Innovation: The Latest Asset Class to Disrupt the 60:40 Portfolio

Innovation: It’s a strategy that can both drive the strategy and be the backbone of your portfolio. Direct investment in startups is a trend that has gained ground among private investors as of late, and for good reason. In addition to the SEC’s new guidelines on what defines an “accredited investor,” paving the way for more people to invest in private equity and venture capital, and the Labor Department’s rule changes allowing for retirement funds to invest in PE, investors have a new line to capitalize on direct investment. The investor gets the satisfaction and sense of ownership that comes with investing in a project from the ground floor — and with a good chance of getting some double-digit, market-beating returns to boot.

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Long only open to institutional investors such as pension funds or endowments, access to alternative asset classes such as direct investment in companies opens a venture capital-style approach to long-term investing that can help foster the development of new products and new businesses, all the while offering the opportunity to tap into a healthy source of yield with less correlation to what’s happening on Wall Street. Yet, perhaps the greatest potential benefit to direct investing in small businesses is one that offers returns beyond anything a bank can quantify: being able to make a direct impact in new, small businesses, helping to bolster the economy in a way that goes beyond stocks and bonds.

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Beating the 60:40 portfolio

When it comes to putting together a retirement plan, the longstanding conventional wisdom is the 60:40 portfolio breakdown: three-fifths of that portfolio goes into equities, namely tracking the S&P 500; with the remainder going into Treasuries, considered to be the safest of bond investments. The asset allocation logic is thus: aim for a bit of returns and if things head south, those bonds will keep your retirement from going pear-shaped.

Sounds straightforward enough. Yet if you’ve been up on your economic and financial news over the past decade or so, you’d know that a contrarian viewpoint on this topic has more or less become the investment go-to. Given quantitative easing and interest rates that have been grazing zero, bonds, while secure, aren’t exactly a place to get steady returns.

If you hadn’t guessed, much about the present state of the markets defies conventional wisdom. For more than a decade now, the stable-yet-scanty returns on Treasuries and other high-rated bonds have left asset allocators on a search for yield that has gone across asset classes that push the boundaries of alternative investments, but of what is often considered a portfolio component. Fine wine, golf resorts, and vintage Lego sets have all been touted at some point as the latest hot source of yield to extract returns beyond what’s in the traditional 60:40 portfolio.

Granted, your investment adviser might not think the contents of your now-Millennial child’s toy closet is the surest bet to plump up your retirement fund. Nonetheless, looking beyond what’s on the crawl on your Bloomberg or CNBC screen can make sound financial sense. Low interest rates aren’t going away anytime soon. While equities have pulled quite a bit of heft on their own, a diversified strategy is a sound tactic.

Direct investing pays off

Family offices, which cater to high-net-worth and ultra-high-net-worth clients, occupy a unique space in the investment landscape. Straddling the space between individuals planning for retirement and larger institutional investors such as pension funds that have to answer to boards and public scrutiny, they have both the financial resources and management leeway to try strategies that might be too outsized for the individual investor yet not quite vanilla enough to pass the muster of a pension board. Essentially, family offices can be investment pioneers. This entrepreneurial investment spirit is helping literal pioneers.

Following the late 2000s recession, direct investment by family offices grew by 206 percent from 2010 to 2015, according to a recent study by data and research firm FINTRX. Over the past year, that amount grew 11 percent. Come 2020, roughly half of all family offices in the world make direct investments in companies, according to the study, which got a nod in a recent installment of New York Times columnist Paul Sullivan’s Wealth Matters vertical.

“There’s been an incredible recovery in the stock market, but how do I commit more to the public markets when I’m looking at these valuations and it’s still a rocky road ahead?” asked Eric Becker, founder of Cresset Capital and longtime investor in healthcare companies, in the column.

Private markets offer a source of alpha uncorrelated to what’s happening in the markets and the factors that influence them: say, geopolitics, pandemics, or natural disasters. What’s more, as Sullivan points out, some family offices are seeing the opportunity to make direct investments into startups as a way to give back to an industry that may have given their family its start. Beyond the charitable aspects, however, there is also institutional knowledge afoot. A family office has generations of insight into the sector into which they’re investing, giving a unique level of due diligence.

This literal in-house savvy is parlaying into some smart early-stage investments. According to data from both the FINTRX study and from family office research service Campden Family Wealth, the lion’s share of single family office direct investments and venture capital have been made during early-stage and seed rounds — and not without some healthy returns. Campden’s survey showed an average 14 percent return on their venture investments during the year leading up to the study; direct investments garnered an average 17 percent. To more than 85 percent of the 110 representatives of ultra-high-net-worth families, these returns either met or exceeded their expectations.

Avenues for direct investment

The next question is: how can investors connect with direct investment opportunities? Startup incubators are a good place for family offices, registered investment advisers, and other accredited investors to seek out projects and startups whose goals and interests align with those of their portfolios.

Does the idea of approaching a startup incubator still befuddle you? Take the approach that you’d take to identify sectors in which you’d be looking to make equities allocations. If, say, some sort of tech gadget would prove intriguing for example, look for an incubator that sponsors the development of future IPO-worthy gadgets. Often located either nearby — if not also working in tandem with — major research universities, these groups provide the business and management advice these scientists and engineers make to take their inventions beyond the prototype stage.

For investors, this means the chance to get in on a project at its very beginning. For inventors, it’s getting the capital stream needed to keep on researching and perfecting. In essence, it’s a chance for family offices and other high-net-worth offices to pay it forward to the next generation of industrialists. Projects that help bolster industries that are either crucial to COVID-19 recovery, like healthcare, or will grow independently of economic winds, such as the military, can offer opportunities for positive returns now and into the next market cycle.

Inventors and investors: They’re just one keystroke away from each other on the keyboard. Their goals align as well. Direct investment in innovation can offer more than a sizable gain in a portfolio. Putting money into the next great project helps plant the seed for more economic growth, helping economic recovery on several levels. Family offices and other private wealth institutions got their start from capitalizing on a good idea. Just because that’s how that family’s story started doesn’t mean that there can’t be another chapter.

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Anne Szustek Talbot is a longtime content specialist, with nearly a decade and a half of experience covering news in and communicating on behalf of firms working in the asset management, litigation, financial technology, and tax sectors; as well as broader topics such as emerging markets, foreign exchange, and macroeconomics. Her most recent journalism position was as the online editor at Institutional Investor, where, among other responsibilities, she helmed the publication’s op-ed section and third-party thought leadership content. On the public relations side, she has earned coverage in an array of top-tier outlets including Cheddar, CNBC, Forbes, and The New York Times. Previous roles have taken Anne across borders and industries; her earliest roles were working for the senator from her home state, handling communications work, and as an intern diplomat for the State Department at the US Embassy in Tashkent, Uzbekistan and at the US Consulate General in Istanbul, Turkey, where she would return to launch her media career. Anne leans on her varied background to reach across industries and develop the most effective messaging and publicity campaigns on behalf of BX3 and its clients. Anne holds a BA in linguistics and Near Eastern Languages and Civilizations from the University of Chicago, from where she also earned her MA in Middle Eastern Studies. A native of the Minneapolis area, she now lives in Brooklyn, where she trains as a distance runner and in a nod to her hometown, has DJed under the handle Cherry Spoon.