Educational Spotlight: Alternative Investments
Alternative Investments, or “Alt’s” for short, have being gaining popularity for the last decade or so, and now have been in the headlines for some potential problems, particularly in Private Credit. Let’s take a look at what Alt’s are, and why investors may, or may not want to include them in their portfolio.
The two most common asset classes are equities and fixed income. Equities are stocks (ownership shares) of companies, while fixed income securities are typically bonds (debt) from companies or governments. Fixed income can also include pools of loans, such as mortgages, other collateralized loans (e.g. car loans), bank loans, etc. Stocks and bonds diversify each other – to a point. Not all stock market drops coincide with bond prices rising. 2022 was a good example of this, as rising inflation spurred higher interest rates, which devalued bonds and catalyzed the stock market drop. While it has been unusual for stocks and bonds to fall together over the last couple of decades, going a little further back in time, it wasn’t unusual at all. Stock/bond diversification failed in 2022, as it has often failed in the past. Commodities, on the other hand, did quite well in 2022. This demonstrates why there is a demand for other assets besides stocks and bonds. While there may not be any one official definition of Alt’s, the term generally stands for investments other than publicly listed stocks, bonds or funds of stocks and bonds. Some examples of Alt’s include: private equity, private debt, private real estate, gold, commodities, long-short hedge funds, commodity trading advisors (CTA), farmland, timberland, collectibles, viatical settlements, catastrophe bonds and so-called cryptocurrency. These generally have, or claim to have, limited correlation to stocks and bonds, increasing portfolio diversification.
Alt’s offer several advantages relative to only having publicly traded investments in a portfolio. First, they can offer higher returns. Public markets are efficient, meaning there are plenty of smart participants with access to great information such that the price of publicly traded securities trends toward its fair value. Put another way, it’s hard to get an edge. In private markets, there are many, many investments and often they are not large enough to attract very large investors. There is generally no way to index (i.e. capture the average return of all available investments like an index fund). The investments are often in less established businesses that need to offer a higher return to attract investors. For all these reasons, private investments may offer higher returns. (There is an argument that after adjusting for risk, private investments do not offer a higher return, and may offer a lower return, so individual mileage may vary, and investors should take the promise of higher returns with a grain of salt.) The second advantage of Alt’s is lower risk. This does not apply to all Alt’s, but there are many that offer greater stability than public markets. In general, prices of private assets do not move around as much as publicly traded securities. Finally, Alt’s offer diversification. Many have very low or no correlation to stocks or bonds, and some have even historically produced “crisis alpha”, meaning they’ve gone up when markets were going down. Trend following CTAs are a good example of this.
Investors should carefully consider the downside of Alt’s as well. First, the fees embedded in Alt’s are typically much higher than those in publicly traded investment funds. Upfront charges can run 5-10% of the total investment or more. Ongoing fees are often 1-2% per year, plus 20% of returns. While these fees may be justified, they create a high hurdle. Second, Alt’s are often illiquid. Investors may be locked up for years and often do not know when they will have access to their capital. Illiquidity is not just for the convenience of the managers – it is structural. If a fund buys real estate or private businesses, it cannot easily sell assets. It is now popular for funds to offer some liquidity, such as 5% of outstanding value per quarter. This can either be done first-come first-serve, or pro rata. Under normal circumstances, outflows should be fairly minimal, and they can be funded by the cash flow of the investments and new inflows. For investments that have very little cash flow, this may be problematic. Investors should consider the concept of duration mismatch. If a private fund invests in companies or properties that require a long time to sell, offering short-term liquidity, while sounding good, can create a real problem. Once redemption requests become unmanageable, management must “gate” investors. This could prompt others who were not considering redemption to put in a redemption order just in case. This rush to the exits can spook potential investors and ultimately require the fund to start selling assets. Similar to a bank run, this loss of confidence can cause the fund to collapse. A third drawback of private investments is the lack of transparency. Public securities are repriced whenever the market is open. Private investments can easily be held at stale prices or marked up to inflated prices. Private investment fund managers can get paid on this performance enhancement. One recent trend is buying positions from other funds at a significant discount to listed Net Asset Value (NAV) and then marking the value back up to the predecessor fund’s (NAV) and counting the difference as a gain. A fourth potential drawback is higher risk. While this appears to contradict risk as a positive for Alt’s, one should remember that there are many types of private investments, some of which may be quite safe, or at least truly uncorrelated to traditional investments, reducing portfolio risk. Others may be quite risky. People considering an investment in Alt’s should look beyond the stated (historical) volatility, which probably looks much lower than what the underlying assets would produce. Some private equity funds, for instance, claim to have lower volatility than treasury bonds. This is an illusion based on infrequent pricing. If you measured the value of the stock market quarterly instead of daily, it would look a lot less volatile as well, as there would be no price changes at all other than four days per year. There is nothing special about private investments that cause them to be less likely to lose money than public investments. On the contrary, they are often investments in small companies, with shorter track records. In a good economy, private investments can do a great job of hiding (or laundering as some have called it) volatility, but in a really bad economy, they are unlikely to provide the diversification they promise. (This is a very general statement. Specific Alt’s may be immune to economic cycles.) Rather than looking at historical correlations when one investment is only periodically repriced, consider what forces would cause an investment to go up or down. Private real estate should act a lot like public real estate. Private equity should act a lot like public equity. Private debt should act a lot like public debt.
What is an investor to do? Alt’s make a lot of attractive promises, and they have a great track record of improving portfolio returns and diversification. On the other hand, high fees, lack of transparency, and difficulty in diversifying without committing millions of dollars to Alt’s present high hurdles. Investors should proceed (if they want to proceed) with caution. Don’t be swayed by rosy projections. Question what environment was present when the beautiful track record was built. Look past the artificial volatility numbers. Drill down to the underlying businesses and identify risks before counting how much money you could potentially make. Engaging a professional advisor in this tricky space makes a lot of sense and is generally required for most Alt’s. Make sure the advisor is knowledgeable, is willing to be open about their own limits, and sits on the same side of the table as you. Commissions can be quite attractive for financial salespeople selling Alt’s, which can impair objectivity. A fee-only advisor will not have to overcome this conflict of interest.
If Alt’s appeal to you, tread carefully. There may be some great opportunities out there, but there are also landmines. Know what you are buying and why. Consider your own liquidity needs. And always be prepared to say no, because one can build a perfectly fine portfolio using only publicly traded securities.