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P2: Advantages Of Function-Centric Investing

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In Part 2, I continue discussing a few more advantages & benefits of function-centric investing [Approximate Reading Time = 15 minutes].

In addition to the advantages discussed in Part 1, function-centric investing allows for the inclusion of new asset types & categories. You can be diversified into many areas, or concentrated in a narrow range of investments.  It also ensures each investment decision made is not arbitrary, and has a purpose directly related to your plan.

 

Room For The Unknown (New Types & Categories):

New asset types or sectors may appear, but there may be no room in conventional asset allocation strategies or investment styles for them.  Certain asset types may not be considered, simply because the investor doesn’t know how they can be used.  Typically, traditional asset allocation may group different industries into one larger sector, which then limits the capital available to the individual industries.  The sector may not be included at all in the defined allocation because it isn’t a conventional sector or popular choice.

Function-centric investing makes room for assets, categories, businesses, or financial instruments that you may not be aware of or familiar with, or that simply doesn’t exist yet.  You may not know of a particular asset or financial instrument, and the techniques available for their use, until the need for it arises.  But instead of just selecting from a predefined basket of assets & categories that you are currently familiar with, you would perform research to determine what else exists that may be able to fulfill the intended function or purpose.  You can then compare a wider variety of investments and uses for the job.

Examples:

Unknown asset types. Are some even assets?:  Income Trusts were and are still are unknown to many average investors.  Many investors don’t even know about the existence of inverse ETFs, corporate bonds, put options, futures, etc.  Triple net leasing in physical real estate is unfamiliar to most stock investors.  Are options & futures even considered assets or really techniques?  If they aren’t assets, they might be excluded altogether.  Instead of being limited to asset types you know of, you can expand your circle to encompass more, and select the most efficient for the intended purpose.

Industries/sectors overshadowed:  A resource investor might allocate 50% to metal miners, 50% to energy (oil & gas).  Potash  producers became popular in recent years, but could be grouped into mining.  Instead of a potash play competing for capital with the wide variety of metal miners in the portfolio, you could freely allocate capital towards them if they are more promising than traditional metal miners.  Potash might be considered part of agriculture.  But instead of excluding it altogether, you can invest in it as well. Other examples include solar technology (tech or energy), mobile payment processing (tech or finance), diamond mining (non-metal mining), environmental (tech or infrastructure), etc.

New assets – Carbon emission credits: The CCX (Chicago Climate Exchange) established the world’s first emissions credit trading system in 2003. Today the ICE (IntercontinentalExchange) allows trading in futures, options, and spot contracts, based on Certificates in Emission Reductions (CERs), European Union Allowances (EUA), and European Reduction Units (ERU). This set of assets doesn’t really seem to fit with any other particular categorization. Instead of excluding new assets such as these, you can invest in them.  Even if it does not make sense for you at the current stage in your plan, there may be a scenario in the future which may see value from using them.

 

Capitalize On Opportunities Of the Moment:

From time to time large opportunities occur in areas outside the categorization bounds of a particular investment style and its associated allocations.  We often see investors that invest in a particular type or market, fixate on just that type or market.  They are unwilling to acknowledge the opportunities available in a different type or categorization (especially when their own is in decline).  Sometimes, they may acknowledge, but are conflicted to take any action.  With function-centric investing, you won’t miss out on opportunities of the moment, because you are not restricted to just one type or category.  More importantly, it allows you to see the opportunities based on economic & investment conditions, without bias. You can freely capitalize on any opportunities you see that can satisfy a particular role or function.

