Session 41 (of 42): The Promise and Peril of Alternatives!

0:01 Welcome back. In the last few sessions, we've looked at a range of alternative investing. We started with real estate, the biggest alternative investment class, and then we looked at gold and fine art and and trophy assets. Last session, we looked at Bitcoin. And earlier in the class, we looked at venture capital and private equity and hedge funds, which also are often put into the alternative investing class. The reason I'm bundling those is in the last two decade there's been a strong sales pitch to endowment funds, mutual funds, pension funds to move more of their money into alternative investments. You can see that shift if you look at a comparison of how much went into alternative assets in 2001 versus 2022. An increasing shift into alternative investments from close to nothing or less than 10% to 20 25 30%.

0:53 Now part of this was driven also by what type of fund you were. Pension funds and foundations were much more much more wary about entering into alternative investments than family capital. So for whatever reason, family capital jumped in with both feet into alternative investments. And part of the pitch for alternative investing came from big high-profile investors who succeeded by being early adopters. most famous at least among the college endowment community was David Swenson at Yale. You know he was you know you got to give him credit he saw the appeal of alternative investing before other people did. He put Yale a significant portion of Yale's endowment into alternative investments and it paid off for Yale at least in the early years and we'll talk about what's happened recently but clearly it paid off. So alternative investing was sold on the idea of if you added alternative investments to your portfolio, you would get a better trade-off. So this is a fairly typical graph of the sales pitch which looks at what happens to the sharp ratio, the ratio of your return to standard deviation based upon how much money you allocate to alternative investments. So across all endowments, it's 74. If you have less than 10% invested to alternative assets, you get 0.54 but more than 30% you make 1 point.

2:19 The higher this number, the better. You're getting a higher payoff for any given unit of risk. So in a nutshell, that is the pitch, right? By adding alternative investments, you get a better risk return tradeoff. And in the process, people loaded up on private equity, venture capital, hedge funds, and those alter those other investment groups we talked about. Now this in fact is coming to individual investors. People are thinking about how to package this. So as we get ready for that pitch, it might be worth taking a closer look at whether in the last 20 years institutional investors, these funds that have moved into alternative investments have received those promises of better trade-offs of risk and return.

3:01 So this is from one study that looked at what happens when you add a certain kind of hedge fund to your portfolio. Right? In theory, when you add hedge funds to your portfolio, because they're supposedly lightly correlated and have alphas, it should improve your return risk rate. And what this study found that if you left your money in 6040, in other words, you did none of this fancy stuff of allocating to alternatives, your shop ratios were barely different after the investment than before. In other words, the sales pitch of better shop ratios don't so seem to show up in practice, at least for the subset of funds that this study looked at. In fact, in a further evidence of this, Richard Enis, who's been very tough on alternative investing in general in terms of the of whether they deliver on the promise, argued that public funds have actually lost value because of the shift to alternative investments that their annualized excess returns that are being positive has become negative. That the adding on of alternative investments has actually created a negative alpha.

4:08 So what I'd like to do in the rest of the session is talk a little bit about what it is that's failed in this process that's resulted in this gap between promise and delivery. The bottom line is you look across time the long-term beneficiaries are more skeptical than ever before. Yale in fact recently started reducing its alternative investing and papers in the last five or 10 years especially have argued that you know maybe if you properly adjust for risk those benefits that you saw in terms of sharp ratios in the early years of alternative investing have pretty much disappeared. So let's look at what's under the surface. What's causing this failure? First, remember the correlation matrix that I showed you when I first introduced alternative investing. After all, it's one of the reasons we go into alternative investing is you look at those correlations that this is good by adding this to my portfolio, which is mostly long stocks and bonds. I'm going to get better tradeoffs.

5:08 It turns out that those correlations might not be what they might not reflect reality for two reasons. One is many alternative investments are not in traded assets, private equity, venture capital. You're saying, "But how do we come up with returns?" They're based upon people appraising the value of what they hold. Now, I'm not accusing anybody of fraud, but appraise values tend to lag real world values. What I mean by that, if you know, if you're in public equities and they're down 30%. There's no hedging, you're down 30%. But if you're a venture fund and you're down 30%, it turns out that it often takes two or three years for the 30% to play out. There's a lag between when bad things happen when they show up. And that lag is going to show up as a lower correlation. The second, it turns out that those correlations that look low are low if you look across all periods.

