It seems you can’t go anywhere in the investment community without hearing something relating to blockchain or cryptocurrencies.  A certain frenzied nature has taken over the discourse by both backers and detractors of digital assets.  Yet, price movement alone is no reason to spend time understanding a potential investment; there has to be a fundamental opportunity.  In this Market Update, we’ll introduce the concept of cryptocurrencies and their defining characteristics.

What is a cryptocurrency?

The term “cryptocurrency” describes many different digital assets, to include Bitcoin, Ethereum, Litecoin, and Ripple, among others.  Cryptocurrencies use blockchain technology and a decentralized transaction accounting and verification network.  We’ll now examine each of these characteristics.

Blockchain technology:  Blockchain technology describes how cryptocurrency transactions are recorded.  Essentially, every transaction on a blockchain is recorded as a “block”, verified by other users of the transaction network and affixed to the end of the chain as a permanent record.  As additional transactions occur on the blockchain, these blocks are added to the end of the latest transaction record, creating an ever-longer record of historical transactions.  This method of transaction accounting was created to move the record-keeping function of ownership away from the banking system toward a decentralized network.  This record-keeping method is facilitated by the requirement that all transactions are 100% transparent to all participants in the network.  A final critical feature of blockchain record-keeping is the concept of immutability.  Once a transaction has been affirmed by the network and added to the blockchain, it is no longer able to be altered.

Decentralized network / distributed ledger:  Blockchain’s unique system of accounting and verification is another key feature of cryptocurrency.  The only way that a transaction is affirmed and added to the blockchain is through a network of authorized participants.  A group of authorized participants must agree on a transaction’s validity.  This feature is different from the traditional method of transaction verification currently utilized in the banking system, where a financial institution validates digital transactions in conjunction with the US Federal Reserve system.  This decentralized feature removes the influence of any central bank.

All cryptocurrencies that utilize a blockchain have a cryptographic mechanism as part of their security protocol.  This mechanism ensures that owners of cryptocurrencies do not spend the currency more than once.  Transactions are verified by miners, who are compensated for verification with newly minted currency.  In order for an authorized participant to engage in the validation of transactions and coin creation (a.k.a mining), they must possess the computer processing power to solve increasingly difficult mathematical equations.  This feature helps preserve network integrity (via barriers to entry and quality of work) and also promotes a secure environment that is unmatched by existing security software architectures.

Differentiating characteristics among all the various cryptocurrencies would be too numerous to name, yet all claim to offer unique value propositions.  Some examples include transaction processing speed, smart contracts, digital store of value, improved governance, etc.  These unique value propositions are part of what drives differential values between digital assets.



The Investment Case For Digital Assets

Since its inception in 2009, Bitcoin has been a controversial topic in investment circles.  The primary reasons relate to its intangibility (the concept of a digital asset can be difficult to grasp) and untested nature of the technology given its limited existence.  Further, stories of Bitcoin theft[1] and its proliferation in organized crime circles[2] help account for why many in the investment community have viewed digital currencies skeptically.

Yet, now that the technology and digital assets have matured, the investment case for Bitcoin (among others) is transitioning from obscure and uninvestable to mainstream and speculative.

For investors with a high tolerance for risk (and associated volatility), an investment in a digital asset could be appropriate using a modest amount of one’s liquid assets.  What follows are a few reasons digital assets would be appropriate for a “highly speculative” risk bucket:

  • By many measures, blockchain and cryptocurrency are technologies still in their infancy. Though widespread adoption remains on the horizon, adoption could rapidly increase, especially in light of the myriad positive business/municipal applications.  Here is an abbreviated list of ways blockchain technology could be positively transformative:
  • (i) Real estate records: In countries where land records are unreliable (due to corruption) or non-existent (Greece), transparency via the blockchain could have a major impact.  A 2015 Economist article describes this benefit.[3]  Not only would uncertainty around ownership and frivolous legal expenses disappear, but it would give governments the ability to levy taxes in a fair and consistent way.
  • (ii) Campaign finance records: During every major political contest in the United States, invariably the discussion turns to campaign finance reform.  A key first step in reforming this critical function of our democracy would be to bring transparency to the campaign finance system using a blockchain registry.  A blockchain-based currency would provide complete transparency, requiring all sources (or “wallets”[4]) to be documented.  If everyone knew where the money is coming from, reforming campaign finance would be much easier.
  • (iii) Remittance transfers: This utility of Bitcoin has already been recognized by those sending money to relatives in other countries.  With the cost of transfers using Bitcoin at a fraction of what it would be using established services like Western Union, the appeal for both sender and recipient is undeniable.
  • Venture capital firms and operating companies (e.g., IBM, Google, Bank of America) are spending large amounts of capital to advance blockchain technology initiatives. It’s too early to tell whether too much capital is being allocated to this technology, but very legitimate corporate investors believe the risk/reward justifies the capital spent.
  • Prominent business leaders who once opposed any involvement in cryptocurrency are now tacitly endorsing its application. You may recall that in mid-2017 the CEO of J.P. Morgan (Jamie Dimon) noted that Bitcoin was a “fraud” and that it “won’t end well” for those who recently purchased the digital currency.  Fast forward to 2018, and Dimon now “regrets” the comments he made and finds the underlying blockchain technology valid.  Incidentally, J.P. Morgan is now a market maker for Bitcoin trading.
  • Digital assets no longer appear to have the speculative fever of 2017 baked into prices. Price movement in 2017 could be characterized as parabolic, leaving Bitcoin and other digital assets vulnerable to a shift in sentiment.  2018 has seen a significant (~60%) fall in the value of Bitcoin, making for a much better initiation point for an investment.


In summary, cryptocurrency and blockchain technology are interrelated yet unique concepts.  On the one hand, blockchain technology presents a new way to track and account for property in the digital age.  There is no single investment in blockchain, and typically the only way to secure access to investments in blockchain is through either venture capital allocations or operating companies.  On the other hand, cryptocurrency is a digital currency with an associated value attached to each coin.  The creators of Bitcoin (or any digital currency) designed the currency using blockchain technology.  Just like any other currency, Bitcoin can be purchased via a currency broker for relatively little cost.  (Note, neither Charles Schwab nor TD Ameritrade are able to facilitate transactions in Bitcoin given they are not foreign currency brokers.)  For those investors with an extremely long time horizon and tolerance for price volatility, Bitcoin could be considered a rare portfolio diversifier at a much better initiation price.





[4] Wallet is the cryptocurrency equivalent to an account where securities are held.  All wallets are visible to Bitcoin network participants, yet ownership is anonymous.

Authored By:

Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of July 2018 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. No graph or chart by itself can be used to determine which securities to buy or sell, or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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With equity markets trading close to their all-time highs it would be easy to assume that most stocks in the S&P 500 are experiencing a similar performance.  After all, the index represents the market, right?  In our opinion, we are approaching a new phase of the current equity market cycle.  What follows are a few observations that characterize this new phase:

  1. Companies that have built shareholder wealth on “brand value” are having difficulty competing in a world where white label (especially in consumer products) is increasingly sought after.


