Q3 2023 Commentary: An Alternative Universe: FOMO
Pine Haven Investment Counsel, Inc.
Paige Johnson Roth, CFA®
What are “alternative” investments and why is Wall Street (aka the Financial Industrial Complex) always pitching these products? These products often appear to be sophisticated, and they are exclusive – so that you must want to invest in them!
Alternative investments are assets that don’t fall into the typical conventional categories of stocks, bonds, and cash. There are several main types of alternative investments: Hedge Funds, Private Equity, Venture Capital, and Real Estate. Although they all have their own idiosyncrasies, they do have a few traits in common. For the most part these investments are “packaged” and not traded on major exchanges. Investors need to commit to locking their money away for the long haul, as getting your money out of these investments can prove to be challenging. Because of the increased levels of risk and lack of SEC regulation, most require you to be an “accredited investor.”1
Do these investments have better returns than publicly traded, conventional securities (i.e., bonds, stocks)? And what about the risks and the risk/reward tradeoffs involved? Why would you want to invest in them?
First, a few definitions:
Hedge Funds: Specialized investment vehicles that pool capital from accredited investors and invest in a variety of assets often with complex portfolio construction and risk management techniques. They are managed by professional investment managers who have the flexibility to use a range of strategies and financial instruments, such as short selling, leverage, and derivatives. There are many different types of hedge funds with different goals. In some cases, the focus is high return, and in other instances the goal is to lower risks.
Private Equity: Investments made in privately held companies or assets that are not publicly traded on a stock exchange. It involves pooling capital from various sources, such as institutional investors, high-net-worth individuals, and sometimes even pension funds, to acquire, invest in, or provide financing for businesses. Private equity firms typically acquire a significant ownership stake in the companies they invest in, and often take a management role.
Venture Capital: A form of private equity that focuses on early stage, high potential, high risk, and high growth startups. Many of these focus on the technology sector.
Real Estate (Non-Traded): Real estate funds are pooled investments that invest directly in properties. Some of these are structured as REITs (Real Estate Investment Trusts) and some are partnerships. Investors hope that in addition to the appreciation of the tangible asset, there will be ongoing operating income as well. Some alternative investments are notorious for their high fees. Historically, managers of private funds charge what is known as a “2 and 20” fee structure.2 That is, they charge an annual investment fee of 2% and performance/incentive fee of 20% of the profits. How do these investments perform in the long term? Do they successfully manage the risk / reward trade off?
Alternatives and Manager Selection
The above chart demonstrates that manager selection is critical to strong returns, perhaps even more so in alternative investments. The highest number represents the return of the top quartile manager, the orange diamond is at the median, and the bottom number is the lowest quartile over a 10-year period. Performance is particularly dispersed non-core real estate, private equity, venture capital, and hedge funds, underscoring the importance of choosing an effective manager to unlock the return-enhancing potential of alternatives.
Famously, Warren Buffett made a bet in 2007 with a hedge fund company, Protégé Partners LLC, that in 10 years a S&P 500 Index Fund would beat the hedge fund. Warren’s bet got off to a rough start with the financial meltdown in 2008; however, after 10 years, the index fund returned 8.5% and the hedge fund 2.4%. But alternative investments are not all targeting high returns – some are targeting a reduction in risks and volatility. A representative from Protégé Partners LLC even wrote "Hedge funds do not set out to beat the market. Rather, they seek to generate positive returns over time regardless of the market environment. They think very differently than do traditional 'relative return' investors, whose primary goal is to beat the market, even when that only means losing less than the market when it falls." 3 With high fees and returns that don’t blow your socks off, why would any investor make the choice to allocate their hard-earned funds to these funds? Psychology and marketing play a huge role. Beyond the sophisticated sales techniques they use to draw people in, hedge funds are often seen as a status symbol. Peer pressure (and F.O.M.O. – or the ‘Fear of Missing Out’), the illusion of sophistication, and some level of ego can provide an extra push to diversify into ‘alts’.
In short, alternative investments are complicated investment vehicles that have a mixed performance record and because of their fee structure, they enrich the respective pockets of their managers. From a performance and risk perspective, as a group they have done reasonably well, however, no better than most balanced funds. Yes, there are the titans of this industry who have done extraordinarily well. As tempting as some of their pitches are, at Pine Haven, we believe that most investors should stick to a balanced mix of high-quality equities and bonds to meet their investment goals.
1 Accredited Investor: Net worth over $1 Million (excluding home) and income over $200,000 ($300,000 for a couple). Professionals and Institutional Investors. SEC.gov | Accredited Investor
2 Two and Twenty: Explanation of the Hedge Fund Fee Structure (investopedia.com)
3 Buffet's Bet with the Hedge Funds: And the Winner Is...