Examples:

Corporate bonds opportunity: During the broad based, but short-lived panic in 2008, the price of high quality corporate bonds declined severely (-50% on average).  Those safe & low risk bonds were suddenly yielding double digit distributions of 10-20% across the board.  A passive ETF investment style, growth investment style, or a portfolio allocated only to equity assets, all would have ignored & missed the opportunity in that particular asset class. Instead, you would able to line your portfolio with recurring double digit returns (distribution) each year, as well as an additional opportunity for an even larger double digit capital gain when you sell them (as most are trading above par). At one point, Wells Fargo Capital XII 7.874% Pfd [BWF], was selling around $14.50.  At that price the yield was roughly 13.5% in interest payments, which would also give a return of close to 80% in capital gains, if sold today at $26.30/share.

Gold vs Equities: During the financial crisis of 2008, gold investors refused to invest in equities, which were undervalued on a broad basis.  In particular, US equities in the financial and real estate sectors experienced the most severe price weaknesses.  Some of the most competitive companies were trading far below their intrinsic values.  Macerich [MAC], arguably the best run US mall operator & developer, was trading at roughly $6 per share at one point (which also yielded 30% in dividends).  Wells Fargo [WFC], the best run US bank was trading at $10 for a period of time. There are also other examples of high quality equities that operate internationally (outside those two sectors), such as Walt Disney [DIS], Coca-Cola [KO], etc.  However, the opposite was also true.  Equity investors refused to invest in gold or other precious metals.  Between the periods of Jan 2008 and Jan 2011 gold rose from approximately $800 to $1500, which represents an increase of approximately 88%.  With function-centric investing, you are flexible enough to see and capitalize on a variety of opportunities where others may refuse to.  Both asset classes would have returned to you, high double digits, which I would consider undeniably good investments.

 

Diversification or Concentration:

Diversified and concentrated investment styles have always been at odds with each other.  But it all depends on the situation and the conditions.  Sometimes its advantageous to diversify, while at other times concentration is more beneficial.  With function-centric investing you have the flexibility to diversify capital across a wide array of investments or concentrate it into a narrow selection, depending on the needs or functions that are required at a certain stage. You are not made to spread yourself further into additional areas experiencing increasing risks, or prevented from keeping only a narrow holding which may have less risk.  Conversely, you are not pressured to hold a narrow range of assets where risk is increasing, or prevented from spreading into a diverse number of areas that may all have large potential with low risk.

Example:

Diversified sources of risk: Consider the 12 months prior to the most recent financial crisis & market crash. The markets were increasingly overvalued, companies were already laying off employees or closing plants, and a major credit & housing bubble looked ready to burst.  A diversified portfolio may have held a variety of investments such as domestic & international stocks & corporate bonds (in multiple sectors), market index ETFs, mortgage backed assets, REITs, income trusts, mutual funds, physical real estate in the US, and shares of a private start-up.  All had deteriorating market conditions, with increasing real risks. Such a portfolio would have seen all those asset types & categories decline in unison.  There would have also been a very high likelihood of the private start-up being unable to secure financing & declare CH11.  Instead, you would not feel conflicted to direct capital out of those areas (perhaps except for a few select holdings) and pare down debt of the start-up, to later redirect into a narrow holding of investments.  Such a narrow holding could have consisted of cash, gold bullion or a gold index (SPDR Gold Trust ETF [GLD]), and secured investments such as TD Bank’s 5-Year Stepper GIC 2008 (whose low return would be considered relatively high in the foreseeable future).

 

Nothing Is Arbitrary, Everything Has A Purpose:

Conventional styles may say that you can make exceptions and bend the predefined allocations to accommodate more of a certain type or category.  They may also say that you can switch investments as long as they are part of the same type or category.  That raises several questions.  What is the significance of setting the specific allocation to begin with if you are bending it?  How is the allocation scheme determined (percentages, categories)?  Why are the specific investments in a portfolio chosen for the allocation scheme?  More often than not, the reasons are likely to be highly arbitrary.  It is likely answers may be along the lines of “to gain exposure to the category”, “40% and 60% sounds reasonable”, “the investment looks promising and is from that category”, etc.

