Rules of Thumb For Alternative Investing
Sometimes, rules of thumb can be a useful shorthand to make decisions. An effective rule for us has been when people from the east coast come to south Texas to tell me about a “new” investment product that can’t miss. When this happens, beware.
A good example is an investment product called “alternative investing” or alts, for short. An alt is anything not a stock or a bond. These products will package private equity, venture capital, hedge funds, real estate, commodities, art, crypto or collectibles.
Each variation is accompanied by a slick sales pitch encouraging placement in clients’ accounts.
The pitch starts by claiming alts diversify portfolios while reducing risk while offering opportunities for higher returns. It sounds like a magic bullet.
Before you take that plunge, proceed carefully.
With any investment, you exchange money today, to get more value in the future. Be pragmatic about future returns and holding time frames necessary to achieve these returns.
Alts are not magical. They are just an asset category to invest in. Wall Street tells very seductive stories designed to separate people from their money.
When Wall Street shows up in rural Texas wanting to sell the “can’t miss” deal, put both hands on your wallet.
If it is that great of a deal, they would keep it for themselves. If it is not that great of a deal, then follow the money and you’ll see what motivates people.
If they are investing alongside you, and under the same terms, then that might be a rare opportunity worth evaluating.
Most of the time, it is an opportunity for Wall Street to sell something with high fees they would never touch themselves. Or worse, it may be an investment that isn’t working out and now they are repackaging it to pawn it off on others.
The higher the complexity, the harder it is to determine how well it will work. Unlike publicly traded stock or bond market assets, alts are difficult to accurately value. This allows for abuse of underlying fund shareholders. This increased level of complexity and transparency makes it harder to reasonably assess expected rates of returns.
Investing benefits from an Albert Einstein phrase. Everything should be made as simple as possible, but no simpler. This certainly applies to successful investing. If you can accomplish good returns by owning businesses, why allocate money to things that are very difficult to understand?
Many alt providers argue that these products are “non-correlated.” The theory is that building a portfolio of non-correlated assets means one will zig while another zags. In the process, volatility is muted but returns remain strong. This is a favorite of academics. However, it doesn’t work. Ever since the evolution of high-speed computerized trading, the financial markets have become more correlated than ever.
Keep your costs reasonable. If the underlying asset is illiquid, hard to understand or hard to value, then quite often the holding costs are higher. Higher costs generally lead to worse returns.
Warren Buffett has said that you don’t know who is swimming naked until the tide goes out. This can apply to many things, but especially debt.
Good examples are the $10 billion Starwood Capital real estate fund that is now limiting withdrawals because higher interest rates are increasing holding costs while tenants are less likely to pay up for many properties. A year ago, the same happened with Blackstone’s largest real estate fund.
With both Starwood and Blackstone, they owned illiquid real estate purchased with enormous amounts of borrowed money. The Work-From-Home trend lessened demand for many real estate properties. At the same time, interest rates jumped, increasing the cost to service the debt. This combination caused this type of alternative asset to freeze distributions of cash flow to investors.
Unsuspecting shareholders were trapped.
Further complicating matters, most alternative investments have fewer regulations from the U.S. Securities and Exchange Commission. This opens the door for more in the way of investment scams and fraud. Historically, alts were aimed at institutional or accredited investors. Now, they are targeting less sophisticated retail investors.
If you decide to pursue alt investing, buyer beware. Transparency, liquidity and valuations are hard to come by. Unlike Olympic gymnastics, investing does not offer extra points for an increased level of difficulty. Keep it simple.