Session 38 (of 42): Alternative Investments

0:00 Hi, welcome back. Through all the sessions in this class where we've talked about different investment philosophies, we've tended to focus on financial assets, stocks, bonds, and other traded assets. And in the process, we've ignored what can be called alternative investments. So, in this session, I want to focus on that alternative space. what we call alternative investments, why we're drawn to them, what is it that attracts, and at least for this session talk about the biggest of those alternative investment classes, which is real estate. So, let's get the show on the road. Almost every investment book, every valuation book is directed at people who are long only on financial assets, stocks and bonds. What does that mean? can buy stocks or you can buy bonds but you you really don't talk about the alternative to doing that. In the process though as we said we're ignoring vast swats of the investment universe. What does that include? It includes people who go short on assets. It includes people who invest in other asset classes real estate, gold, collectibles, cryptos and people who build their wealth by by building up private businesses. These ignored investment classes are what we call alternative investments. In the last two decades, they've been marketed as a class to many investors who have the bulk of their wealth in stocks and bonds. But historically, they've been held by only a small subset of investors. Now, let's face it, there are people who become wealthy by putting their money in these alternative investments. And it behooves us to talk about this as an investment philosophy, a philosophy of focusing on these alternative investments and building your wealth through them. So let's get the show on the road. Much of traditional investing and much of what we learn about portfolio theory as I said was directed towards people who are long only on financial assets. What are we missing when we do that? Three groupings. The first is on the long short axis that people instead of buying stocks might sell short on them.

2:06 Included in here of course are hedge funds which we've already talked about derivative investing and structured products. The second the second grouping we're missing is in the public private dimension. Much of our focus is on publicly traded assets. But what about private businesses? Here again, venture capital, which we've all talked about, private equity and private credit come into play. And then if you look at asset class, there are a whole group of asset classes or investment classes we don't really look at. That includes non-traded real estate, collectibles, gold, artwork, NFTs, which are the non-f fungeible tokens, which became part of the crypto growth over the last 15 years, and cryptos themselves, Bitcoin, Ethereum, etc.

2:54 Now, of course, when you look at what makes them attractive, there are two things that make them attractive to most investors. Most of us, because we're so focused on our holdings and long only short stocks and bonds, find alternative investments attractive because of their low correlation. I put quotes around the word low because sometimes the low might be not quite true. It might not be low, but we perceive low correlation. saying so what adding them to a portfolio composed mostly of stocks and bonds will make that portfolio more efficient in terms of delivering higher returns for any given level of risk. The other is a little more subtle. The perception at least is there are some very smart people in each of these spaces especially in venture capital and private equity where we assume that and hedge funds where we assume that those people are able to beat the market.

3:44 We'll talk about the logic of why we think that is and therefore are better in a better position to deliver alphas in a world where traditional public market investors have struggled. Remember the sessions on active versus passive investing. So we'll talk more about the sales pitches but you can see the missing pieces. Let's focus more on each of these dimensions. Let's start with long short. In principle there's really no difference between a long and a short position. And all you're doing is reversing the cash flows in a long position. You go buy something first, buy shares, buy bonds. So the negative cash flow happens first when you buy and then you wait and sell later. So the positive cash flow comes in when you sell. In a short position, you reverse the sequence. You sell short. So you collect the cash flows up front. Then you buy it back a year, two years later.

4:36 The negative cash flow comes later. Mathematically, positive followed by negative. negative followed by positive. Either works as long as the positive exceeds the negative, right? But in practice, it's undeniable that regulators and many investors view selling short as very different than going long from a moral standpoint and investing standpoint. What do I mean by moral standpoint? There's this perception that if you sell short, you must be a speculator that you really are not interested in creating value over long the long term. I don't understand it but it is what it is. Many institutional investors though are restricted to be long only. We talked about equity mutual funds. Equity mutual funds for the most part have to be long only. They can buy shares but they can't sell short. For a century or so hedge funds have carved out the special place at least in US markets. They've been allowed to be both long and and sell short. Although many hedge funds don't take advantage of the selling short and it's undeniable that being able to sell short changes the kinds of return combinations you can offer investors.

