We are always on the hunt for asset classes with a low or negative correlation to the traditional asset classes we invest in: stocks, bonds and cash. Low correlation is the holy grail of modern portfolio theory (MPT). The general thinking is that by adding a new asset class to your portfolio that has low (or negative) correlation to your existing holdings, you will be able to improve your total holdings’ risk adjusted returns.
Said in layman’s terms, you do not want to put all of your eggs in one basket (diversify!); if some of your investments go up while others are going down (negative correlation), you will be happier in the long run.
Straw hats might diversify wool caps, for example, or umbrellas might diversify mittens. We have heard arguments made for diversifying traditional portfolios of stocks and bonds with commodities, viatical settlements, catastrophe reinsurance, farmland and master limited partnerships. Some of these alternatives show more promise than others.
The biggest challenge in demonstrating or proving non-correlation is the fact that many, many valuation models rely heavily on discounted cash flow analysis. It doesn’t take a professional designation to understand that cash flows matter: higher and more frequent cash flows are better, lower and less frequent are worse.
The issue is that standard valuation models discount those cash flows by an interest rate for the expected duration of the cash flows. For any flows of cash, a higher discount rate will generate a lower valuation. $1,000 per year forever has a current value of approximately $20,000 if discounted at 5%; using even a slightly higher discount rate of 6% yields a new, lower valuation of $16,667.
This basic arithmetic applies regardless of the source of the cash flow. Whether we are talking bond interest payments, equity dividend payments, rents from real property or royalties from oil & gas or intellectual property, they all are subject to dilutions in value from rising interest rates.
There can be offsets, of course. If corporate earnings are rising fast enough, the value of the equity may offset the reduction in the value of the dividend stream. So too, if the value of the minerals associated with the royalty stream increases fast enough, the decline in value of the royalty payments may be offset. It’s complicated, but suffice it to say that when someone is touting the non-correlation of an asset class, be sure to question if discounted cash flows are involved in calculating the value of the underlying assets.
That was an exceedingly lengthy intro to and disclaimer for an alternative class of assets known as intellectual capital rights or royalty payments. First popularized by the so-called David Bowie music bonds, they are a securitization of the cash flows paid to rights holders of intellectual property like the copyrights on songs and movies, for example.
The largest collections, or catalogues, of these rights are owned by very large, publicly traded corporations like Vivendi (Universal), Bertelsmann (BMG) and Sony. Other players in the music publishing space include privately held organizations like Kobalt and Warner.
When financial engineering made it possible to buy and package the rights to payments due to individual songwriters and performers, it opened up the market to obtain direct exposure to the royalty rights outside of the public companies and private partnerships. It is a little like being able to buy individual oil wells instead of buying a publicly traded integrated oil behemoth.
In 2011, Royalty Exchange was established to allow individual and institutional investors and the owners of royalties the ability to buy and sell those rights online.
Other vehicles have been created to offer diversified portfolios with varying degrees of liquidity including private partnerships like those offered by Round Hill Music Royalty Partners and a recent IPO on the London Stock Exchange called Hipgnosis Songs Fund.
To be crystal clear, we are not recommending music royalties as an asset class nor any of the securities or exchanges mentioned in this article. While they may have promise over the long term, each requires a professional level of due diligence to determine risk and suitability for each individual investor. Moreover, they may be subject to some of the same risks as your traditional holdings like the risk of rising interest rates or that of an economic downturn.
In the meantime, we will continue to seek out investments that have the potential to offer diversification to traditional portfolios of stocks, bonds and cash. As always, caveat emptor!
