Episode 19
THE GOOD, THE BAD, AND THE UGLY: DO ALTERNATIVE INVESTMENTS HELP OR HURT YOUR PORTFOLIO?
Episode Description
In episode #19 of The Big Bo $how, Big Bo (a.k.a. Jason Blumstein, CFAⓇ) offers listeners a simplified look at the complex and often misunderstood world of alternative investments.
What are alts? Why have they become so popular in recent years? And do they have a place in your portfolio?
In this $how, you’ll hear all of that, along with:
A breakdown of the “Big 3” types of alternative investments (Private Equity, Venture Capital, Hedge Funds)
4 things investors should consider before taking the plunge into alternative investments
How Warren Buffett went toe-to-toe with the hedge fund world
Lessons about alternative investments from Steph Curry and Aaron Rodgers
Hope you enjoy the $how!
Episode 19 Key Takeaways:
00:00 What the dog days of summer have to do with alternative investments and your portfolio.
04:20 The recent explosion of interest in private equity.
06:51 A look at the data that suggests success in venture capital investing is a moonshot.
09:59 Taking a high-level look at hedge funds and liquid alts.
13:00 Overlooked concerns about liquidity and common misconceptions about returns in alts.
16:37 Warren Buffett’s comical bet with a hedge fund — and what it shows us about alternative returns
18:49 Eye-opening private equity data from a University of Oxford study.
21:33 What is the concept of “regime change” and why does it have such major implications on potential returns?
27:27 What can Steph Curry and Aaron Rodgers teach investors about alts?
Episode Transcript
All right, and welcome to episode 19 of The Big Bo $how. We're here in the dog days of summer, if you're a parent like me, you know the constant refrain from your kids, “I'm bored.” I hear all the time from my son this summer. You see, boredom is a dangerous thing. In life, too much time on your hands and too much time spent sitting around can be a catalyst for getting into trouble when you're a kid. See, when I was a kid, I was a pretty good kid. But even I would do dumb things in the summer when I was bored. Like, for example, me and my brother, my older brother, we used to have bottle rocket fights when we would literally shoot bottle rockets at each other and see whoever was hit first and whoever was hit first. Last. Luckily for us, we never hate each other. For adults. However, boredom looks a little bit different. We all have our obligations that don't slow down in the summer, work, kids vacations, these things keep us all busy.
But in investing, boredom can also be dangerous. We know that the best investors, those like Warren Buffett and Charlie Munger are those who buy high quality companies at attractive valuations and typically hold them for a while, rarely tinkering with them, and letting the power of compound interest do its trick for them. But investors who follow the headlines too closely are those who want to make changes when they're quote unquote, bored, or chase the next big thing, they can also get themselves in trouble.
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So why do I bring this up? Over the past few years, there's been this huge buzz and craze and noise about alternative investing. I've been seeing a lot of discussion around this space this year. And over the past couple years. And now it's even getting into advisors, studies have shown that nearly 30% of advisors are actively investing in recommending alts to clients. So alts are often positioned as another way to improve portfolio diversification, lower risk and create return paths that aren't correlated, blah, blah, blah, blah, blah. However, I think about it a little bit differently. I see a lot of confusion, a lot of history, a lot of people not truly understanding what they're potentially investing in, not seeing the pros and cons clearly, not keeping it simple or KISS and not prescribing to the time and discipline squared mantra that is tried and true.
So on episode 19 of The Big Bo $how, Alts: The Good, the Bad and the Ugly. I'm going to review different types of alternative investments for things that you can consider before you decide to invest and make sure you stick around to the end to find out what Aaron Rodgers and Steph Curry have to do with alternative investing. So sit back, relax, and welcome to episode 19 of The Big Bo $how.
Alright let's get after it, episode 19. In this segment, we're going to go over the different types of alternative investments that are out there. And we're not going to cover them all because there's so many different types. We are going to cover the big three, the three that are most prominently out there in the marketplace, in private equity, venture capital and hedge funds. So what are these? Let's break these down simply because most of the times when I talk to people, they don't even necessarily understand what this all means.