  2. Companies generating little to no innovation in products are experiencing a much-deserved valuation adjustment.


  3. The potential negatives of corporate acquisitions are starting to show through. Management teams that cannot deliver on announced goals are seeing dramatic adjustments share price. Contrary to popular belief, not all acquisitions are beneficial.


These are just a few examples (of many) that need to be recognized when looking at equity investments in the current environment.  By no means are the companies depicted above unique.  To the contrary, there are many more we could show.

This brings us to the key concept of this article: investments that have the perception of being “safe” can no longer be relied upon as such.  In large part, I’m referring to consumer staples businesses.  These are companies that sell household consumer products, that advertise heavily to build brand value, and that have been relative outperformers when equity market conditions became difficult.

In our opinion, successful equity investing in the future will require an adjustment in thinking about what is safe and unsafe.  We are not alone in recognizing this subtle shift in mentality.  For those who have been following the annual Berkshire Hathaway meeting (held over the weekend of May 5th), the Oracle of Omaha highlights as much in the various comments he’s made throughout the conference.  In summary, Warren Buffett indicated that applying traditional “value” strategies once used early in his investing career would likely not result in the same positive outcomes today for a variety of reasons.  He goes on to say that value oriented investors need to remain vigilant against investing in “yesterday’s moats” (i.e., competitive advantage that is eroding).  With the pace of competitive dynamics quickening, ensuring company management teams evolve with the times is imperative.

Another insight we take away from the three points above is that intangible assets are less valuable than once thought.  Take brand value for example.  Some companies like Coca-Cola and Clorox have spent decades and hundreds of millions of dollars on advertising to establish a positive brand image.  Brand value is becoming less relevant in an era where (1) consumer purchases are increasingly migrating online, (2) retailers like Whole Foods Market/Amazon, Costco, and Kroger are placing an emphasis on private-label products versus branded products, and (3) stagnation in wage growth is driving consumer demand for lower-priced private label products.

In all, this article is not meant to be a call to action for our clients/investors to dump shares in consumer staples.  Instead, we draw a comparison between investing based on (potentially hazardous) rules of thumb and legitimate opportunities in the marketplace.  As we’ve always indicated, there’s no such thing as a “forever” stock.  We evaluate companies and their competitive positions at regular intervals to solidify our understanding of each position we own in our portfolio.  As you might expect, this takes a significant amount of time and effort.  We feel this knowledge will translate into a significant benefit if/when equity markets turn decidedly lower.  Until that time, we will keep our eyes open for new opportunities that may not fit within historical definitions, and we will be on alert for potential value traps.

Authored by:

Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request.  The opinions expressed are as of May 2018 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  No graph or chart by itself can be used to determine which securities to buy or sell, or when to buy or sell them.  As with any investments, past performance is not a guarantee of future results.  There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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On December 22nd, 2017, President Trump signed the Tax Cuts & Jobs Act (“the Act”) into law.  The bill passed Congress through the reconciliation process, thereby avoiding filibuster in the Senate but requiring revenue neutrality over a 10-year period.  As a result, many of the key provisions are scheduled to sunset at the end of 2025, assuming they are not sooner reversed or otherwise changed by a new administration or Congressional leadership. While the Act represents sweeping tax reform with significant changes to income taxation for individuals and businesses, the focus of this article is on the Act’s impact to estate planning. 

Under the Act, gift, generation-skipping transfer (GST) and estate exemptions doubled. Starting in 2018, each person may transfer $11.2 million free of transfer tax.  Married couples may effectively transfer $22.4 million due to portability of exemptions between spouses. Exemption amounts will adjust annually for inflation. The annual gift exclusion for 2018 is $15,000 per year per donee, and the unlimited education and medical exclusions remain so long as payments are rendered directly to the provider.

To the surprise of many, stepped-up basis remains under the Act. This means the tax basis of assets transferred as a result of death are stepped up to the asset value as of the date of death resulting in reduced future capital gains liability for beneficiaries. Basis step-up represents a significant planning opportunity in itself. For example, assets in a traditional credit shelter trust of the first spouse to die will not receive a second step-up upon the death of the second spouse. Reworking an existing estate plan or adding provisions to an existing plan may provide the opportunity for an additional step up at the second death. With fewer estates subject to the estate tax, basis planning may become a greater priority for many. Note that assets gifted during life do not receive a step-up; rather, gifted assets have carryover basis, meaning the gift recipient maintains the donor’s basis.

It is critical that clients review existing estate planning in light of the higher exemption amounts. Plans often use formulas based on the exemption amount to determine trust funding levels.  As you might imagine, this could result in inadvertently over or under funding trusts for a certain class of beneficiaries. For example, some plans fund trusts for the benefit of grandchildren to the extent of the GST exemption. With the much higher exemption under the Act, adjusting for the new exemption amount could result in little or no residual funding for the surviving spouse.

It is estimated that fewer than 1000 estate tax returns will be filed per year under the Act. As such, non-tax objectives such as asset protection, succession and legacy planning may be more relevant. Reviewing your plan in the context of the Act is also an opportune time to ensure designated fiduciaries (executors, trustees, guardians) are still consistent with your wishes.

For some, particularly couples with combined estates under $11.2 million and without extenuating circumstances, the new law may provide opportunities for simplification if previous planning had primarily been tax-motivated. For example, rather than automatically funding trusts upon the first death, a client may instead wish to leave everything to the surviving spouse with the ability for them to disclaim into a trust. Disclaimer trusts allow the surviving spouse (in conjunction with an attorney and other advisors) to determine whether to fund a credit shelter trust when their spouse passes based on circumstances at the time of death. If the trust is not needed, it does not have to be funded; but, if it makes sense to fund the trust, the spouse can disclaim their inheritance into the trust. Nonetheless, the benefits of simplification should be weighted against the more protective nature of traditional trust planning.

For clients with estates that were taxable under prior law (over the $11.2MM married threshold and $5 million for single clients), the Act provides a window of valuable planning opportunity. The Act’s higher exemption levels translate to tax savings of 40% of the value of an estate between $11.2 million and $22.4 million per couple – for a $22.4 million estate, that’s an almost $4.5 million gift from the government. . .but only to the extent assets are transferred while the exemptions remain at this level. Since it is hard to predict when we will die, it is arguably prudent to use the higher exemptions now via lifetime transfers. Another benefit of lifetime transfers is that subsequent growth of assets transferred occurs outside of your estate. To the extent leverage can be infused into the planning, e.g., through sale of assets to trusts or transfer of discounted assets, the tax savings can be amplified. If you are eager to capitalize on the higher exemption amounts but uncomfortable parting with significant assets, non-reciprocal spousal limited access trusts, aka SLATs, (or self-settled domestic asset protection trusts, aka DAPTs) for single clients, might be advisable. These strategies are too complex to cover in a couple of sentences but may warrant further exploration with your advisor. 

