“Alternative” investments (aka “Alts”) are probably best defined as investments that are anything other than stocks or bonds (and cash is just a bond with a really short duration).
A few years ago I got the CAIA (Chartered Alternative Investment Analyst) designation, and I attend alternatives conferences periodically to be well informed. A recent conference prompts this note.
The attendees at this conference (like all the others) were very enthusiastic about alternative investments, and I was frequently asked about our usage. I usually responded, “I got the CFA to mostly index and the CAIA to own no alternatives at all – it’s a severe level of overkill.” I also sometimes just said we didn’t use them, but I was “alt curious,” which usually got a laugh. Here I thought I would set forth in detail my reasons for avoiding alts.
Though some of my reasons may apply to them as well, in what follows I am not talking about alternatives that have no current or prospective cash flows (other than from selling someday) and are impossible to value mathematically. Proponents will argue with me about that impossibility, but, in my opinion, they are merely grasping for rationalizations to own the investments – particularly since I have never seen anyone do a mathematical analysis on them that concludes they are overvalued.) Those alternative investments are frequently called “collectibles” and would include art, wine, stamps, coins, watches, antiques, beanie babies (at one time), NFTs (more recently), rare cars, trading cards, gold, cryptocurrencies, etc. (That last one, crypto, people would argue isn’t a collectible, but outside of the narrow use of facilitating crime there is no significant current use case for crypto despite a lot of hype. Blockchain, yes. Stablecoins, yes. Bitcoin, et al, no.) Some of those are more ridiculous than others as investments, of course, but all of them share the property that the investment case boils down to, “I think it will go up.” That opinion could, of course, turn out to be right, but it’s vibes-based, not empirical, and since they were first issued in 1997, TIPS are a far better option for protecting wealth against the ravages of inflation.
With those preliminaries aside, let me explain why I am unpersuaded to invest in currently popular alternative investments such as Venture Capital/Private Equity, Private Credit/Debt, and Real Estate (Hedge Funds too, though those are less popular today because the returns have been relatively abysmal for a while).
The trivial (and well-known) reasons are:
- The fees are very high (compared to traditional investments). Indeed, in economic theory the returns will flow to the scarce factor of production. Supplying capital is not that factor. You would expect (and I do) that more or less all of the excess returns flow to the managers of the funds to the extent they have skill. (You may wonder about the “more” – many, probably most, managers are better at purporting to have skill than they are at having skill. They charge a lot either way.)
- There is a hassle factor to investing in these. The investment process is onerous. The redemption process is onerous (frequently on purpose). They generally produce K-1s rather than 1099s, and those K-1s are notoriously produced very late – often running up against the extension (not regular) tax deadlines. These things aren’t terrible, but they do tend to annoy the investors. In addition, the work to research and perform due diligence is substantial, which would require us to increase our fees to cover researching and managing them.
- Alts are illiquid, and more illiquid precisely when you don’t want them to be. This illiquidity is frequently touted as an advantage in the sense that you earn an illiquidity premium, but it isn’t clear why that would be so. Suppose you own shares in a partnership that invests in real estate, for example, that underlying property is illiquid, so it’s purchased at X% off some “true” value. You will also sell at X% off some true value on the back end. Consequently, on the price appreciation there is no advantage whatsoever (though the cash flows from the investment would be higher as a percentage of the amount invested). Even aside from that, it appears that today many investors will happily pay an illiquidity premium because in poor markets they can pretend the value of their investment has not declined when it really has. (Cliff Asness has eloquently made this point here.)
- The purported low volatility and low correlations with traditional investments are simply not true (or at the very least greatly exaggerated). It’s merely a function of the assets not being appropriately marked to market, which makes the apparent risk and correlations seem low as a matter of pure mathematics. Further, many investors (and advisors) give these factors far too much weight. The return of the proverbial cash stuffed in your mattress has zero volatility and zero correlation with all other investments – but it’s still a terrible investment. (Lottery tickets are also completely uncorrelated to the rest of your portfolio.)
So far, so banal. I think there are four other substantial reasons though:
- There is extreme positive skewness in the distribution of returns of the investments. This means most of them do poorly, but you are “saved” by the very few that do extremely well. This means you need to own a lot of them, but you would have to be extremely wealthy to afford to do so. This can be partly mitigated with funds-of-funds, but those produce another layer of high fees causing investors to start even further behind.
- The “good” funds won’t let you in. As Marx (Groucho, not Karl) said, “I refuse to join any club that would have me as a member.” That should be your attitude toward alternative investments unless you are (again) extremely wealthy or a very large institutional investor. The funds with excellent track records are not only closed to new investors, they may also be returning capital to outside investors and converting into family offices for the owners and employees. The capacity of any very lucrative strategy (if you can find one) is very limited. If they need capital from you (or me!) that is a sign that it probably isn’t a great investment. Many remember David Swenson (of the Yale endowment) for his enormous success with alternative investing and writing Pioneering Portfolio Management touting that approach, but fewer realize he subsequently wrote Unconventional Success: A Fundamental Approach to Personal Investment for individual investors telling them not to do that – they aren’t the Yale endowment!
- You can’t differentiate luck from skill because you will never have a long enough track record. To know whether a portfolio manager who has been beating the market by 2% annually (which is enormous) has skill would require a track record 56 years long. (This is a difference of means test assuming a normal distribution, 2% alpha, 20% standard deviation, and 90% correlation with the benchmark.) Thus, realistically, you will never know with any high degree of confidence whether a portfolio manager is skillful. I wish it were otherwise, but it simply isn’t. With alternative investments it’s even worse. The “uncorrelated” nature of them means the time horizon needed goes up even more. Returning to the earlier example, if the correlation is reduced from 90% to 85%, the time horizon necessary increases from 56 years to 83 years! And keep in mind that many alternatives promise zero correlation (if that were true, the time horizon needed to know with 95% confidence that the alpha is positive, not 2%, simply not a negative number given the other listed parameters, is 543 years). The investment industry, particularly in the alternatives space, is almost entirely faith-based rather than evidence-based.
- Proponents of alternative investments will tell you to be very careful in what you purchase because one alt is not like the other – even in the same sub-type. (And, of course, their company sponsors the good ones.) With traditional index funds, there are advantages and disadvantages of full replication vs. sampling (though full replication seems better). With alternatives you definitely need full replication, which is impossible because of investment minimums. (It’s impossible for access reasons as well, but I’m focusing on the minimums here.) In academic theory you would start with a market-cap weighting methodology and then deviate from that based on the strength of your belief in the investment. How much belief do these alternative investments require us to have? The market cap of the U.S. stock market right now is roughly $60 trillion. Suppose you are contemplating investing in a real estate limited partnership that owns property worth $60 million. For every $1 million invested in U.S. stocks, how much should you put into the partnership? One dollar. But, of course, the investment has a $100,000 minimum (minimums vary, but that’s typical). So, suppose I have $10 million in U.S. stocks, I should invest $10. But the promoter requires me to be 10,000 times overweight that holding to access it. I’m sorry, I will never have enough confidence to overweight something by that much in my portfolio! Obviously, this is just one example with made-up numbers, but you will always be massively overweight the holding and thus should have confidence approaching certainty that it will have a high return. Arguably, you could also use the Merton share calculation.
TL;DR: Friends don’t let friends buy alts! (IMHO, of course.)