So let's talk about private equity. Private equity is simply pooling money together to buy a business that is private, meaning it's not traded on a public exchange, like the New York Stock Exchange, or the NASDAQ, etc. If you're public equity, you're a company like Apple, or Google or GE, they are public companies. If you buy a company that's private, then you are using private capital, hence private equity. This can also be the form of real estate, you can pull private money together to buy real estate. And oftentimes, the private equity playbook is to buy a business that they think they can operate better for a reasonable price, typically with a bunch of debt and a small amount of equity, which helps amplify the returns or try to help amplify the returns. And then they typically sell it within three to five years to someone else, ideally, at a higher multiple or multiple of earnings or what's called EBITDA — earnings before interest, taxes, depreciation, and amortization, which is a proxy for cash flow. And the private equity industry has really started to blow up recently, in terms of size, the private equity industry as a whole employs about 11.7 million people, which is nearly 3 million more than just a few years ago, there are more than 18,000 PE funds, a nearly 60% increase in just the last five years. The private equity or PE industry as a whole has about $4.4 trillion in assets under management, including $1 trillion of uninvested capital, and the size of these funds have more than doubled since 2016.
So now let's move on to venture capital. What is venture capital? Venture capital is a form of equity financing or capital is invested, typically, from minor minority stakes in startup companies, companies that are poised for what people think are significant growth. Usually, private equity, or the normal form we talked about earlier, invest money in more mature businesses, where venture capital typically invests in startups, either a startup that hasn’t even created revenue, which is pre-revenue, they need seed capital, or a company that burned through their capital and actually has revenue and now they need more capital. Just like private equity, venture capital too has grown a lot of the reasons why is because a lot of people see these big tech companies like Facebook or Google, and they think,” Oh, wow, this is what you can do with venture capital, you can start up and fund a small company, you can grow like a Facebook or Google or to the moon.” However, the truth of the matter is that based on data and research that I've done from the National Venture Capital Association, WHO estimates that 25 to 30% of startups backed by venture capital, go on to fail.
And as a general rule of thumb, startups, out of every 10, three or four will fail completely, three or four will return the original VC investment, you just get your money back, and only one or two will produce substantial returns. Now, this isn't anything new, I should be telling you. This is what venture capitalists know. And people that go into the space should already know that odds are most of the businesses like any businesses, their stats at 90% of businesses or startups in America fail, that most of them are going to fail. And you're hoping for that one to two home runs that cover the losses of every failure. Now, again, as I said earlier, there has been a lot of money chasing this space in recent years. If you look, and this is data that's tracked by Ernst and Young, in 2010, there was about $33 billion of venture capital backed deals. Fast forward to 2021, that number grew by almost 11x. There was about $360 billion of venture capital backed deals. Now, obviously last year, people knew about the market slowdown, the numbers fell last year, all the way back down to $235 billion, but still well above where they were almost 10 years ago. So a lot of money entering the space.
Now let's go into hedge funds. And hedge funds are really a lot of different things. They're essentially limited partnerships of private investors whose money is managed by professional fund managers using a wide range of strategies, some that have leverage, some then invest in non traditional assets, hoping to have above average returns, you can buy things long, basically hope the company goes up, or you can short companies hopefully betting that the company goes down. So and that's how they got the original term of hedging, the market goes up or the market goes down, we can hedge and hedge on the downside. So that's how the original term came about. Now there's this whole other area that's bubbling up in the industry of what people call liquid alts. And there's way too many of these to get into. All I would say is, there's no ETFs, there's no mutual funds, all different flavors and varieties. And when I've personally looked at some of these things, they're all not none of them are created equally. They're all different. So it's very tough to say what is what or who is who, they're all very new, they don't typically have a lot of assets, not a long track record. And there's a very wide swath of these types of investments. So hopefully in this section, I gave you a good overview of what alternative investments are, the big three that people typically will invest in to give you a little more knowledge, a little more education on the alternative space.
However, when we get back, we're going to take a quick break. And when we get back, we're gonna go over four things that you should look into before you decide to invest.