Regardless of your wealth level, as existing estate plans are reviewed, it is important to weigh the pros and cons of prior planning. Just because a strategy may no longer seem relevant, formalities such as required payments between entities or administrative procedures cannot be ignored. Many clients may be wondering if their life insurance trusts are still necessary; we recommend a thorough evaluation of available options before acting. For example, perhaps the policy could be modified to a paid-up policy, or a large gift could be made to the trust to facilitate future maintenance of the policy while eliminating the need for future annual Crummey notices; or alternatively, the policy could be terminated with cash surrender value distributed among beneficiaries. Before deciding to unwind strategies that may be in place, consider the potential for laws to change again.

A couple of final thoughts – with higher exemptions, it may seem unnecessary to file an estate tax return for a nontaxable estate. However, a return must be filed to preserve the unused exemption of a deceased spouse. This will be particularly critical if exemption amounts decrease in the future. And regarding incapacity planning (powers of attorney, revocable trusts) for higher net worth clients, it might be advisable to allow your agent or trustee to make transfers up to the exemption amount to ensure maximum planning opportunities if you were to become incapacitated prior to a provision sunset.

Bottom line – it is prudent to review your estate planning in light of the new tax law. And, as with many things in life, flexibility is key. 

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you our your business.

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We’re proud to say that our Director of Investments, Todd Jones (CAIA), was recently quoted in the Forbes article “3 Lessons Traders Can Learn from Investors.” He was the article’s primary source.

The Forbes article details the dangers of emotionally charged investments, the importance of keeping a balanced portfolio and the difference between risk and volatility in investments.

Todd is quoted on the importance of keeping a balanced portfolio (which we cover a lot in our insights, including this one on the benefits of alternative investments and portfolio diversification).

On the issue of short-term traders selling quickly in times of stress, Todd says, “To me, this makes no sense, as the need to rebalance should be based on the returns of each asset class as they relate to each other. This prevents unnecessary trading/capital gains and maintains a consistent risk profile.”

As for volatility, “It’s just noise,” says Todd. Invest in your own knowledge of fundamentals: it’ll help you understand if there is a risk in sudden stock surges or dips or if it is simply the natural highs and lows of the market itself.

At Gratus Capital, we serve clients across the US with a tailored team approach based on the principles expressed by Todd in this article. We’re a boutique wealth management firm focused on serving successful individuals, families, foundations, and endowments with a low client-to-advisor ratio and fee-based advisory services. What new financial goals do you have in mind? Contact us to learn how we can help.

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Forest fires are terrifying to witness. Having lived in California for a couple of years in the mid 2000’s, I didn’t have to go far to find traces of nature’s fury given the dry climate. Once started, forest fires have little hope of being extinguished by human efforts – only contained. The goal of the heroic fire crews that battle the inferno is to “control burn” as much fuel in advance of the actual blaze so that there is nothing left to burn once the fire arrives. There is no doubt, on seeing an actual forest fire from a distance or its aftermath, that the intensity is high, the path is indiscriminate, and the damage is quick but severe.

Activity in global equities over the past three trading sessions (February 2nd, 5th, and 6th) is allegorical to forest fires, seeing steep daily declines in stocks for seemingly no reason. Yet, was there really no reason for the recent declines? As we’ve indicated since Q4 of 2017, the fuel for the recent forest fire was created through the combination of (1) excessively high investor sentiment, (2) exceedingly low volatility (e.g., VIX), and (3) large money flows into stocks. Each one of these, alone, was not problematic, but all combined made a different situation entirely. Incidentally, observation of the conditions above led our Investment Committee to recommend a portfolio rebalance prior to the recent drop.

What sparked the sell-off?

While pinpointing the exact reason is almost impossible, the most likely source of the recent selling pressure has been the upward movement in US interest rates. As can be seen in the chart below, recent moves in the 10yr US Treasury bond have brought rates to near 3%, a level not seen since 2013 during the so-called “taper tantrum.” Higher rates become an issue because, at some point, bonds become competitive with stocks for portfolio allocations.

In our opinion, the other root cause of the sell-off has to do with the unwinding of the short volatility trade that has been very popular with both hedge funds and pension funds. Essentially, since the “flash crash” (which occurred in late 2015), volatility in the options markets (as measured by the VIX index, seen below) has moved to extremely low levels. This low reading in the VIX index signals that portfolio hedging with options has not been occurring to any significant degree. Further, this expectation of low future volatility was being speculated on by many (to include pension funds) as a way to enhance return in a portfolio. The problem with this strategy, however, is that once investors begin to unwind these speculative VIX positions, this process creates a positive feedback loop sending volatility higher. Many taking these speculative positions may have only fully realized the risks inherent in such a strategy once the sell-off began.

Where do we go from here?

Just like in a forest fire, while the intensity is high and the moves are erratic, we don’t see the selling pressure lasting for much longer once the fuel of interest rate movements and VIX position unwinding dissipates. That is not to say that equity markets could not move lower from here over the near term. But given the tinder of suppressed volatility, low interest rates, and excessive investor sentiment, a garden variety correction in the 5-10% range makes sense. On the other side of this current corrective phase for equity markets, the excesses will have been cleared out, allowing investors to focus on some of the positive factors present in the markets. In our view, global equity markets can move higher over the remainder of the year based on a combination of the following positive dynamics:

(1) Global earnings and revenue growth are strong
(2) All major economic regions around the globe are in a synchronized expansion
(3) US Interest rates aren’t rising in a disorderly manner
(4) High Yield bonds aren’t signaling duress
(5) Global inflation remains modest (between 2-3%)

In summary, as we await the culmination of the current corrective phase in equity markets, we would like to highlight that periods like this underscore the need for diversified investment portfolios. This diversification includes allocations to cash, fixed income and, where appropriate, alternative assets. Specific to cash holdings, most portfolios have been positioned with elevated cash levels due to our recent rebalancing activity. This cash will give us optionality in the case that equity prices decide to move markedly further from current levels. We’ll look to redeploy this cash as opportunities arise.

As we approach the final stages of the current bull market, episodes like the one we currently find ourselves in should be considered the norm as opposed to the exception. This heightened level of equity volatility will test resolve and challenge investor convictions, which is why we’ve been revisiting client risk profiles and cash flow goals in recent months. Rest assured, we are mindful of many of the risks being discussed in the equity markets. If the fundamentals of this aging economic recovery change then we will take appropriate action. For now, we need to let the fire burn the accumulated tinder on the forest floor so that we can move higher from here.

Authored By:

Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of February 2018 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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“There is an art to science, and a science in art: the two are not enemies, but different aspects of the whole.”  —Isaac Asimov

“Rely on the ordinary virtues that intelligent, balanced human beings have relied on for centuries: common sense, thrift, realistic expectations, patience, and perseverance.”  — John C. Bogle

“Never buy anything from someone who is out of breath.”  —Burton Malkiel

Patrick Nolan, CAIA, Portfolio Manager – Private Markets  — At Gratus Capital, my role includes sourcing and screening investments, conducting due diligence, negotiating investment terms and monitoring performance of private investment opportunities.  In this post, I want to describe the process I use and share some interesting experiences I have encountered along the way.

Sourcing, Screening and Due Diligence

Due diligence is the research and analysis of a company or organization done in preparation for a business transaction [i].  Of the “investable universe,” select firms are identified as potential investment candidates.  Of these, fewer make it through a preliminary screening and are reviewed more deeply.  From the firms selected for review, only a small portion are selected for a full due diligence review.