6:01 But during a market crisis, the correlations start to converge on one, especially on venture capital and private equity and hedge funds, which are after all the biggest segments of alternative investing. Take 2008, take 2020. I'll wage of venture capital, private equity, hedge funds were reflecting what was happening in public markets in terms of transactions. even though you might not have seen that in the appraised values. So the low correlations might be understated or misleading at least for a subset of alternative investment. The second and this has always been true but people often underestimate how much it matters is when you enter the alternative investment space you're investing a entering a space that's less liquid.

6:44 You're saying who cares I don't need liquidity. That's what you say right now. You know when you need liquidity? During a crisis. And during a crisis, it turns out that these investments get even more illquid. So when you look at the transactions caused in the need for liquidity, it turns out that even those people who claim they don't care often start caring during crisis. It's also true that many alternative investments there's a lot of opacity. You put your give your money to a hedge fund, they don't let you in on the process by which they pick stocks. you're on the outside looking in. Now, in good times, you might not care that they're opaque. That you can't look into a venture capital fund or a private equity fund or a hedge fund. But we know historically opacity can also become a device that people use to hide bad stuff. So, liquidity and opacity, we underestimate how much we care until we actually start caring.

7:37 And third, and this is something we talked about in the context of venture capital and private equity earlier in this class, as more money flowed into alternative investing, partly because they were so good at selling themselves to endowment funds and pension funds, it turns out that those alphas that we observed in each of these classes has dissipated over time. You saw that with venture capital over time. You saw it with private equity over time. You see it with hedge funds over time.

8:05 Increasingly, it's difficult to argue that any of these groups collectively deliver alphas greater than zero. There's still some winners in each of these groups. The one thing that these groups have that public equity might not have is there's more continuity. If you remember the most successful VCs stay successful, become a much more difficult game to win. And it's and as you know as you get exchange traded funds and passive investment vehicles the game is getting more difficult. I've described this as the investment world getting flatter.

8:37 It's showing up in disappearing alphas. So the low correlations might be just surface level liquid illquidity and opacity are much bigger issues than you let on until you get into a crisis and disappearing alphas. And there's a final component. The cost structure at many of these alternative investing vehicles is outlandish. 2 and 20. The 2 and 20 fee that hedge funds are 2% of your money every year. 20%. I, you know, I I I can entirely go along with the notion that markets are inefficient, that they make mistakes.

9:13 But I can almost I'm willing to wager significant amounts of money that no market inefficiency is big enough to cover 2 and 20 in the long term. So when you have these hefty costs up front, it turns out to be very difficult to create that return that you saw on paper when you were sold that fund. So as you look at alternative investments, keep in mind all of those. Now, I'm not suggesting that you should avoid alternative investing altogether, but you need to be picky. And when you look look at it, it's a correlation that should guide your choices on alternative investments.

9:49 Already you can see that that'll mean that you should probably not include private equity, venture capital, and hedge funds in the alternative space- or at least private equity and venture capital. Private equity and venture capital are actually I think closer to correlations of one with public equity markets. maybe a hedge funds but a subset of hedge funds which have potentially negative correlations. So focus on that with real estate. If you remember the correlations have risen over time. So you want to focus on segments of real estate which don't move with public equity. Second you need to avoid high cost vehicles. So somebody comes in and offers to get you into an alternative investment and says they're going to take 2% of your money every year and 20% of your upside. Throw them out of your office. So there's no way you're going to cover it. And as a general rule, you want to keep it simple. If you are investing in an alternative where you don't even know what people are doing, it's so complex.

10:46 Probably better better off not investing in that space. Be realistic about your own time horizon and liquidity needs. Don't try to tell people you have a long time horizon and you don't care about liquidity. because that might sound good, but if you truly need liquidity, then you might have to factor that into what alternative investments you make and how much money you put in them. And finally, be wary of this historical data, whether it's an alpha or correlation matrices. Not only are they backward-looking there hefty amounts of sampling bias, and there's reason to believe that at least in this space, many of these numbers are not reliable because they're not based on actual traded prices. their estimated numbers.

11:28 Now, of course, as you do all of this, recognize that the world is changing with the advent of ETFs. Many alternative investments which used to be a liquid are becoming more liquid, more more transparent than they used to be. So, keep the door open. If you've never had alternative investments in your portfolio, at least be aware that they exist. Look at the risk return tradeoff and ask yourself, does it make sense for me? It might make sense for everybody else, but it might not make sense for you. I hope you found this session useful and I thank you very much for listening.