Alternative Investing: Promise and Performance!

Key Concepts

• Alternative Investments: Investments outside of traditional stocks, bonds, and cash.
• Traditional Investing: Focuses on publicly traded stocks and bonds, with cash as a buffer.
• Long-Only Investing: Holding assets with the expectation that their price will increase.
• Short Selling: Betting on the decline in the price of an asset.
• Correlation: A statistical measure of how two assets move in relation to each other. Low correlation is desirable for diversification.
• Alpha: Excess return above a benchmark, often attributed to manager skill.
• Venture Capital (VC): Funding for early-stage, high-growth potential companies.
• Private Equity (PE): Investment in established private companies, often for buyouts or growth.
• Private Credit: Lending to private companies, bypassing traditional banks.
• Real Estate Investment Trusts (REITs): Companies that own, operate, or finance income-generating real estate.
• Collectibles: Assets like art, gold, and NFTs that can be held for investment.
• Cryptocurrencies: Digital or virtual currencies secured by cryptography.
• Sharpe Ratio: A measure of risk-adjusted return, calculated by dividing excess return by standard deviation.
• Drawdowns: The peak-to-trough decline in an investment's value.
• Illiquidity: The inability to easily convert an asset into cash without a significant loss in value.
• Opacity: Lack of transparency in an investment's underlying holdings or strategy.
• 2 and 20 Fee Structure: A common fee model for hedge funds and private equity, charging 2% of assets under management and 20% of profits.

Alternative Investments and the Investing Universe

The traditional investment framework primarily focuses on publicly traded stocks and bonds, with cash serving as a liquid buffer. This approach, however, overlooks vast areas of the investment universe. Alternative investments encompass private businesses, venture capital, private equity, non-traded assets like real estate, collectibles, and even cryptocurrencies. They also include strategies beyond traditional long-only investing, such as short selling, which is a hallmark of hedge funds. While alternative investments have always existed, they were historically accessible only to the ultra-wealthy and institutional investors. In the last two decades, there has been a significant push to bring these investments to the mainstream, particularly targeting institutional investors and now individual investors.

The Sales Pitch for Alternatives

The primary sales pitch for alternative investments rests on two key arguments derived from portfolio theory and market dynamics:

1. Low Correlation for Better Risk-Return Tradeoffs: The core idea is that by adding assets with low correlation to existing stock and bond holdings, investors can achieve a better risk-return profile for their portfolios. The less correlated an asset is, the greater the diversification benefit. This is illustrated by correlation matrices showing that certain alternative asset classes exhibit correlations well below one with the S&P 500, suggesting potential diversification advantages. The pitch often includes hypothetical portfolio illustrations showing that adding alternatives can lead to higher returns and improved Sharpe Ratios (a measure of risk-adjusted return).

2. Exploiting Market Inefficiencies and Manager Skill (Alpha): The second argument suggests that the alternative investment universe, being more illiquid and opaque, is more prone to market mistakes. Skilled managers, such as hedge fund managers, venture capitalists, and private equity investors, are believed to possess the expertise and localized knowledge to identify and exploit these inefficiencies, thereby generating "alpha" (excess returns) on top of the diversification benefits. Evidence presented includes dispersion in returns within alternative asset classes, with the perception that top performers in areas like venture capital and private equity tend to sustain their success over time, unlike in public markets where winners often lack staying power.

Components of Alternative Investments

Alternative investments can be broadly categorized along three dimensions:

1. The Long-Short Divide: Traditional institutional investors are often restricted to long-only strategies. Hedge funds, historically, have had the flexibility to engage in short selling, allowing them to create different return distributions. The growth of derivatives markets (options, futures, forwards, structured products) has further expanded the possibilities for creating positions that deviate from traditional stock and bond movements.

2. The Public-Private Divide: This dimension distinguishes between publicly traded companies and private businesses. Venture capital funds provide capital to young, growing private companies, ranging from angel financing for idea-stage ventures to growth capital for scaling businesses. Private equity firms invest in more established private companies, often for buyouts or to facilitate owner exits. The private credit market has also emerged, where private investors provide loans to businesses, setting their own terms and assessing default risk.

3. Non-Traded Asset Classes: This category includes assets that are not typically traded on public exchanges. Historically, real estate was largely held by individual investors with local knowledge. While securitization through REITs and mortgage-backed securities has increased, real estate's representation in public markets is still considered to be below its true economic value. Collectibles, such as gold, fine art, and increasingly NFTs, also fall into this category. Cryptocurrencies, like Bitcoin, are also argued to belong here, as they represent an asset class with unique characteristics not found in traditional portfolios.

