The Rising Cost of the Free Lunch

This article first appeared in The Assetizer, GenTwo's newsletter and podcast platform.

Diversification has long been known as “the last free lunch in investing”. But as asset classes become more correlated, building truly diversified portfolios is getting harder and harder. To change this, investors are desperate for alternative and non-traditional assets. Asset managers must have the tools to give it to them.

Harry Markowitz, who invented modern portfolio theory, famously said that the diversification is the only free lunch in investing. This simple but powerful insight – that you can get the same or similar returns with less risk by diversifying – has been one of the chief drivers of asset allocation and portfolio construction for the last 70 years.

As most investors know, diversification only works if you can hold assets that aren’t correlated. That is, whose prices don’t dance in unison, but travel to the beat of different drums. As a recent piece in The Economist pointed out, this is becoming increasingly difficult to do.

This dilemma is based on a paradox.

Today, it is easier than ever to invest in all sorts of assets. Thanks to trading apps, index funds and all the other advances in modern finance, retail and professional investors have instant access to investment opportunities from every nook and cranny of the globe, and increasingly to new asset classes like crypto. The investment mainstream has never been wider, broader or more full of opportunities.

And that’s the problem. It turns out that diversification starts to break down when too many investors are in on the trick. This is one reason, The Economist points out (as do others), that correlations among asset classes as well as regions are rising dramatically.

Building a portfolio that looks diversified has become a cinch. Building one that is actually diversified, in the sense that its components offset each other’s risk, has become much harder.

The Economist

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Given this, it’s no wonder that savvy investors are looking ever farther afield for investment opportunities.

Two areas where they have cast their gaze are private markets and “passion” assets, like art or wine. But it’s bigger than that.

As we wrote in our book, Assetization, the universe of currently non-bankable, hard to access assets is two-thirds as large as the universe of bankable assets that the investor mainstream can access.

Besides private and passion assets, these include things like real estate, digital assets (especially the more obscure ones) or belief assets (not the same as passion assets, more on that in a future post).

We are also seeing interest in more exotic-type investments.

In future cash flow assets, people or organizations securitize future earnings. For example young athletes might raise money for the training today with a promise for investors to share in their success tomorrow. (In an upcoming post we’ll show how minor league baseball players are doing this today.)

Prediction and wager market assets can let investors bet on things like the weather.

That’s a lot of potential for diversification. (As well as more yield generally, which is another driver of interest in alternative assets.)

The trick is making these assets investible.

That’s what we are about at GenTwo. Through the Assetization process – which is our term for the kind of universal, low-cost, low-friction securitization process we are dedicated to building – it will become easier and easier to bring these types of assets into the mainstream. Assetization will provide asset managers with a powerful tool to give their clients the diversification they seek.

Of course, this raises the questions of if someday all possible investment opportunities will become mainstream and thus – with the logic of The Economist piece – diversification will die entirely.

That however is a question for another day (and potentially another post).

Tom Lyons
Head of Content, GenTwo