The Spandex Rule of Investing: Why “Alternative” Investments Aren’t for Everyone

What Are Alternative Investments (Alts)?

In an investing context, I contend that “alts” are like Spandex: not for everyone. “Alts” refer to alternative investments – an umbrella term for various holdings that are quite different from the usual public company stocks and investment grade bonds that Nexus invests in. Alts aren’t generally “liquid” or freely traded on a stock market. They include such things as hedge funds, private equity, private credit, and real estate.

Why Do Pension Funds Love Alts?

The case for alts seems persuasive. Sophisticated institutional investors, such as CPP Investment Board and Ontario Teachers, have been investing successfully this way for decades. Alts are managed by highly-skilled, sophisticated professionals who, because of the “closed”/locked-in structures employed, are able to be patient and make long-term commitments to the underlying investments, unconcerned with the potential for inopportune and disruptive external demands for liquidity from their investors. Because the alts investor typically, in effect, make a long-term commitment of his/her capital (often for 10 or more years), alts offer much higher potential returns than conventional, liquid investments. Being private, and therefore not priced daily, prices of alts aren’t nearly as volatile as those of listed equities. Their returns are consequently less “jumpy” as well. Finally, alts offer access to a much broader buffet of investible assets than those typically available through the conventional stock or bond markets.

What’s not to like?

Investment Flexibility Matters More Than You Expect

Well, it turns out, all too often private clients need their investible assets to be more flexible than initially expected. Life happens. You decide to buy a new home. Or help one of your children buy theirs. Or turn a big chunk of your investment capital over to a new manager. Or pay for an expensive medical treatment. Or wind up an estate. Or. Or. Or. What all these “or’s” have in common is that they’re imaginable in advance, but to one degree or another unexpected when they happen. It’s then that the illiquidity of alts – their inflexibility – can be problematic. Remember that load-bearing wall between the kitchen and family room that was fine when you bought your home, but now stands between you and your dream of combining the two rooms into one big, beautiful open space? With enough money, it doesn’t matter. But for most people, it does. Which are you? How sure are you? And for how long?

By contrast, consider a pension fund. A fund with new members joining in their 20’s must be able to make payments to those same members 70 years or more later. In between, the fund simply collects periodic pension contributions, invests the capital, and makes monthly pension payments. It navigates like one of those enormous ocean-going containerships: steadily over very long distances. It’s the ultimate “long game”. So it should be no surprise that a pension can make very long-term investments without fear of its ability to do so being undermined by the kind of demand for flexibility that private clients can all too easily face.

What Are the Hidden Costs of Private Market Investing?

On the topic of expertise, it is absolutely true that investing with a skilled, experienced alts manager makes all the difference. The challenge is how to find and identify such a manager. It is job enough to distinguish between luck and skill when assessing managers who do what Nexus does. There, at least, the performance statistics and resulting track record are readily accessible and can be presumed to be a reliable reflection of history – leaving aside the question of whether past is prologue. By contrast, it is a considerably more difficult task to obtain and evaluate data of the same quality for alts managers. Indeed, there is a good case to be made that only a professional evaluator of alts managers can make such an assessment successfully. So, if the alts manager gets well rewarded for managing the alts portfolio, and a professional needs to be paid to help find such a manager, that sounds like a lot of “leakage” between the end investor and the underlying investments. And this is before factoring in the considerable costs of distribution – all the work required to make alts available to the private client segment.

How Stable or Risky are Alts…Really?

The claim that alts returns are less volatile than those in the public markets is pure sophistry. An infant figures out all by themselves the concept of “object permanence” – just because I can’t see it doesn’t mean it isn’t there. (Think: peek-a-boo.) In the same spirit, just because alts prices aren’t published frequently is no proof that alts values don’t fluctuate. If I tried to claim that the absence of a “For Sale” sign on my front lawn is proof that my house is worth the same as a few years ago, even though neighbourhood properties are changing hands at prices that are well off their highs 3 years ago, you’d channel your inner Col. Sherman Potter (he of M*A*S*H fame) and shout “Horse hockey!”

There is also the issue of signalling. Normally we’d say that securities whose values jump around a lot are risky, while those whose prices are stable are “safe”. With alts, the usual signalling is turned off, or at least turned way down. There can be way more risk embedded in an alts vehicle than is evidenced by its leisurely and infrequently reported fluctuations in price/value. Lulling the alts investor into believing his/her position is dramatically less risky than a conventional balanced portfolio is, to put it gently, not doing anyone any favours. And the bigger the disconnect between belief and reality, the greater the shock when something punctures that belief. When the majestic oak in the back yard collapses after a lightning strike and is revealed to have been hollow and decayed inside all along, that in itself is a shock, to say nothing of the damage done by the falling branches. And, as with that oak, it is virtually impossible for the uninitiated to see what’s really going on inside an alts vehicle.

Is Regulatory “Democratization” of Alts a Good Thing?

The topic of alts is timely in light of the growing efforts throughout the investment industry and, indeed, by securities regulators to make them more readily available to virtually all investors, big and small. Admittedly, there is something vaguely undemocratic and inherently unfair about restricting access to only the largest, wealthiest investors. Regulators are especially alert to this sort of discrimination. They’re constantly on the prowl for evidence that one group or other enjoys an advantage, especially if it’s at the expense of another. But they’re also in the business of investor protection. And there is a natural tension between, on the one hand, the “come one, come all” paradigm that seeks to avoid discrimination by making everything available to everyone, and, on the other, the desire to protect some types of investors by restricting them from accessing certain investments. It’s not an easy balance to strike. But it seems unlikely that granting wide open access to all to opaque, illiquid investments with no more than a “caveat emptor” is the best answer.

The Bottom Line: If It’s Too Good to Be True…

Finally, when a purveyor of alts wants to sell me something that sounds almost too good to be true, my inner “WIIFT” detector goes off: What’s in it for them? Why do they need to hunt me down and sell me this stuff if they already have so much invested capital to manage from the likes of Ontario Teachers and CPP? What in their breathless pitch like the one above, are they glossing over? Or, expressed differently, why does this sophisticated “club”, which I’ve been excluded from for decades, suddenly want li’l ol’ me as a member? Is what’s on offer perfectly suited to my needs? Or is it the other way around: I’m perfectly suited to someone else’s need for more capital to manage or for a buyer to take an existing holding off someone else’s hands. Call it cynicism, if you will. I think of it as healthy skepticism.

Warning: the views expressed here are seriously out of step with conventional wisdom. Some might even say they’re old school, démodé, unsophisticated, or even (perish the thought!) hopelessly corrupted by conflict of interest. Perhaps. But that doesn’t mean they’re wrong. You be the judge.