I introduce this process to demonstrate that conducting due diligence according to a standard requires considerable effort.  After sourcing and screening, I use metrics to disqualify managers and judge the best from the rest.  I developed this due diligence process from my experience in institutional-level timberland and apartment investing.  In addition to my experience, I rely heavily on the Institutional Limited Partners Association’s (ILPA) [ii] sample Due Diligence Questionnaire and Chartered Alternative Investment Analyst Association publications.

According to Brown, Fraser and Liang, the cost of due diligence depends on a series of factors, including the time spent, the level of thoroughness and whether accounting firms, law firms, third-party service providers and consulting firms are used. These authors assume “a conservative cost of due diligence of $50,000 to $100,000 [per single institutional hedge fund allocation]” but contend that effective due diligence of funds in the selection of fund managers can generate alpha for an investor’s portfolio [iii].

I’ve heard that there is an art and a science behind any worthwhile endeavor.  Gratus’s due diligence process has a solid foundation in the “science” of private investing.  Having proper procedures in place is critical, but so is a focus on the spirit of the task.  Procedure must not cloud the goal of judging the worthiness of a manager and the overall attractiveness of an opportunity.  To demonstrate the two sides of due diligence, I’ll list some of the questions behind the “science” and then share the more interesting anecdotes that make up the “art”.

The “Science” of Due Diligence

Below are a few of the ILPA’s recommended BASIC questions for Limited Partners to present to Investment Managers:

  • Will Placement Agents be used during the fundraising process?
  • Were there any carry clawback situations in any of the Firm’s prior funds?
  • Are any investments in the Firm’s track record excluded from provided materials?

And a sampling of recommended DETAILED questions to an Investment Manager:

  • Describe any significant staff departures that are expected to occur between now and the end of the Fund’s investment period.
  • How will investment opportunities be allocated between active funds? Discuss any funds and/or separate accounts with potential allocation considerations.
  • During deal structuring, what is the process for integrating ESG-related consideration into the deal documentation and/ or the post-investment action plan? (ESG: Environmental, Social and corporate Governance)

In addition to 15 pages of similar questions, the ILPA goes on to provide multi-page templates for reporting portfolio investments, funds, professional references and team member biographies.  To top it all off, the ILPA ends with a list of 33 requested documents including Firm budgets, a list of LP secondary sales, and annual meeting presentations for the last 2 years!  Lastly, third-party auditors, custodians, accountants and investigators are suggested in order to triangulate and verify the subject’s response.  The result is a pile of information that may be erroneous or even fraudulent.  The process may create value, but it may also only create a false sense of security.

The “Art” of Due Diligence

Clearly the ILPA provides a road map for thorough institutional private investment due diligence.  The inclusion of third-parties to verify facts creates another layer of confidence.  But at what cost?  What resources are required of both the interviewer and interviewee to conduct such a review?  What great opportunities are missed if the ILPA is followed too closely?  Clearly there is a role for these questions if the investor is a public institution that is highly sensitive to any type of headline risk.  But many investors are not political targets with a large public presence.  Additionally, most investments only carry a small portion of the possible risks covered by the ILPA.  Common sense is in order.  Relying too heavily on the ILPA would be counterproductive for some investors’ task at hand.  This is where I value the “art” rather than the “science” of due diligence.  Below I’ve categorized some examples that capture the subtleties of properly evaluating a manager and a potential private investment.

Lack of Professionalism

  • What should you do when a manager is unreliable during the due diligence process?  Do they say they will do things and not follow through?  Can you responsibly trust a manager to conduct themselves professionally after they’ve been awarded your money if they are unreliable before they’ve received your money?  Better to pass on the relationship.
  • How should you approach an opportunity with incomplete information?  Many popular managers request verbal commitments prior to having finalized legal documents.  This tells me a few things: either they are well-seasoned and have numerous relationships or they are trying to pressure investors into a deal while withholding details. Verbal commitments with pre-existing managers is one thing, but making first-time investments with a manager that requires commitments prior to providing complete information is a bad idea.  Lastly, this may reveal that the manager’s clients have become complacent and are relying on the persistence of past performance. These are signs of a mature and well-worn strategy that may be better to avoid [iv].

Misleading Marketing

  • Sloppy marketing materials are a sign that the manager is likely sloppy in other facets of their business and possibly in their investment underwriting.  When I find marketing materials that specifically contradict or do not mesh with corresponding legal documents, I penalize accordingly.  While these mistakes are likely careless, they may also be purposefully misleading.  I don’t want to deal with a manager that is guilty of either.
  • I’ve come across managers that sell a popular trend, even when it isn’t entirely accurate. For example, one office manager suggested that a property was in the currently en vogue market of Nashville, TN.  Technically the property was a part of the greater metro-area, but it was 17 miles from downtown.  Not exactly an honest description.
  • I often see project-level returns in marketing materials.  This is clearly misleading, because clients will receive the performance net of fees and expenses.
  • Optimism is not a strategy.  I often see deals where the entire strategy is the assumption that past performance will persist or that there will be increased demand for the product in the future.  For me to become comfortable with a deal, I want to see a model with flat or decreasing demand, a.k.a. cap rate expansion.
  • “Cash-On-Cash” return.  What if you gave me $10 today and I gave you $1 each year for 10 years. Does that sound like 10% “Cash-on-Cash” return?  Or even worse, an average of 12.9% “Cash-On-Cash” return?  There are more realistic examples, but I see this line of reasoning often when managers quote “Cash-On-Cash” return.  The confusion stems from unreported losses, return of capital that is not income, or a reduction of capital account balance. Distributions are meaningless if you don’t know whether they represent income or return of capital.  Often, one cannot be certain until the asset is sold and fully realized. Solution: Ask for equity multiples and IRR returns.

Unattractive Terms

  • Conflicts of interest are sometimes unavoidable.  If they are small and are properly transparent, then conflicts of interest will not disqualify a deal. Three conflicts that I recently found were unnecessary and were a somewhat dubious effort to sneak additional fees out of the deal.
    • Fees based on Potential Rent.  Why not compensate on actual rent?  Potential rent can be set by the manager as a benchmark.  ‘Fees based on Potential Rent’ is synonymous with giving the manager a blank check.
    • Acquisition fees based on purchase price. This is pervasive in real estate, but I think it should be challenged more often.  Once a manager has client capital secured, they are actually incentivized to pay more for a property!  I don’t see this going away, but I also like to bring it up with managers and let them know that I do not like this form of compensation.  A better solution might be a percentage of equity, as this would incentivize the manager to balance the proper mix of debt and equity.
    • Fees on construction costs.  This is another perverse misalignment of interests, and managers should be pressured to seek compensation elsewhere [v].
  • Catch-up clauses.  I will try not to get lost in the details here, but catch-up clauses on carried interest are an additional layer of fees that managers often use.  I suspect that many investors do not fully realize the hidden expense of a catch-up clause.  Put simply, think of a catch-up clause as retroactively removing the performance hurdle after it has been achieved.  This is sometimes referred to as a soft hurdle (catch-up) or a hard hurdle (no catch-up).  Consider a 20% carried interest (often called the ‘promote’) and an 8% hurdle (often called the ‘preferred return’).  If there is a 13% return after management fees and expenses, then with no catch-up, the manger would receive 1% (20% of the return above 8%).  With a catch-up, the manager would receive every dollar from 8% to 10% in order to ensure that they receive 20% of all profits, and then 20% of profits from 10% to 13%.  This catch-up comes to 2.6%.  This equates to a 10.4% return for the LP investor instead of 12%.  This also means that the manager has less incentive after a gross return of 10%, because they’ve received most of their compensation already.
  • Lastly, how long do you want to be invested in a deal?  Managers say they will be out of a deal in 5 years, but when you ask for it in writing in the documents, sometimes they won’t agree.  If a manager will not put a 10-year maximum term on a 5-year business plan, then I have less trust in their business plan.  Managers often want full flexibility to hold a property and avoid selling into a poor market.  I’ve worked around this problem by agreeing on buy-out clauses.  In short, a manager’s legal documents should reflect the business plan.