5:46 Earlier on in this class we talked about hedge funds often deliver lower returns than traditional mutual funds but their standard deviations are so much lower that they deliver better ratios of returns to risk. And finally, if you look at the opening of derivatives markets, which are relatively recent, the last 50 years, you've had options and futures markets open open up. The the truth is derivatives markets allow you to be short on a on a stock without actually selling short on the stock by doing what? By buying a put option on a stock, you're effectively selling short. So long short, the much of what we've built in investment theory comes out of being long. But you can clearly see the potential that you open up by being able to sell short on things that you think are overpriced. The second dimension is public versus private. Again, much of the focus in investing in valuation is on publicly traded companies. But there are lots of private businesses. They need capital, too. If you're a young private business, of course, you go to venture capitalists to get this capital.

6:50 And we talked about what venture capitalists do well and do badly in a in in in an earlier session. We talked about activist growth investing and the returns that they offer. If you remember that session, much of the payoff to venture capital in terms of adding that alpha has decreased over time, but venture capital provides capital and they presumably make a return on that investment. for more established private businesses which are larger you know more mature private equity has been the source of capital. So you got venture capital, you got private equity. They fall in the alternative investment space. And then when you turn to borrowing money, historically companies borrowed money either from banks or in the bond market. But in the last few years, you had a private credit market explode where investors pull their funds to lend to private businesses rather than invest in the equity. We'll talk about the rationale for private credit, what it does well and badly. But again, you can see with venture capital, private equity, and private credit, you open the public private domain to more investors. And finally, if you look at asset classes, real estate in particular, it's true there's a segment of real estate that is traded. We'll talk about that traded segment either as real estate investment trusts or real estate securities or in the bond market as as mortgage back securities. But the bulk of real estate for much of the 20th century and spilling over into the 21st century has remained in private hands.

8:17 Private hands either with owners holding on to the real estate or people are focused just on real estate investing. Right? Then there's a there's a final asset class that we'll that we'll call collectibles. What are collectibles? Collectibles, you know, have an array of different investments. You can start with gold. one of the longest standing holdings that investors have had now centuries. It's held its its its pricing allure. It's a draw for some investors. There are some people who have the bulk of their portfolio in gold. You can have artwork, you know, paintings, you know, you can have digital art in the form of nonfgeible tokens essentially where you're betting on what'll happen to that artwork over time. And at the risk of getting some push back here, you could argue that much of the crypto space falls more into the more into the collectibles column than into the currency column.

9:09 There's an argument to be made that Bitcoin is actually millennial gold. So essentially with asset class, you can see how much is left out with traditional investing. Now in terms of the sales pitch for alternatives, I kind of mentioned it up front. I want to reemphasize it. The biggest sales pitch that people have used to sell investors on alternative investments is they have low correlation with their existing holdings because your existing holdings are mostly in traded stock and bonds.

9:36 We'll see if that's true in terms of the numbers and whether you should trust those numbers, but that's partly what drove in the last two decades getting endowment funds and big investment funds to invest some of their money into alternative investments. The other pitch is the people who run these alternative investments especially VCs, private equity and hedge funds are the smartest among us. There's this illusion or perhaps delusion that there is smart money and that this is smart money and smart money is more likely to deliver alphas. In a world where that's become more difficult to deliver in public equity markets, maybe you're looking outside alternative investments might deliver those alphas. So let's take a look at this correlation matrix as it's called to see what it teaches you as an investor about the add-on value of an alternative investment. Let's assume you have all your money invested in an S&P 500 index fund. So let's go to the last line. Adding bonds to your fund will actually make your fund better in terms of the risk return tradeoff because the correlation between investment grade bonds, so I'm talking about you know corporate bonds is only 37. The scale here is a correlation of one means you have an investment group that works moves entirely with whatever you're holding. As correlation drop below one, you're actually adding something that has the potential to create a better trade-off in terms of risk and return.

11:01 And the lower the correlation becomes and remember correlations can go from plus one to minus one, the more efficient your risk return trade-off looks like. So investment grade bonds reason I mean they move with your stocks most of the time but not by enough that you don't get some benefit by adding them adding cash and that's the definition of something riskless has a correlation of zero that's often why we add cash is its value stays the same no matter what happens to stocks but let's take a look at hedge at first international equities let's suppose you have your money in the S&P 500 say look what if I put my money in foreign stocks 50 years ago Oh, that was a good thing.

