Let Royalty Investments Help Slice the Pie

Oct 08, 2014

Between stocks, bonds, commodities, real estate and royalties, one can make a bullish case for anything. Too often overlooked is allocation: how does one combine the various financial ingredients to make the most profitable feast?

Many advisors have historically relied on the Rule of 100, a basic metric which uses age to guide asset allocation. Starting with 100, one subtracts his age, the remaining number serving as a snapshot of what percentage of a portfolio should be allocated to higher risk bets. The idea is that one grows older; he becomes more risk averse.

For example, a 45 year old with $1,000,000 to invest could allocate up to roughly $550,000 to higher risk investments, with the remaining $450,000 in income and low volatility.

In recent years, most alternative investments have been lumped into the risk category, and for good reason. While not directly correlated with the economy, assets such as gold, foreign exchange and leveraged loans have demonstrated wide fluctuations and in many cases, negative net returns.

Over the past three years, for example, gold prices as measured by the benchmark SPDR Gold ETF (GLD) are down apx. 25%.

Losing Luster:

Let Royalties Help Slice the Pie

SPDR Gold ETF (GLD) €“ 3 years

Source: BigCharts.com

But royalties, as previously discussed, are a legitimate alternative. Because they're not actively traded, there's no market-to-market volatility. So although royalties constitute risk assets such as stocks, their lack of liquidity makes them, unlike stocks, an inherently long-term bet.

Buying a royalty is buying an income stream, which will fluctuate, but will never be negative. The primary risk is opportunity risk, not decline in investment value.

It's for that reason I believe royalties can partially be considered part of the income allocation of the Rule of 100. Like corporate bonds and preferred stocks, royalties also provide consistent income €“ but that's all they provide.

As a professional money manager investing for the long term, I see the inherent uncertainty in an illiquid royalty investment as being mitigated by its nature: royalties are streams of cash flow, not a equity, debt or physical commodity that can soar or plunge.

In the past, we've classified royalties as income streams with embedded call options. By that reasoning, they bridge the chasm between risk asset and income alternative.

So when allocating a risk budget, one could think of royalty investments as being split with half of the position considered risk and half considered income.

For instance, an investor wanting to add risk to a portfolio could consider a 5% purchase of income-producing royalties as being 2.5% in the "risk" category and 2.5% in the "income" category.

This approach acknowledges the variability of royalty investment income with the assurance that, unlike more speculative options like stocks or alternatives like gold, there will be income: quarter after quarter for as many as 35 years.

Next week: A music royalty mutual fund?