All right, welcome back to The Big Bo $how episode 19 – Alts: The Good, the Bad and the Ugly. Now we're gonna go into four things to consider before you decide to invest in alts, for items that you need to consider before you potentially make the plunge slash decision. The first is illiquidity. And why do I bring this up? Because when I talk to clients or individual investors that are talking about alternative investment, the first question I ask them is, “do you realize that you might not be able to get your money back for a long period of time?” and they typically don't realize that that's because most alternative investments, whether it be private equity, venture capital, a hedge fund, there's what's called a lockup period. Sometimes this could be as little as one to two years for some hedge funds, or as long as 10 years for private equity and venture capital. And if you're an individual investor, you might not have the luxury to put a large percentage of your money into something that you might not be able to get back for 10 years, things happen in life, because a lot of the alternative investments came up through pensions, and endowments, and pensions, and endowments don't necessarily care about liquidity, Because they're investing sometimes for 30 plus years, if you're on a pension or school endowment, so the lack of liquidity in the institutional world is a lot different than what it is in the individual and high net worth investor world. So before you move forward, think about the lack of liquidity and that you might not be able to get your money back for many years.
The second is returns. So a lot of people think alternative investments are going to get them better returns than you get in public markets, or people say plain vanilla stocks and bonds, right. So if you think about the returns, the first thing I would say is that the return landscape in the alternative space is not very transparent, and not very centralized, if you will, there's no centralized way and processed way for every single private equity firm and every single venture capital firm and every single hedge fund to report their performance to a database. This is different than what happens in the public markets. There's public databases, like a company called Morningstar, where you're required to put in your performance and all those performances could be tracked. There's nothing like that. So there's a lot of studies out there that while there might be some private equity firms, or some studies that say, there's higher returns in venture capital or private equity, can you really trust this data, because there's also many studies out there that show that the ones that report their data, or only the good ones will make sense, if you have good performance, you're going to report that if you have bad performance? Well, you don't have to necessarily report that to the centralized database, because there isn't one. So a lot of these studies that show about the performance, and databases are typically skewed to the upside. Now, let's just say for example, the people actually get better performance, assuming there is a centralized database, the jury is still out.
Now, I'm going to quote one very, at least in my mind, because I'm a huge Warren Buffett fan, one very comical bet that Warren Buffett made back in 2008, where he issued a challenge to the hedge fund industry, where he said, placed a $1 million dollar bet. And he said, If you think your hedge funds can outperform a simple S&P 500 index, I'll give you a million dollars. And there's one company, I'm not going to name their name, that took on this bet. You can look up the study and find out the name if you'd like. It's all public information. And this was what's called a fund of funds. So this fund invested in many different hedge funds. So what this company did is of course, we can beat the S&P 500. We're hedge funds, we're amazing. And they took five different funds and allocated each fund and said, okay, yeah, we're gonna put a little bit in each of these funds, and we're gonna get better performance than the S&P 500. And the bet was over 10 years, so it started in 2008. And it was supposed to end in 2018. So through 2016, the returns on the hedge fund average was 22%, was 22%, versus the index fund the S&P 500, which was at 85%, or a difference of 63%. And in 2016, that hedge fund company quit, they said, alright, you beat me, you prove the point. And if you look under the hood, at all five of the hedge funds that this company allocated to, not one of the hedge funds even came close to beating the S&P 500. One returned 3% over the timeframe from 2008 to 2016 versus 85%. That was the lowest and the highest was 63%. So even the highest other performers still underperformed over the time frame by almost 23%. So there's no overwhelming data within the hedge fund space that you can get better performance from what I've seen.
Now let's look at the private equity space and in the private equity space, there's a University of Oxford study that found that since 2006, returns for private equity have been about the same as public equity. The University of Oxford, a very respectable institution, found that since 2006, private equity returns have been the same as public equity returns. Now, given the suspicious person I am and everyone thinking private equity is the best thing since sliced bread. I said, let me actually look at these and see if I can find data myself. And I actually stumbled upon CalPERS CalPERS, which is the California pension for teachers, the largest US pension institution out there, they actually publish their returns, you can find them online.
And what I found is that since 2006, the same timeframe as this Oxford study, the average return for the private equity funds that in alternatives that they've invested in had an average return of about 11.5% where the S&P 500, during this timeframe had a return of about 10.6%. So slightly better, is it materially better 1% a year since 2010, the returns have actually been the same 15.4% versus 15.5%. But again, let's just give them the benefit of the doubt since 2006, they outperformed by about 90 basis points — 0.9%. However, if you take a step back, CalPERS is the largest pension. So if you look at the names and the institutions that they're investing in, these are the biggest and most respected names in the private equity world. And I would assume they would get the first pass of what they wanted to invest in because they're the largest investor. This is an assumption I would make. So if the largest pension system in the United States of America, over this timeframe from data that they reported, can only beat public equities, by only 0.9%, by having the best information by having the best access, what do you think the second guy is going to be able to do? My guess is equal to worse. So even in the private equity world, the data does not show that these returns are superior than public equities. So be skeptical, in my opinion, when you're going to invest in all of the returns that you think you will get.