11:41 It actually had low correlation with the S&P 500. Those days are done. The correlation between international equity and the S&P 500 is86. There's some benefit, but it's marginal. What about hedge funds? Hey, hedge funds have a correlation of 72. That's pretty high. It's not one. So, there's some benefit, but relatively small. Adding currencies or managed futures, much bigger trade-off. So, this correlation matrix by itself will shift over time. It'll change depending on what we put in. But here's the bottom line. The the big pitch for alternative investments is that their correlation is low or negative. And adding them to your portfolio will make your portfolio more efficient in risk return. But you can already see that that sales pitch is stronger with some alternative investments. Gold maybe you know maybe some kinds of hedge funds but not so strong with other kinds of pitches you hear for alternative investments.

12:38 Now what about the alpha argument? We're going to come back and talk more about alphas in these individual cl you know about as we look through time. But if you look across the different alternative investment classes here are two realities that kick in. First is there is some alpha at least on average as you look across these investments. Alpha is in terms of returns that look higher than they should be given the risk in these investments. But here's the open question. Is that because we're mismeasuring the risk in these investments or is it because these investments are actually managed by people who deliver alphas? The other thing that should come out to you when you look at this graph is how much divergence there is within each class.

13:21 Let's take private equity. The median private equity fund at least in the period that this particular graph was constructed delivered a return of 6 1/2%. The 75th percentile was 7. The 25th percentile was 5 1/2%. But look at the spread. There are funds out there that deliver much lower and much higher return. So within each of these classes, you can see a big divergence. But the median value tends to reflect this tradeoff that you see. If you remember our discussions of venture capital and private equity, remember what's happened to those alphas that excess returns over time. They've shrunk as these investment classes have become bigger. So you can see the basis for both the correlation and the alpha argument. Now before we talk about alternative investments as a grouping and look at individual alternative investments, I'm going to put in what I think is something we all we need to think about as investors. There are two words we use in investing interchangeably that we shouldn't. One is the word value. The other is the word price. We talked about this earlier in the context of you know of an earlier session on value valuing something versus pricing something. But to value something you estimate the expected cash flows and you estimate what you would pay for those cash flows given the risk in those cash flows. So let's say you know stocks they can be valued based on expected cash flows risk and you come up with the with the present value but they can also be priced by looking at other stocks like the stock we're trying to price and using know scaling the price to something that they share in common earnings book value and then saying my stock is cheap or expensive given what people are paying for other stocks just like mine. Assets have cash flows they can be both valued and price. So you can value a stock or you can price the stock. You can value a bond or price the bond. You can value a private business or price the private business.

15:15 What about commodities? Commodities are things we use to produce something else, right? Iron ore is a commodity by itself. You know what are you going to do with iron ore? You can value it at some macro sense by looking at the demand and supply for iron ore, but that's messy and it's not really useful. For the most part, we price things like iron ore or oil against what the own their own history. You can say $50 per barrel is cheap because for the last 25 years the price has ranged from 45 to 90 and 50 looks at the bottom end of the range. Commodities can be valued in a macro sense, but they're often priced. What about currencies?

15:58 Currencies can't be valued. If you ask me what is the value of a dollar, I have no idea. But I can price the dollar against other currencies. That's what an exchange rate is. And if you're a good currency, a currency that maintains value, low inflation and greater acceptance. I can use it all over the world, you should trade at a higher price against a currency which has much more loss in value over time because it has high inflation or it's not accepted around the world. Currencies can only be priced. As for collectibles, they cannot be valued. And here's why. When you buy gold, what are your cash flows? There are none.

16:34 If you don't have cash flows, you can't value something, but you can price it. We'll talk about pricing gold, but you got to price it against something that you think is a competitor for your money. So, currencies and collectibles can only be priced. Commodities mostly are only priced. Assets can be both valued and priced. You're saying, "So what?" Let's take some alternative investments and talk about whether they can be priced, valued, or maybe only one of the two apply.

17:05 Let's take real estate. If you buy commercial real estate, a rental property, you have cash flows, right? The rental income. You can value real estate, but you can also price real estate against what? Against other buildings that look just like yours on a square foot basis. If you have residential real estate, you could implicitly estimate a rental income, but it's mostly priced. Real estate for the most part is a pricing game, but you can value it, especially with commercial real estate.