Evidence and Institutional Adoption

The sales pitch for alternatives has been demonstrably successful in attracting institutional investors. Data shows a significant shift in asset allocation by pension funds, foundations, and insurance companies towards alternative investments over the past two decades. For instance, pension fund allocations to alternatives have grown from less than 10% in 2001 to around 30% by 2022. Family capital has seen an even more dramatic increase, with 52% allocated to alternatives. The success of David Swensen at the Yale endowment fund, which significantly increased its allocation to alternatives starting in the 1990s, served as a prominent case study and role model for other institutional investors. Research from Cambridge Associates also suggested that endowments allocating a substantial portion (over 20-30%) to alternatives achieved better Sharpe Ratios.

Critiques and Weaknesses of the Alternative Investment Pitch

Despite the compelling sales pitch and apparent institutional adoption, significant critiques and evidence suggest that the promised benefits of alternative investments may not always materialize in practice.

1. Questionable Correlation Benefits: A 2022 study examining pension funds that added hedge funds to their portfolios found that despite low correlations, there was almost no improvement in Sharpe Ratios. Furthermore, during bad years (market crises), these lightly correlated hedge funds did not significantly mitigate losses, with drawdowns appearing just as severe as in traditional portfolios.

2. Disappearing Alpha: The argument for manager skill and alpha generation is increasingly being challenged. Several factors contribute to this:

   • Market Saturation: The massive growth of private equity and venture capital has attracted a wider range of investors, including average and below-average performers, diluting aggregate returns.
   • Increased Competition: The investment landscape has become more efficient, with data, models, and analytical tools leveling the playing field and reducing the edges that once allowed for significant alpha.
   • Passive Investment Replication: The rise of ETFs and passive investment vehicles allows for the quick replication of successful hedge fund strategies, leading to the rapid dissipation of any excess returns.
   • Historical Data Limitations: Historical correlation matrices and alpha figures are often understated or misleading. Illiquid and non-traded assets (like private equity) are appraised rather than marked to market, creating a lag that can artificially lower measured correlations. During market crises, these correlations tend to increase, negating diversification benefits.

3. Illiquidity and Opacity Issues: While often presented as a trade-off for potential higher returns, illiquidity and opacity become significant problems during market crises. Investors who claim to have long time horizons may find their liquidity needs increase dramatically during downturns. Illiquidity also translates into transaction costs (wider bid-ask spreads, price impact) that erode returns. Opacity prevents investors from understanding the underlying risks, especially when performance falters.

4. High Costs: Alternative investments typically come with higher fees than traditional investments. The "2 and 20" fee structure (2% management fee and 20% performance fee) significantly burdens returns. Even with reduced fees (e.g., 1.37% and 16.4%), these costs can be substantial and difficult to overcome consistently. Richard Enis argues that alternative investing has, for many institutional investors, actually lowered their overall risk-return tradeoffs due to these costs.

5. Fading Performance: Evidence suggests that the historical outperformance of hedge funds and private equity has diminished. While private equity investors significantly outperformed public equity investors between 1993 and 2007, this gap has largely closed since 2007. Similarly, hedge fund alpha has significantly decreased, with many now underperforming passive investment vehicles. The recent announcement by Yale of plans to divest a significant portion of its private equity investments due to underperformance further underscores this trend.

Recommendations for Investing in Alternatives

Despite the criticisms, the speaker does not advocate for completely avoiding alternative investments. Instead, the advice is to be highly selective and strategic:

1. Focus on Low Correlation, Not Alpha: The alpha pitch is considered largely defunct. Investors should prioritize alternative investments that genuinely offer low correlation with public markets. This might make private equity and venture capital less attractive as they are seen as extensions of public markets. Some hedge fund strategies that run counter to public equity returns might be more suitable. Bitcoin, if it can maintain a low correlation with risky stocks, could also fit this criterion.

2. Avoid High-Cost Vehicles: The "2 and 20" fee structure is strongly discouraged. Investors should avoid any alternative investment strategy that is overly complex and not fully understood by both the seller and the buyer.

3. Be Realistic About Time Horizon and Liquidity Needs: Investors must honestly assess their time horizon and liquidity requirements. Individual investors may have shorter time horizons than they believe due to impatience, panic, or peer pressure. Institutional investors should consider their clients' time horizons.

4. Distrust Historical Data: The speaker emphasizes the unreliability of historical correlation matrices and alpha figures. These may be artificially inflated due to pricing lags in private markets or may reflect past performance that is no longer sustainable.

In conclusion, while alternative investments offer potential diversification benefits, their promised alpha is largely gone, and their costs and illiquidity can be significant drawbacks. A discerning approach, focusing on low correlation, avoiding high fees, and maintaining realistic expectations about time horizons, is crucial for any investor considering alternative assets.