In all, I hope this description relays my view of both the art and the science of private investment due diligence.  The science is certainly an important and necessary step in reviewing an opportunity, but thinking creatively is also important when seeking the best possible managers and investments.   As an alternative asset manager, we will continue to strive to bring both aspects of the process together for the long-term benefit of our clients.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice.  The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  As with any investments, past performance is not a guarantee of future results.  In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses.  There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.  Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.


[i] Merriam Webster Dictionary defines due diligence as: research and analysis of a company or organization done in preparation for a business transaction.

[ii]  “The ILPA is the only global, member-driven organization dedicated exclusively to advancing the interests of private equity Limited Partners through industry-leading education programs, independent research, best practices, networking opportunities and global collaborations.  Initially founded as an informal networking group, the ILPA is a voluntary association funded by its members. The ILPA membership has grown to include over 400 member organizations from around the world representing over US $1 trillion of private assets globally.”

[iii] Hedge Fund Due Diligence: A Source of Alpha in Hedge Fund Portfolio Strategy

[iv] I have noticed this behavior in many apartment community investments.

[v] I often see these fees on projects sponsored by vertically integrated operators.

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Not so long ago, only the ultra-wealthy and large institutions such as banks and public pensions had access to alternative investment opportunities. Today, almost any individual investor has access to these versatile investment tools. However, the key question is, are alternative investments right for you?

Before deciding, let’s take a look at what an alternative investment really is and its potential impact on an individual investor’s financial portfolio.

According to the Huffington Post[i], alternative investments are investments in assets other than stocks, bonds and cash, essentially investments using strategies that go beyond traditional ways of investing. Gratus Capital Chartered Alternative Investment Analyst and Director of Investments Todd Jones, MBA, CAIA agrees.

However, Jones takes the definition a step further.

“At Gratus Capital, to be considered an alternative investment, the investment vehicle must not exhibit a correlation of greater than 0.60 to either the stock or bond markets in any rolling three-year period,” said Jones. “Otherwise, we exclude the investment from our universe of alternative investments when making selections for client portfolios. Alternative investments are meant to provide diversification and a unique income stream return. In fact, we don’t expect alternative investments to outperform the equities or fixed income markets. Instead, our approach is to identify alternative investments that, on average, have returns that are no greater than the equities markets and no lower than the fixed income markets.”

Jones also believes that almost every portfolio should include at least a small amount of alternative investments because of the diversification value typically generated by this asset type.

Legitimacy of Alternative Investments

“There has been a multitude of alternative investments entering the financial marketplace compared to just three years ago,” said Jones. “Individual investors should be very cautious. Roughly 95 percent of alternative investments available today engage in strategies that provide minimal benefit to a portfolio. Far too often the investment doesn’t perform as described, the return is too low, or the fees are too high.”

Types of Alternative Investments

There are many different types of alternative investments. Sang H. Lee of The Street offers the following examples:

  • Venture Capital
  • Private Equity
  • Hedge Funds
  • Real Estate Investment Trust (REITs)
  • Commodities
  • Real Assets: precious metals, rare coins, wine and art

Jones cautions investors who are contemplating alternative investments such as art, rare stamps, or wine, because the values of these assets are mostly driven by personal taste and sentiment. Instead, Jones recommends that investors focus on alternative assets that can be deeply analyzed: specifically, assets that have ample data to forecast valuations and output key metrics and trends.

Today, we’ll discuss three alternative investment strategies:

#1 – Interval Mutual Funds

InvestmentNews offers the following definition: Interval Mutual Funds[ii] are mutual funds that offer daily purchase for investment but liquidity for limited redemptions at specific intervals (usually quarterly). This change to the mutual fund structure creates large advantages: the fund can simultaneously invest in both private and public assets in a structure that has a liquidity feature and a daily net asset value. This allows the sponsor to create a portfolio of investments that may provide higher levels of yield and noncorrelation to equities, but without the illiquidity and lack of price transparency.

#2 – Private Equity

Financial news giant Investopedia provides the following definition: Private Equity[iii] is capital that is not noted on a public exchange. Private Equity is composed of funds and investors that directly invest in private companies or that engage in buyouts of public companies, resulting in the delisting of public equity.

Typically, private equity investments have been limited to large institutional investors or a person or organization that can allocate at least five million dollars to one single idea or asset. However, access to private equity investments is becoming more of a necessity for mass affluent investors, said Jones.


Recent news coverage of disappointing IPO offerings for private companies such as Blue Apron[iv] and Snapchat[v] is spurring other profitable private companies to remain private, limiting investment opportunities for investors.

“Now, quality companies that would typically go public early in their business lifecycle are remaining private much longer,” said Jones. “This is problematic for investors, since it limits investment opportunities, especially ones that substantially help an investor to diversify their portfolio.”

For Example:

Amazon went public in 1997. The company’s valuation at the time was approximately $300 million.  Today, it’s roughly a $300 billion dollar company. However, all the growth that has happened since Amazon’s public offering has led to massive investment opportunity and growth for individual investors, according to Jones.

With many large private companies retaining their private status, financial advisory firms are creating new opportunities for their clients.

“Back in 2013, Gratus Capital began formulating ways to gain access to private investment returns,” said Jones. “We began forming limited partnerships for our accredited investors, in order to gain access to existing private investments. This past June, we raised capital and closed our first fund that focuses on private debt and credit as well as private real estate. Our subsequent funds will more likely have a capital appreciation focus. We see these limited partnerships as a necessary evolution of our services if we’re to help our clients achieve targeted rates of return. Specifically, we’re seeking to access illiquid markets that are private and that generate above-average market returns.”

#3 – Hedge Funds

Hedge funds use pooled funds of underlying securities to earn returns for investors. According to Investopedia[vi], the most cited reason to include them in any portfolio is their ability to reduce risk and add diversification. Also, a hedge fund that provides consistent returns increases the level of portfolio stability when traditional investments are underperforming or, at most, are highly unpredictable.