Now, the next thing to consider is regime change. And what I mean by that is, whenever you look to invest in something, there's a concept of a regime change. So when you're looking at data, and you're trying to understand things, you have to step back and say to yourself, Well, does the period going forward to get the returns that I think I'm going to be able to get look like the period in the past that I'm basing my assumptions on returns and risk on? And if it's not, that is known as a regime change. And in my opinion, what's gonna go, what's going on currently, and potentially going forward is a totally different regime than what's happened in the past. Why? Number one, the interest rate environment is different. The interest rate environment, as we've discussed in the past, in The Big Bo $how has been a zero interest rate policy interest rates have been low. Now they're high. Now they're getting to more normalized levels. And the Fed saying they're probably not going to lower interest rates for the foreseeable future. And why does this matter? Well, because a lot of private equity and venture capital need leverage, or they need access to capital. So if you're a private equity firm, and you're buying something with, say, only about 20% to 30%, actually equity that you actually own the business and using debt or leverage to buy the rest, well now your financing costs are higher, which take away from the returns of the equity holders. So with higher financing cost, probably will mean that your return probability is going to go down. Now, it also affects the multiple you're going to pay. All else equal, higher interest rates should lower the multiple. So if you're going in there, and you bought something, or if you're already in a private equity fund, that assumes you're buying something at a certain multiple and then five years out, you're gonna fix the company up and flip it for a higher multiple and own out again, might have worked over the past 10 to 15 years because interest rates have been dropping. But if interest rates are rising, the multiple that you think you're going to be able to sell it for might actually be higher. So I'd be very suspicious of that. The other thing is that as we talked about in the first section, there is a ton of new money, of money that has chased this industry over the past three to five years and 10 years, as we pointed out, and all else equal, a concept in economics is that there's more money chasing after the same goods, your return expectation should go down. Because now you have more money, more people looking at the same deals, chasing returns. So your informational advantage and your liquidity advantage, and your price advantage starts to get eroded away. So odds are with all this money that's now in there, I would expect I would think, just from knowing about economics, your expected returns will probably go down since there's a lot more money and a lot more people looking at the same objects and a lot more information out there about the deals that people are trying to get. So the third thing you should be aware of, before you put your money in alternatives is a concept to have regime change.
The fourth thing that I think you need to be aware of is the heterogeneous nature of alternatives. And what I mean by that is not every alternative looks similar, if not anything like the next, just because you're invested in venture capital doesn't mean it's the same. If you knock on the door of another venture capital firm, there's so many different varieties, just because you are invested in a hedge fund, one might take on leverage, one might not one might, might only short one might not one might try to get what's called the arbitrage, one might not, there's so many different flavors, so many different varieties that you really need to look at these things one by one by one. Even when I look at liquid alts that are coming out, there's so many flavors and varieties, they're all so different that you really like I said, need to look at things one by one by one and then when someone says oh, you can do this in a hedge fund or this and venture capital or this and like well it's it's really like comparing my son to my daughter, they're totally different people you got to analyze each individually. So with that said, those are the four things that I would tell you that you need to look at before you decide to invest in any alternative: the lack of liquidity return expectations, regime change, are we in a different regime now than we were in the past 10 to 15 years? I would say yes. And the heterogeneous nature of the industry everything needs to be looked at individualized versus anything sweeping so with that said, we're going to take another quick break and then we're gonna go on a bone no segment ever want to find out what Aaron Rodgers and Steph Curry have to do with this entire discussion.