17:38 Collectibles can only be priced. Artwork, gold, and there's a third group of alternatives that I'm going to talk a little bit about called trophy assets. What's a trophy asset? A trophy asset has cash flows. You can value it as an asset, but because it's a trophy, people value it for other reasons, the pricing is completely disconnected from the value. So, you can get a value, but you compare the value to what people are paying, there is no relationship, and there's no convergence.

18:07 Now, as as an advanced notice on trophy assets, I'm going to argue that sporting franchises, especially in the high-profile sports, the NFL, the Major League Baseball, the NBA, the basketball in the US, Major League Soccer, you know, but outside the US with soccer, Premier League in the UK, IPL, Indian cricket teams when you get trophy assets. Why? Because the people buying them are not interested in buying businesses. They're buying a trophy. And when you're buying a trophy, you price it. So even though there might be a cash flow effect that can be valued, the pricing dominates.

18:42 As I said, this session I want to talk about real estate, the most the biggest alternative investment class because I think we need to give it more attention. Some real estate is traded in the US. I've actually categorized the traded component of real estate. REITs, real estate, investment trust, development real estate. So these are publicly traded companies either do development are diversified in real estate or have real estate operations but they're a tiny fraction of the market. They're only about 4.15% of the market cap. Real estate traded real estate is out there but it's a tiny segment. In fact if you go global that 4.15% becomes even smaller on a global basis. Even less real estate is traded than even in the US. You think so what?

19:27 There's a huge chunk of real estate that is not rated. It's estimated the start of 2024 about $400 trillion in real estate around the world in residential and commercial real estate which makes it a much bigger market than public equity but much of it is not traded. Now why do people buy real estate? If you're buying it as an investment, you're buying it for the returns, right? And if you're buying it for the returns, the question is what are the what do the returns look like on real estate versus public equity or the bond market. Let's compare it to, you know, stocks and bonds because those are the traditional investments made. With stocks, the way we measure returns is we look at traded stocks, the S&P 500, or with bonds, we look at traded bonds. We can compute the arithmetic, the average return, a standard deviation. So these are the numbers we tend to you to be able to look up easily. So on traded investments, stocks, T-bonds, T bills and corporate bonds, you can look at publicly traded indices and compute their returns and standard deviations.

20:35 You can do this with traded real estate as well. And many people when they come up with returns for real estate look at the traded portion, real estate investment trust. But remember when you looked at the previous W this is a tiny segment of real estate. In the last two decades we've had indices that try to measure the returns on non-traded real estate. The case and Schiller for instance have a very widely used index of residential real estate. And here's the challenge you face with both commercial real estate and residential real estate that's not traded. Remember you need a price to get returns. You got to come up with an estimated price. The way Case and Schill have come up with the estimated price is look at transactions on similar real estate.

21:18 Your property might not have been sold or bought, but since a property near it has been sold or bought, use those transaction prices on the on the traded on the on the portions that were bought or sold to update the index. So that's one of the caveats. These returns are not as reliable because they don't come from daytoday hour to hour prices. is they come from these transaction prices. And if you look at the returns on non-traded real estate, they don't look that great. I mean, in fact, if you look, especially at residential real estate, it looks that you'd have made a 4.42% return, which is less than the return you'd have made on T-Bonds. But here's the caveat. These are transaction prices.

22:04 You look at the change in price. You know what you're missing is if you had actually bought this residential real estate and rented it out, you'd have a rental income. So presumably this 4.42% captures only the price appreciation part of real estate. And then you add on the rental income. That could may bring it up to to at least on par with commercial real estate. So price appreciation in general in real estate has been pretty modest over the last century, four to 5%. If you add on the cash flow, you get to about 8 or 9%.