BarclayHedge[vii] reminds investors that hedge funds are not currently regulated by the U.S. Securities and Exchange Commission (SEC). The financial research firm adds that hedge funds can invest in a wider range of securities than mutual funds can. While many hedge funds do invest in traditional securities, such as stocks and bonds,  they are best known for using more sophisticated (and risky) investments and techniques.

Choose Alternative Investments that Align with Individual Goals

BlackRock[viii] recommends investors choose alternatives that align with their distinctive goals. The investment giant gives four common objectives:

  1. To mitigate the effects of stock market volatility
  2. To lower correlation to traditional stock and bond markets
  3. To invest capital for a longer time frame in exchange for higher return potential
  4. To hedge a portfolio against inflation or rising interest rates

In Closing

At Gratus Capital, we believe that almost every financial portfolio should include some level of alternative investments specifically to sustain diversification and separation from the stock and bond markets.

Alternative investment strategies are not to be taken lightly, particularly when deciding between liquid and illiquid assets. Overall, it’s important to focus on what you’re seeking to achieve within your financial plan and how much risk you’re willing to take.

Alternative investments tend to come with higher risk; however, they can also come with greater than average returns. If you have questions about alternative investments or your overall lifetime financial plan, please contact us.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.










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When one considers Dennis Rodman, what typically comes to mind are his off-court exploits – most notably his trips to the communist state of North Korea[1]. It’s hard to tell what Rodman is bringing to the table during these meetings other than something akin to being a court jester. But in this update, we’ll focus on Rodman’s on-court exploits and what he did for basketball teams he played for during the late 1980s and early 1990s.

What relevance does Dennis Rodman have to an investment portfolio? According to teammates and opponents, Dennis Rodman brought a valuable combination of defense and second-chance opportunities. In our mind, defense and second-chance opportunities in the NBA translate into investment portfolio benefits such as diversification, staying power, and optionality. We’ll discuss each of these concepts below, but the overarching concept is that all portfolios could use more Dennis Rodman.


We’ve written about the concept of diversification in recent publications as the S&P 500 has been one of the best-performing equity indices over the last eight years. There was a confluence of factors, to include stable currency, political stability, and savvy corporate management, that contributed to this positive outcome for US equities. Yet, as we sit here at the midyear point in 2017, the winds of change are blowing in favor of companies domiciled outside the United States. Consequently, in many alternative strategies we have implemented in portfolios, the correlation/diversification benefits are starting to become more apparent.

The crux of the argument relating to diversification benefits is seen clearly in the mathematics of a portfolio drawdown. We illustrate this concept below, displaying the return required to get back to even based on various levels of portfolio drawdown.

Essentially, if you can construct a portfolio in a way that reduces the drawdown by owning non-correlated assets, you allow the math to work in your favor.  We believe alternative assets/strategies are an effective way to mitigate portfolio risk.

Staying Power

This concept may be new to many clients but it is one that we’ve been thinking a lot about recently.  Staying power is a behavioral concept that has application to every long-term investment portfolio and refers to the idea that portfolios will either succeed or fail due to investor behavior during stressful market periods.  As we’ve all witnessed over the years, we know people who can’t handle watching their portfolio losing money.  How many people do you know that sold out of all their equity exposure during the financial crisis and haven’t repurchased yet, or they have only recently added it back while equity markets are at all-time highs?

All this being said, if a portfolio contains assets/strategies that are zigging when the market is zagging, an investor’s ability to remain invested in the “riskier” portion of their portfolio goes up dramatically.  This staying power could be seen in the win/loss record of almost every team Dennis Rodman was on over his career, due to the fact that Rodman was a master at keeping his teams in the game with both tenacious defense and rebounding.  These two traits took the pressure off the superstars that surrounded Rodman.  We believe that a properly diversified allocation to alternative assets/strategies has the potential to reduce pressure on the more volatile segments of a portfolio (typically equities) over a full market cycle.


Finally, we believe that all portfolios should be constructed with a degree of optionality.  Optionality is the flexibility a portfolio has to make changes or adjustments during significant stress periods in the financial markets.  The way in which most portfolios possess optionality is via a cash position.  Cash is said to have a high degree of optionality because the “price” of cash does not fluctuate and is readily accessible to redeploy in the event opportunities arise on very short notice.

Optionality is an important characteristic to have in a portfolio primarily because it allows investment decisions to be made without external influences.  For example, we believe investors like Warren Buffett and Seth Klarman have enjoyed success partly due to the fact that their portfolios carry a significant amount of cash (optionality) at almost every point in time.  In the case of Seth Klarman (via his investment vehicle Baupost LLC) the average level of cash over the last 30yrs has been 20%.  In the case of Buffett (via his investment vehicle Berkshire Hathaway) that cash level has been even higher!  The point in mentioning these levels is that both Klarman and Buffett have been able to succeed because they are almost always investing in opportunities based on merit.  Further, when they are making investments, they do not need to sell something to free up capital.  In this way, they are making only one difficult decision (what to buy) and not two (what to buy and what to sell).  Optionality is something investors should consider, as we currently find many equity and fixed income markets at extended valuation levels.

In summary, every team needs a Dennis Rodman, just as every portfolio could benefit from alternative holdings that generate a return that is different from traditional stocks and bonds.  While the benefits described (diversification, staying power, optionality) above may not be intuitive in the midst of an eight-year bull market, these benefits are invaluable during periods of significant market distress.  To that end, even though we have no way of knowing when the next significant downturn will come in the financial markets, that doesn’t mean we shouldn’t begin preparing for the next occurrence.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.


[1] In fairness, I cannot claim credit for the idea of correlating Dennis Rodman with alternative strategies.  That idea came from Chris Cole of Artemis Capital.  On the Artemis Capital website under “Market Views,” you’ll find a very interesting publication entitled “Dennis Rodman and the Art of Portfolio Optimization.”

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Most financial advisors advocate maximizing employer-sponsored 401(k) accounts or municipal 403(b)s. Generally, we agree. However, you could be missing out on tax savings if you aren’t careful.

Before going any further, let’s be clear on what we mean by tax efficient. According to Wikipedia, a financial process is said to be tax efficient[1] if it is taxed at a lower rate than an alternative financial process that achieves the same end.

The collaborative encyclopedia offers two tax efficient examples:

#1 – Passing one’s assets on to one’s heirs using a Grantor Retained Annuity Trust, for example, is potentially more tax efficient than simply letting the heirs inherit the assets.

#2 – An exchange-traded fund (ETF) that follows the S&P 500 Index generates fewer “taxable events” than a mutual fund that follows the same index.

Another Viewpoint

Financial educational portal The Balance[2] uses the term tax diversification and offers the following definition: Tax diversification is a financial term that refers to the allocation of investment dollars to more than one account type.

The Balance clarifies the term further by adding, “Tax diversification is similar to asset location (not to be confused with asset allocation), which refers to spreading investment dollars among various account types (the location of the investment assets) and choosing the best investment types that work best in those accounts.”