However, with function-centric investing nothing is arbitrary.  You don’t end up buying investments for generic reasons like “to make a capital gain”, “it’s going to be worth 3x as much”, “for the dividends”, “it was undervalued”, “exposure to that industry”, “capitalize on macro trend”, “I think it will do well”, etc. Likewise, you don’t end up selling for generic reasons as well such as “the 20% rule”, “I’m overweight in the sector”, “everyone is getting out of that asset”, “there hasn’t been any price movement”, “share price dropped”, “etc. The reasoning goes deeper and is much more focused.  Each investment has a purpose, satisfies a particular function or role, or handles a particular threat, that is derived from your long term plan.  Capital is allocated according to priority and particular details of the role the investment is playing.

Example:

What, Why, When, How?:   Consider that your long term plan might include a scenario of a significant rise and spike in food prices as a concern.  Your research may indicate several reasons that point to a relatively high probability of such an occurrence (population, land usage, climate, contamination, industrialization, etc), with momentum gaining within the next 12-24 months from the date research was completed (lets say 2 years ago) and lasting at least 5-7 years.  You decide that further assessments will be required during that time period to determine if it might be shorter or (most likely) longer.

Your assessment indicates (for several reasons – supply/demand/usage/etc) that the food items with the greatest direct & indirect impact will primarily be corn & soybeans, and secondly wheat.  Livestock prices will also increase, but will be due to their feed’s dependence on the primary & secondary items.  So the rise in livestock prices is instead deemed to be a sub-concern or derived concern.

Estimations & calculations of the impact to you over the 7 year period would be an approximate 65% total increase in your food costs, and works out to be approximately $2900. You look to protect yourself with an asset that would rise somewhat along with the primary & secondary items, if the scenario becomes true.  However, you don’t expect a large return from it (or no return if prices do not rise at all). The intent is to purely keep up with inflating food prices. $4500 of capital [$2900/0.65 = $4461] is allocated towards this function, with the expectation to hold it for a minimum of 7 years.  You acknowledge the potential scenario of needing to hold for a longer period or allocating more capital, after subsequent assessments are made a few years (3, 5 yrs) down the road as planned.

A variety of ideas are researched from food manufacturing stocks, ETFs, agricultural LLPs, etc, You determine that the most suitable investment for the role is E-TRACS USB Bloomberg Commodity Index ETF [UAG], due several factors.  This includes its liquidity and ability to add or reduce capital to it, linkage to the specific basket of futures contracts, and exclusion of livestock futures.  It also includes heavier weighting on the crops of interest (corn 20.6%, soybean 20.79%, wheat 13.97%) with a significant drop in weighting to other crops (sugar, cocoa, coffee, etc).

 

Summary:

To summarize from both Part 1 & Part 2:  Function-centric investing has the flexibility to adapt to changing conditions, include planning for market downturns, and handling & avoiding risk.  It does not eliminate potential investment ideas prematurely, and allows for the inclusion of new asset types & categories. Capital allocation can be diversified into many areas, or concentrated in a narrow range of investments.  Investment decisions are not arbitrarily made, and have a purpose directly related to your plan. It’s a different approach that addresses some of the limitations found in other investment styles.

 

Disclosure:

I am long Wells Fargo Capital XII 7.874% Pfd [BWF], Macerich Co [MAC], Wells Fargo & Co [WFC], Walt Disney Co [DIS], Coca-Cola [KO], and E-TRACS USB Bloomberg Commodity Index ETF [UAG].  I currently hold TD Bank’s 5-Year Stepper GIC 2008.   I no longer hold SPDR Gold Trust ETF [GLD].  I do not intend to buy/sell any of the above mentioned investments within the next 9 trading days.

 

UPCOMING:  In upcoming articles, I will talk about long term planning which ties investments, goals, and function-centric investing all together.

Thanks & Happy Investing! — The Investment Blogger © 2012

Series NavigationFunction-Centric Investing Paradigm: IntroductionP1: Advantages Of Function-Centric Investing