22:36 It's again not mind-blowing, but the standard deviation in returns you're also going to get from looking at these appraised real estate values is going to be low. Not because real estate is not risky, but because you don't have traded prices. You're looking at these transaction prices. So that low standard deviation might be a delusion because if that non-traded real estate was actually bought and sold on a minute-by-minute basis, who knows what the standard deviation would be, but as a class real estate has not been a standout in either direction. It's not hugely impressive returns, but it's got returns that match up to many publicly traded assets. And the question is, how much of it should you hold in your portfolio? Now, your bigger pitch for real estate might be not that its returns are higher than on stocks and bonds, but that by adding real estate to your portfolio, you make your portfolio deliver a better trade-off. Why? Because real estate historically has not been highly correlated with traditional traded assets. Let's suppose, let's say you took, you know, your residential house and you took the S&P 500 and this is a study that looked at cove movement over a long period. the correlation between your the value of your home and the value of the S&P 500 is minus.13 which means historically putting some of your wealth in a residential house was good was was a good investment decision because even though it might appreciate only 3 or four or 5% a year by adding it to a portfolio composed of stocks and bonds you made your overall wealth more stable. That was the push between getting people to buy their own home and in fact extending beyond that into real estate. You can see that with other components of real estate. The correlation with publicly traded assets historically has been either low or negative. And the pitch for adding real estate to your portfolio came from that negative correlation. When I did my MBA in the early 80s, this was a big pitch you heard in investment classes. should add real estate to your portfolio because it has either has a low correlation with stocks or a negative correlation. We'll talk later about how that correlation might have shifted over time, but that's really the pitch. Now, one of the ways you can see this this low correlation payout that's not abstract is by looking at the returns you make across different investment classes in different time periods. In this table for instance, I've looked at the returns by decade that you'd have made on stocks, on T- bills, on T- bonds, on corporate bonds, and then I add gold and real estate to the mix.

25:14 Now, we'll talk more about gold in the next one, but at least you have the introductory table here. And then I look at the returns by decade. I'll talk a little bit about why I have no returns for gold all the way through 1969 when I talk about gold. But let's take real estate, right? If you look at the returns in real estate between 1930 and 39, it's a big you look at that return. So why would I invest in real estate?

25:38 I'd have made 6.19% on an annual base in stocks, 2.91% in T- boost, 5.93% in Tond only 87%. In fact, in most decades, the return on real estate lagged the return on financial assets. But then you get to the 1970s and you can see the benefit of adding real estate and we we'll talk about gold more as I said in a future session is real estate held its value in the 70s when the other financial assets melted down.

26:13 You can already see that this negative correlation we're talking about essentially means that real estate can hold its value under some some macroeconomic conditions that are not good for financial assets. So the low correlation is just the entree to thinking about why adding an investment class is good for you is in some periods where macro risk damages your financial assets having an alternative investment might allow your wealth to kind of hold up. So with that long lead in what the 20th century taught us about real estate, let's see how real estate as an investment class has changed over the last few decades. In this graph I have pictures of risk premiums in different markets. If you remember ear in an earlier session we talked about equity risk premium. This is the price of risk in the equity market capturing the the the push and pull between greed and fear. The second the second number that you see there is a BA rated spread which is basically the spread in the bond market between a BAA rated bond and the T-bond a measure of risk risk premiums in the bond market. And then you have two numbers specific to the real estate market. One is called a cap rate. You're saying, "What's a cap rate?" It's a rate that real estate investors use to price real estate properties. Here's how it works. Let's say your cap rate is 10%. And you have a rental property that makes a million dollars. You will be pricing that property at 10 million. You're saying, "How do you go from the million dollar in rental income to the 10 million?"

27:44 Remember the cap rate was 10%, you divide the rental income by 0.1, the 10%. you get $10 million. In a rough sense, it's a measure of the expected return that real estate developers bring to the game. And if you subtract out the risk-free rate from that, you come up with a risk premium for real estate. That's a green line. Already, you can see in the 1980s, there's something weird going on, right? You're getting a negative risk premium. You're saying that basically means you're settling for less than the risk-free rate. You might wonder why why would I do that? Remember that that table with negative correlation between real estate and other financial assets, especially in the 70s. If you're adding something with negative correlation, you're buying insurance. Key word is buying insurance.

28:27 And how do I make you pay? By accepting a return less than the risk-free rate. So the 1980s reflects real estate standing in the 20th century as a hedging investment class. And then things seem to change starting in the late 80s going into the 90s and clearly into this century. The risk premium in real estate is starting to look like the risk premium in equity and the risk premium in bonds. You're saying, "So what?" Remember the old days, you own stocks, you own bonds, and you owned your own house, real estate. You had a bad year in stocks and bonds, your real estate held its value. So you your wealth was pretty intact. That's no longer true in this century. You have a good year in stocks. You have good year in bonds. You have a good year in real estate. You your house went up in price.