Tax Efficient or Tax Diversification

For the purposes of this post, we’ll use the two terms interchangeably, since they both seek the same end result. To help you more effectively evaluate tax efficient strategies, we asked Gratus Capital Director of Financial Planning Kevin Woods, CFP® for some advice.

Lack of Tax Diversification Negatively Impacts Retirement

“One of the reasons tax diversification is important for investment portfolios is due to the need to minimize paying taxes during retirement,” says Woods. “Keep in mind that if you place all of your money in tax-deferred investment vehicles, such as a 401(k) or Individual Retirement Account (IRA), you could end up paying more in taxes as compared to if you’d placed some money in taxable accounts today.”

Avoidable Yet Common Mistake

According to Woods, there are many people who only save for retirement using a traditional tax-deferred retirement account, such as an IRA, and never accumulate savings through an additional investment brokerage account.

“Placing all your money in tax-deferred retirement accounts imposes a built-in liability,” says Woods. “Essentially, a percentage of your retirement savings must go towards paying taxes.”

On the flip side is someone who invests in both traditional tax-deferred retirement accounts as well as other investments through a brokerage account. The investor who only saved using an IRA has to pay ordinary income tax on all of their withdrawals during retirement. Not true for an individual who saved using both an IRA and an investment brokerage account. This investor has a more tax efficient retirement portfolio, since he or she has saved their money in different types of investment accounts that have varying tax implications.

For example, the investor now has the ability to withdraw 50 percent from their IRA and the balance of what they need from a brokerage account and only pay taxes on what they withdrew from their IRA.

Detailed Scenario:

The White Coat Investor[3] provides a detailed example of two retired physicians who each draw $100,000 for the year from their financial savings vehicles. One physician placed all his money in a tax-deferred IRA account, and the other used a mix of tax-deferred and taxed accounts. Ultimately, the physician who used both tax-deferred and taxed accounts ends up paying less in taxes. The end result of the example is: One doctor pays an overall tax rate of 12.5 percent, while the tax-diversified doctor pays 1.9 percent.  

4 Different Tax Planning Investment Accounts

To build a tax-efficient investment portfolio, it’s important to distinguish among the four different types of investment accounts used for tax diversification, says Woods.

These include:

Taxed-Deferred (Pre-Taxed) – such as a 401(k) or 403(b). These vehicles are considered qualified investment accounts and have several benefits. Investopedia provides a simple explanation to help differentiate between qualified and non-qualified[4] investment accounts.

Why are tax-deferred accounts so popular? Woods isolates three key benefits:

“First, tax-deferred accounts enable you to lower the amount of income you pay taxes on now, increasing your take-home pay,” says Woods. “Second, since you’re deferring taxes until you withdraw funds during retirement, your investments grow tax-free during the years you’re making contributions. Finally, most retired investors are in a lower tax bracket as compared to when they were working, lowering their tax obligations when they begin withdrawing.”

After-Tax – such as a Roth IRA, Roth 401(k) or Variable Annuity. There are no upfront tax deductions when you contribute to these retirement accounts; however, you pay no taxes on withdrawals during retirement, and investment growth is tax-free.

“As a rule-of-thumb, if you’re age 55 or younger, a Roth 401(k) or Roth IRA makes sense to the extent that you’re not in the highest tax bracket,” says Woods. “Roths generally make more sense when you have more time to invest before retiring and you’re in a lower tax bracket.”

Taxable – such as stocks, mutual funds, bonds, CDs and money markets. Contributing to these taxable accounts means that you pay taxes each year on the dividends, interest and realized capital gains, rather than when you withdraw these funds during retirement.

Tax-Advantaged – such as municipal bonds or life insurance. These financial vehicles typically include a mix of tax-deductible, tax-deferred, and tax-free as well as other tax benefits.

Possible Diversification Strategies

“There are a number of strategies you can use with your portfolio management to strive for tax efficiency,” says Woods. “One approach is to have all your income-producing investments in your retirement account, thereby not requiring you to pay taxes on your interest each year. What’s more, you can also put all your stocks in taxable accounts, helping to provide a preferred lower tax rate on your dividends and long-term capital gains.”

In Closing

While saving for retirement may seem like a straightforward process, complexities arise when it comes to tax liabilities. “There are a myriad of variables to consider when trying to lower your tax liability both for today and during retirement,” says Woods. “I encourage all individual investors to seek the help of both a CPA and a financial advisor.”

Why both?

Because a CPA is an expert in tax laws and the tax preparation process, whereas a financial advisor is an expert at looking at an individual’s overall financial life. The latter includes financial and estate planning, as well as risk and investment management. Investors need both advocates to help ensure a tax efficient financial portfolio, says Woods.

Woods’ number one recommendation for investors, “Have more than just an employer-sponsored retirement account,” says Woods. “If that’s all you have, then it’s likely your portfolio is not tax efficient.”

At Gratus Capital, our team is made up of CPAs, MBAs and Certified Financial Planners. We believe that it takes a well-diversified skill set and team approach to ultimately guide individuals to financial freedom while lowering their tax burden. If you have questions regarding tax diversification or any other financial concerns, please contact us.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.





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Most investors think quality, as opposed to price, is the determinant of whether something is risky.  But high-quality assets can be risky, and low-quality assets can be safe.  It’s just a matter of the price paid for them.

– Howard Marks (Sept 2015)

It seems not a day goes by where a media outlet or publication doesn’t run a story on the death of active management. Whether these stories note the current tidal wave of money being dumped into low-cost index mutual funds and exchange traded funds (ETFs) or the idea that some large percentage of active managers fail to beat their benchmark, it’s all the same story.  Even notable investing legend Warren Buffett in his annual letter to shareholders[1] recommended that individuals allocate almost all their investable assets to an S&P 500 index.  Everywhere you turn, the drumbeat of passive investing is audible.  But is it a siren’s song?

Doesn’t it strike you as odd that humans spend countless hours getting the “best deal” on items to include toothpaste, cable bills, gasoline, and groceries, and yet do not put in equal amounts of effort to a far more critical commodity: their financial assets?  Put another way, the word “deal” as described in the prior sentence is meant to imply a recognition of price consciousness.  The passive approach to investing mandates that you ignore your inner drive for price consciousness.  To me, this behavior seems a little strange, but recent flow of funds data[2] would suggest that many investors are, in fact, eschewing price consciousness in favor of simple “market exposure”….just as the equity markets touch new all-time highs.

As with other manias in financial markets history, we think what is really going on here is momentum investing.  In financial markets, the phenomenon of momentum refers to the positive feedback loop that is created by prices that go up over a short/intermediate-term time frame.  This upward bias in prices draws in additional investors near the mid-to-latter stages of the cycle as FOMO (Fear Of Missing Out) creates a buying frenzy.  Investor memories can be myopic, and you don’t have to look hard for examples of this activity.  Some would include: technology stocks in the late 1990s, single family homes in the mid-2000s, master limited partnerships (MLPs) in the 2010s, and the soup du jour is exchange traded funds (ETFs) based on indices.

So why is it a problem that so many investors are now price insensitive, and how are we (Gratus) accounting for this new potential risk?  We touched on this topic in an update last year, but I believe it’s time to revisit the issue as the answer may not seem obvious.

