually, I remembered the name change, was able to map out directions to our destination, and we enjoyed an evening of basketball – even though the Warriors lost 🙁
This is a very simple lesson, right? You need to know the name of your destination before you can map out directions. As you may have assumed, I have a personal finance parallel here, but let’s start with some background…
Back in March 2020 markets were bottoming, as investors and the world was trying to make sense of COVID. As stocks were bleeding, some investors were shocked to find that their “bonds” were also depreciating at a rapid pace. I hold bonds in quotations here because classical finance categorizes investments into four primary categories: stocks, bonds, alternatives, and cash. Within these categories there are subcategories, and even subcategories of those subcategories, but portfolio pie charts and performance are often reflected in this macro view of stocks, bonds, alternatives, and cash.
So, what was happening to “bonds” in March 2020? Well, high-yield or junk bonds were behaving like stocks, which based on their risk/reward characteristics, would be expected. Treasuries on the other hand – also bonds – were appreciating in value, also to be expected, based on the natural “flight-to-safety” reaction to tumultuous markets.
But… All you would’ve cared about was what was happening to YOUR bonds. And this had a lot to do with what mix you had of high-quality bonds versus credit-sensitive bonds. Just like me trying to navigate to “Staples Center” wasn’t giving me the answers I needed this broad definition of bonds wasn’t giving investors much clarity or comfort.
David Bahnsen responded to this reality with quite a large project that he coined, “Magnify.” Just like a magnifying glass can provide better visibility, Operation Magnify sought to give investors more clarity regarding their own investment portfolio (see: Magnifying Old and New Lessons – A Dividend Cafe for the Ages).
Much of this project was simply assigning the right names and classifications to the type of investments people owned. This was a taxonomy of such. I do harken back to my introductory story, in that an antiquated name doesn’t provide much help as your creating your own financial road map. This classical convention of stocks, bonds, alternatives, and cash is outdated, and it did need to be magnified.
So, what is Magnify? For our clients, these revised classifications became how we (1) presented the allocations or design of one’s portfolio and (2) reported itemized performance category by category. Every single dollar and every single investment would be classified into one of these seven magnified classifications. Our primary building block here would be our Core Dividend portfolio and then our next six categorizations are each basically a bifurcation of that traditional nomenclature of stocks, bonds, and alternatives. Each of these allocations, or what I often analogize as ingredients, was meant to be layered on top of this Core Dividend portfolio. Although every portfolio started with that same core building block it would be rare that all other ingredients would exist for one investor – the additions/subtractions are all part of the customization process.
With that said, “stocks” magnified into Income Enhancements and Growth Enhancements. Here we begin to see what that customization looks like in a practical sense, as an investor in the accumulation phase would be much more likely to resource Growth Enhancements versus one in the distribution phase of their investing life where Income Enhancements may be much more suitable. Just as the name alludes to, each allocation or ingredient is meant to amplify that feature in the portfolio – growth or income. So, an accumulator with a greater “risk budget” might invite that extra volatility in exchange for the amplified growth potential. A “withdrawaler” (one withdrawing from their portfolio) might have a financial plan that would benefit from greater income, hence that enhancement would be appropriate. Note, neither of these allocations is constrained to just the stock market. If another asset class supported the mandate outlined for each of these particular ingredients, it would be included. For example, the investment committee could include a security like a Commercial Mortgage-Backed Securities (CMBS) in Income Enhancements, as it would clearly match the income and risk objective for this ingredient. The “enhancement” moniker really means that one would expect both an enhanced outcome (growth or income) AND enhanced volatility. Based on this, these positions are often rationed in a manner where, as an example, for every $5 an investor has in Core Dividend they may have $1 in Income Enhancements (again, purely an example).
Next, bonds were magnified into Boring Bonds and Credit. This solved the riddle of investor confusion around bond behavior and performance. Boring Bonds were appropriately named, as this is where we’d house treasuries, investment-grade corporate or municipal bonds, and government-backed mortgages. The mandate here is primarily capital preservation and volatility dilution, and income creation secondarily. Credit is the inverse, where we’d seek higher income as the primary driver, and we’d allow or accept volatility similar to the equity (stock) market. This ingredient [Credit] allows a lot of latitude in regard to our shopping list of potential constituents, everything from emerging market debt to securitized credit and high-yield debt to bank loans.
Now, when a client is reviewing performance for a designated period, they see each of these categories itemized for clarity. Note, because some of the Credit allocations are floating rate (versus fixed rate) in times of distress in 2022 (caused by rising rates) we saw some of these credit-sensitive instruments with floating rates experience shallower dips in price. This would not be considered “normal” behavior when Credit delivers less downside volatility than Boring Bonds, but these magnified titles absolutely helped express the narrative here in a much clearer manner for investors.
Alternatives kept their same title in magnify, but they were also joined by a close cousin which we titled Illiquids. In the traditional sense, Alternatives have always been a category where allocators could place anything that couldn’t easily be defined as stocks, bonds, or cash. Because the range of alternatives is so diverse, it has almost become the allocation junk drawer of finance. Now, I don’t mean that the underlying parts are junk but rather an analogy to a drawer where you might find a stick of gum or a pair of scissors.
For me, it has always helped to mentally organize alternatives as either being a hedged strategy or a private investment. A private investment just means I could buy a similar structure on the public markets (stocks, bonds, and real estate) but within alternatives, I would have access in a non-publicly traded format – private equity, private lending, and private real estate. On the hedged side, again my own mental division here, I see these strategies primarily focusing on non-correlation, meaning they don’t behave like stocks and bonds. This reality makes these hedged allocations very additive to a portfolio from a diversification standpoint. Much of the diligence of an investment committee regarding Hedge Funds is based on identifying manager skill. It is this very skill that we derive both the benefit (reward) and the potential risk.
Furthermore, Illiquids needed to be defined separately from Alternatives because the liquidity profile was and is much different. In an evolving world of retail investing – as opposed to institutional – many of these strategies we are labeling Alternatives do have fairly favorable liquidity. Meaning that in normal market circumstances, one might have monthly or quarterly windows for redeeming. Of course, this is not comparable to the daily liquidity one might get in a publicly traded stock, but still an evolution from where the industry was 10 years ago. Illiquids on the other hand, are as the name suggests, illiquid. Here an investor might have direct ownership in a commercial property or a private equity fund with a longer lock-up period or even fractional ownership in a private company. This allocation/ingredient is most suitable for larger balance sheets where one has the capacity and willingness to accept this illiquidity. Of course, the belief here is that this illiquidity in itself thins the investor population – the number of people who could or would want to potentially own these assets – which can create more attractive valuations. Remember, an investment’s starting valuation is one of the greatest predictors of future returns; bargain prices leading to superior returns. This concept is often referred to as the illiquidity premium.
With that, you now have a full re-look at Project Magnify:
As mentioned, I believe both 2020 and 2022 were prime examples of why this classification specificity is so important. We saw how different Boring Bonds and Credit behaved during those time periods, as well as Core Dividend and Growth Enhancements. A great segment of market history to study the benefits of diversification.
I will bring us full circle and remind you of my absent-minded moment when I was asking my phone for directions to the former name of the arena, which obviously wasn’t yielding any results. This experience makes me wonder how many investors are finding themselves lost as they are navigating their own finances with terminology that would be most appropriate to retire, replace, or… magnify.