29:13 You have a bad year in stocks and a bad year in bonds. And then you look at your property and real estate seems to be seems to be losing its hedging value. What might be causing it? Lots of factors. But I think one significant factor was that starting in the 80s, we start to securize real estate with the best of intent, right? We wanted to make it liquid and tradable. In many ways, we succeeded at least on a subsegment of real estate, mortgage back securities, real estate investment trusts.

29:46 Something seems to happen when you securitize an investment class. As you securize it, it starts to behave like stocks and bonds. In the process of securitizing real estate, making it more liquid and tradable, we might have removed some of its of its hedging properties. So if you ask me to compare real estate as it was to real estate it is today, here's how I contrast it. In the 20th century, for the bulk of the 20th century, real estate was largely untraded and illquid. It was held by either individual investors as their personal properties or as specialized real estate investors. What does that mean? They invested only in real estate or mostly in real estate. High leverage seem to be part of the real estate game.

30:29 you borrowed 80 90% of a property to buy. The returns were low to moderate but the risk also looked low whether it was perceived or true yet low standard deviations. As you saw in an earlier table, real estate tend to move off in in the opposite direction as your as financial assets and it did seem to offer inflation protection at least for that one decade 1970s where we're exposed to inflation. What has the 21st century brought? Real estate is more liquid and traded. That's a good news.

30:58 The investor base is starting to shift. Institutional investors have entered the real estate market now not just in the form of adding REITs and real estate traded securities to the portfolios in the form of private equity investors entering into actually holding physical real estate. Black Rockck was one of the biggest real estate holders in the country right now. Leverage has stayed high and we'll ask whether that's sensible because real estate prices have become more volatile. And the biggest shift is instead of being negatively correlated, real estate seems to be moving more with financial assets. What does this all mean? It means that if you're adding real estate because you thought it was hedging your portfolio, that hedging property has weakened. And if that is true, the expected returns in real estate would need to go up to compensate for the fact that you now have a riskier asset. On the inflation protection front, the jury is to luck. We don't know whether real estate has lost its inflation protection, but we will see. Now, as an investor, you might say, "What does this all mean? Should I have real estate in my portfolio?" There are three ways you can play the real estate add-on or or investment in your portfolio. The first is you can make it an add-on. If you're primarily invested in financial assets, you add real estate to your portfolio hoping for some hedging properties. As I said, that's weakened. So, I'm not sure it's doing the same service that it did, but don't expect miracles from that real estate investment. It might not match up to your financial asset in the long term, but you're doing it to as insurance or hedging. You could make it the center of your portfolio as an investor. You could have the bulk of your wealth invested in real estate as real estate developers had in the last century. Many of them became immensely wealthy. It's true. They were wealthy, then they went bankrupt, they were wealthy again. It was a boom and bust business. But what did they build their wealth on? Localized knowledge. What I mean by localized knowledge is they knew the cities that they invested in. New York, San Diego, not just in terms of geography and what the premium locations were, but in terms of navigating the rules and the regulations that govern real estate because those can be a labyrinth for somebody who doesn't know the process. So if you want to make real estate the center of your portfolio, you need to find a differential advantage, information advantage you can exploit.

33:24 Or you can trade real estate. The swings in real estate have become greater in the 21st century. And if you're a good trader and you call you can call the shifts in momentum in real estate, you can tra trade real estate. So you've got to make your choice based on what you think you can bring to the table. So what's the bottom line? It is true traditional investing is focused too much I think on the standard paradigm.

33:47 What's the standard paradigm? You you buy stocks, you buy bonds. Key word is buy. You're long on stocks and bonds and financial assets and everything else gets short shipped. In this session, hopefully I've at least opened the door to alternatives. Now, couple of those those doors that we opened, we had already opened the long short phenomenon when we talked about hedge funds and private businesses when we talked about private equity. But this session has primarily been focused on one of those alternatives, the largest in my view of those alternative investments, which is non-traded real estate. The sales pitch for all of these alternatives is built on two premises. One is low correlation with financial assets and you saw with real estate that shifts over time and the potential for alpha way to make excess returns presumably in some of these alternative investment classes.

34:36 So I hope you found the session useful and I thank you very much for listening.