Low Cost ≠ Low Risk

We’ve put this idea first, as we think it is the most important concept to consider when thinking about an ETF or index mutual fund.  Just because the vehicle is low cost (ETF/index mutual fund) does not mean that the assets underlying the vehicle do not carry risk of over-valuation.  Many in the financial media will eschew this point by saying something nebulous like “in the long run” or “over a full market cycle” to indicate why your entry point is irrelevant.  To us, these phrases are meaningless, because every investor’s time horizon is different and considerations around their financial assets are unique to some degree.  So to reinforce the point, just because you can buy an index that has a low management fee does not mean you aren’t paying too much for the underlying assets.

Someone Needs To Do The Hard Work

To us (as we’ve mentioned in prior publications) successful investing all comes down to basic probability analysis and, by extension, risk/reward.  The only way we know how to pass judgment on risk versus reward is to relate an investment to its valuation (i.e. is this investment a good deal relative to how good a deal the investment was at various points in the past or to its future prospects?).  There are many ways to gauge value, but for simplicity’s sake, we will use the price-to-earnings (P/E) ratio.  Simply stated, the P/E ratio relates the share price of a company to the earnings it generates.  The higher the P/E ratio, the worse of a value it becomes and the lower the probability becomes that the subject company shares can perform in line with historical norms.  This is a gross simplification of all the variables that go into the P/E and a rigorous company valuation, but the concept helps underscore a point.  The only investors that undertake company valuation analysis are active investors….not passive index or smart beta investors.  Therefore, if fewer and fewer investors are willing to undertake valuation assessments, then who is judging whether a company is overpriced or not?  Clearly, it’s not the index/ETF contingent.  

Ease of Trading ≠ Better Investment Outcomes

Just because you can trade an ETF (buy or sell) intraday, whenever you feel like it, doesn’t mean that this liquidity is a good attribute.  In fact, Gratus (and others like Credit Suisse Global Strategist Michael Mauboussin) would argue that the more liquid an investment, the more likely it is that an investor will trade that investment.  This is partly due to loss aversion, whereby losses that an investor experiences (whether realized or unrealized) feel three times worse than gains of an equal amount.  Behavioral psychologists Daniel Kahneman and Amos Tversky documented this concept (known as prospect theory) in their academic paper.[3]

Leaving loss aversion aside, buying a low cost index ETF does not guarantee a good investment outcome because the purchase of an ETF implicitly involves investment decisions to include what size companies to purchase (small v. large), where those companies should be domiciled (US v. international), type of company to be purchased (growth v. value), currency exposure, % weighting in the portfolio (overweight v .underweight), among others.

Next, there are instances of equity index /ETFs that actually trade at premiums to the companies within the index they are replicating.  In this way, investing in these select ETFs means you are paying more than you would if you were to buy the underlying constituents.  This is not supposed to happen in an ETF.  Admittedly, this doesn’t happen very often, but when it does (as was the case with the Van Eck Junior Gold Miners) it makes news as the ETF marketing machines have placed considerable emphasis on minimal premiums and low cost.

Contrast the high-frequency trading of ETFs with some of the most successful investment programs, and we believe that the intra-day liquidity of ETFs is more of a marketing tool than an actual benefit to investors.  In the case of Gratus, we prefer to hold our equity/ETF positions multiple years (if not decades). 

Market Structure Degradation

I’ve left this section for last as it may be a little less intuitive than the sections above.  I won’t go into too much detail here but wanted to show a chart that may shed some light on this section.  Put simply, we now have a dynamic where an increasing number of ETFs are being created while the number of underlying stocks are declining.  What new risks does this dynamic present?

Next, obtaining diversification within a portfolio of indices/ETFs is now harder to obtain.  Take the case of ExxonMobil.  It’s a mega-cap energy stock with ample amounts of trading liquidity in its shares and an above-market dividend yield (3.8%).  Due to these qualities and the way these attributes are weighted in both market capitalization as well as factor-based indices, ExxonMobil finds its shares a top 10 holding in a surprising number of ETFs, to include iShares Core Dividend Growth ETF, iShares Russell 1000 Value ETF, PowerShares BuyWrite ETF, SPDR MSCI USA Quality Mix ETF, Goldman Sachs Active Beta US Large Cap Equity ETF, John Hancock Multifactor Large Cap ETF, SPDR S&P 1500 Momentum Tilt ETF.[4]  Does ExxonMobil really fit the requirements of all these types of investment vehicles?  You can see the issue in trying to reduce overlap in an ETF portfolio where a single stock is held in many different indices.  True diversification is harder to attain, which is why at Gratus we are migrating our portfolios to more active approaches.

Finally, within the context of market structure degradation, we will spend a little time on factor-based approaches to ETF/index construction.  In the media, factor-based approaches are commonly referred to as “smart beta”.  While the concept of smart beta is a valid approach to index construction (whereby stocks are selected not just by size but also other factors to include dividend yield, volatility, valuation, momentum) the problem lies with the mass adoption of the concept.  I would note that most major investment firms, to include behemoths like Dimensional Fund Advisors (DFA), now have smart beta index ETFs as a product offering.  Observing this build-up in enthusiasm, our thoughts turn to the risks: if we all agree that equities are trading at elevated valuation levels generally, then what good does weighing by slightly lower P/E or slightly higher dividend yield provide…… if everything is overvalued?  This is where an active manager’s decision on what constitutes absolute value from the smart beta relative value becomes important.  This distinction can be seen very clearly in periods approaching major turning points in the equity markets (e.g. 1929, 1970, 2001).


In summary, as we have outlined above, there are many reasons to be wary of the passive investment revolution.  So how are we addressing this potential issue in our portfolios?  First, by recognizing that index mutual funds and ETFs have advantages and disadvantages.  This is a big first step because the financial media and marketing machines like Vanguard and Blackrock have powerful platforms to spread their message which usually revolves around the ideas that (1) there is nothing to fear with index investments and (2) cost is the only area where an investor should focus.  This, of course, is way too short-sighted.  As even Vanguard founder Jack Bogle would admit, there are limits as to how many market participants could engage in indexing.

The simple fact is, no one knows the exact percentage amount where passive ownership in equity indices becomes problematic.  We would argue that the math of index investing indicates we are closer to this problem area than many realize.  As an investment firm, and not a marketing firm, Gratus has no preference in favor of any investment vehicle.  Our concern is to provide high quality investment counsel and identify the appropriate strategies to achieve specified goals and objectives with the least amount of risk.  For many of the reasons listed above, Gratus has been migrating toward select active investments as we believe better opportunity lies ahead for active strategies with a discernable value proposition.  In an era where price is seemingly becoming increasingly irrelevant, we at Gratus Capital remain committed to the concepts of a value-oriented approach, as we believe that value (or price consciousness) is one of the few time-tested investment strategies leading to long-term success.


[2] Investment Company Institute 2017 Factbook

[3] Prospect Theory:  An Analysis of Decision Under Risk (1979).

[4] Horizon Kinetics, “Indexation: Capitalist Tool”, October 4, 2016

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The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

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