First-principles thinking is the philosophical cornerstone to some of humanity’s greatest innovators, including Gutenberg, Aristotle, and Elon Musk. It involves boiling a theory down to key fundamental aspects that are known to be true, then building systems with an intense focus on those key attributes.
A recent example of first-principles thinking steered SpaceX towards realizing the inefficiencies of single-use rockets, leading them to the development of reusable rockets. This fundamental change revolutionized space travel by reconstructing established systems with a newer, more fundamentally-sound approach.
Portfolio Management Fundamentals
This philosophy can apply to investing as well. While there are near-infinite ways to build a portfolio, science and practice have generally agreed that investors can optimize portfolios by focusing on the following five attributes:
The Five Attributes of First-Principles Investing
- Diversification
- Fee Management
- Simplicity
- Liquidity
- Risk Consciousness
Start at the Beginning
- Diversification
Asset allocation—the selection of asset classes and their weightings—generally determines the bulk of a portfolio’s risk and return. A diversified asset allocation has greater odds of producing strong risk-adjusted returns over time, and is generated by allocating across uncorrelated investments that do not move in tandem with one another.
The simple diversified portfolio below offers an example of how one can invest in nine complementary asset classes: US Large Cap, US Small Cap, International Developed Markets, International Emerging Markets, Investment Grade Bonds, High Yield Bonds, US Treasury Bonds, Real Assets, and Cash.
At this stage, the investment vehicle choice is not yet a consideration. Because the asset allocation is so critical to the portfolio’s performance, the focus is solely on generating the optimal blend of asset classes before making the choice between ETFs, mutual funds, structured notes, or another vehicle.
- Fee Management
Fees decrease the effectiveness of a portfolio by eroding returns. Fortunately, today’s competitive market for investment funds enables investors to construct well-diversified portfolios for a fraction of the historical cost.
The advent of technological infrastructure has similarly introduced competition into the structured note marketplace. As a result, structured notes’ costs have decreased to levels that parallel traditional actively managed funds.
- Simplicity
Introducing new asset classes into a portfolio may enhance diversification, but it can also increase the complexity of execution and management. On the other hand, a first-principles portfolio may benefit from simple diversification with an optimally efficient blend of asset classes.
Using structured notes may be a practical approach to keeping a portfolio’s asset allocation simple. This is because structured note returns can directly enhance an asset class’ benchmark return.
In the next iteration of the first principles example portfolio, the investment vehicles are chosen. The majority is allocated to ETFs, and a portion is allocated to structured notes that are linked to their respective asset class benchmarks.
- Liquidity
ETFs with large amounts of assets and trading volume tend to be highly liquid. In the sample portfolio below, 75% of the portfolio is allocated to ETFs that may offer ease of transaction for the portfolio’s inflows and outflows.
Structured notes are typically held to maturity, which is when performance enhancements like downside protection and upside multipliers are in force. The liquidity factor can be managed by splitting the allocation across multiple notes that mature over time.
Below, the example portfolio shows each asset class’ note position divided into four separate notes. This helps to diversify the credit risk and maturity risk of the structured note positions.
By creating a “ladder” of structured notes that mature in a specific cadence, investors can potentially customize their investments to match their desired level of liquidity in perpetuity.
The ultimate goal is to combine the benefits of structured notes’ performance enhancements with the flexibility to access funds as needed with ETFs.
- Risk Consciousness
Looking back to step one, asset class diversification is a proper foundation for a risk-conscious portfolio. Enhancing exposures with structured notes can add a supplemental layer of risk management, potentially fortifying portfolios against a wider range of outcomes.
For example, some structured note types have the potential to generate a positive return when the underlying asset has a negative return. These contractual performance enhancements allow investors to diversify how an asset class operates, potentially increasing the probability of successful outcomes across more market environments.
The payoff chart below displays a common example of a growth note’s asymmetric risk profile across a variety of outcomes:
- In positive scenarios, the note provides enhanced participation to multiply the underlying asset’s return.
- In negative scenarios, the note has a protective buffer to dampen the underlying asset’s losses.
Why Structured Notes?
Structured notes are simply an investment vehicle, similar to a mutual fund or ETF. However, they have features that set them apart from nearly all other traditional investment vehicles.
Because structured notes use derivatives, they allow for more precise management of risk and reward. More specifically, derivatives can facilitate:
- A bullish, neutral, or bearish view on a security
- Specific price targets
- Leverage to enhance the underlying asset’s return
Combining all the elements of structured notes’ underlying construction allows an investor to pursue defined-outcome strategies with three core benefits:
- Explicit downside protection
- Enhanced upside growth or enhanced yield
- Compensation for the underlying asset’s volatility
Sample Portfolio Line-Item Details
A $100 million first-principles sample portfolio is detailed below. Efficient diversification is produced across nine asset classes that include global core equities, fixed income, and alternative assets. Risk profile enhancements are applied by layering and laddering structured notes within these common asset classes.
Like most engineering problems, developing a prototype is the simple part. Implementation includes case-by-case complexities and happens iteratively. Over time, investors that adopt first-principles investing may migrate towards an optimally diversified, simple, low-cost, liquid, and risk-conscious portfolio like the example below.
Sample U.S. Large-Cap Implementation Over Time
A more granular level of detail for an individual asset class’ structured note implementation is detailed below, with a $22 million initial investment in U.S. large-cap stocks and U.S. large-cap structured notes.
In this framework, the asset class’ core ETF and structured note ladder are implemented simultaneously:
- Invest $16 million in the core ETF. This produces low-cost, passive, liquid exposure to the asset class.
- Simultaneously invest $6 million in four structured notes; $1.5 million each. This produces simple risk profile enhancements.
- Set the structured notes to mature in 2 years, 2.5 years, 3 years, and 3.5 years.
- Perpetually roll the matured notes’ proceeds into new 2-year notes.
This methodology can be applied across the portfolio to enhance each asset class. When the implementation is complete, the result is a diversified, low-cost, simple portfolio with significant liquidity and an enhanced risk profile that fits a first-principles thinking approach.
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