Alright, let's get after the final segment of Episode 19, The Good, the Bad and the Ugly about alternatives in the Bo Know$ segment. And I always like to talk about football, food and finance on The Big Bo $how brought to you by Julius Wealth Advisors. And obviously it's not football season. So there's not a ton of news out there regarding football. So I'm going to weave in some other nuggets of sports but also a football piece as well, and how this relates to alternatives. I'm going to talk about two championship athletes in Steph Curry and Aaron Rodgers and what's been going on in the news lately. You see, Steph Curry, probably the best shooter of all time, revolutionized the game of basketball, which I mean I wasn't good enough to make it to the NBA. But I was a big man, and he pretty much made big men obsolete. What I mean by that it's like a center power forward now you have shooting threes, unheard of. So Steph Curry this past weekend won the American Century Golf Championship, and it's a celebrity tournament that includes famous athletes like Aaron Rodgers, Tony Romo, Charles Barkley and Steph won this with a hole in one and a tournament and won it on a walk off Eagle putt you see for curry golf is something he's clearly very good at. And it provides fleeting moments of excitement away from his regular life and the work he has to put in for basketball. But is he going to leave basketball to pursue golf full time just because he has access on one celebrity tournament? Highly doubtful. And this correlates to your financial goals and your plan. If you took the time to build your plan and did the due diligence, and worked with an advisor, or potentially on your own if you did the work with someone in a collaborative process, you spent the time defining what's good for you and what you're best at, what your core competencies are, what your advisors core competencies are. So don't let flashy distractions pull you away from your established financial path.
The second is Aaron Rodgers and the New York Jets as most might know he wants in the New York Jets, I’m a huge Dolphins fan. When I heard this news, a lot of the Jets fans, I know they're excited. And then I just thought, well, it's still the Jets. And typically, this doesn't work out for the Jets. Just look at Brett Favre. But that's not what I'm here to talk about. You see, the Jets were recently selected for HBOs Hard Knocks series. Of the teams the NFL could have selected, the Jets were clearly the most attractive given that they just signed Aaron Rodgers. However, Aaron Rodgers isn't a fan of this. He's not a fan of having the cameras in the locker room. And he even said that they forced it down our throat, and we have to deal with it. So here again, is an example of a winner, a proven winner, Aaron Rodgers, not better than Tom Brady, obviously, in my mind, but still a winner, who understands that the path to success is minimizing distractions, Hard Knocks, it's an award-winning TV show that it's going to provide a moment of boost and interest in the New York Jets. But those involve the team and those who have experienced NFL success. Know that the fan interest has nothing to do with the results on the gridiron. And winning has nothing to do with that. All it is is pure noise. And to be successful, as I've talked about in the past, you need to block out the noise and focus on what has worked for you and what has worked for you in the past. And what is going to get you the results that have been proven. And sometimes boring is beautiful, and consistency and showing up and executing your plan every day usually works.
So with that said, I hope you learned a lot about the world of alternatives. Something that I think there's a lot of confusion out at the marketplace. Do alternatives have a place in your portfolio? I'm not sure. You'd have to work and understand your individual circumstances. So I can't answer that for you. You're more than welcome to give us a call at Julius Wealth Advisors 201-289-9181 or info@juliuswealthadvisors.com if you enjoyed the $how, or you want to talk more about an alternatives. But I hope this $how provided you with a great explanation of what alternatives are helped to break up a lot of that confusion, four things that you should consider before you decide to make the plunge, and how this world of alternatives and your goals and long-term vision relates to championship athletes. So let's wrap this up episode 19 — the Good the Bad and the Ugly — and I'll end the $how how I end all the $hows in saying always live a life of integrity, always live a life of obtaining knowledge, as much knowledge as possible, and always live a life that you're passionate about.
Until next time — all the best.
Disclosure:
The content is developed from sources believed to be providing accurate information. The information in this podcast is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Julius Wealth Advisors, LLC (“JWA”) is a registered investment adviser located in Englewood, NJ. Registration as an investment adviser does not imply a certain level of skill or training. The publication of The Big Bo $how should not be construed by any consumer or prospective client as JWA’s solicitation or attempt to effect transactions in securities, or the rendering of personalized investment advice over the Internet. A copy of JWA’s current written disclosure statement as set forth on Form ADV, discussing JWA’s business operations, services, and fees is available from JWA upon written request. JWA does not make any representations as to the accuracy, timeliness, suitability, or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. JWA is neither your attorneys nor your accountants and no portion of this podcast should be interpreted by you as legal, accounting, or tax advice. We recommend that you seek the advice of a qualified attorney and accountant