ALTERNATIVE INVESTMENTS UNVEILED: HYPE VS. REALITY... BEYOND STOCKS AND BONDS
What do you do when you get bored? It’s an uncomfortable feeling that no one enjoys. If you’re a parent like me, you’ve likely heard the phrase “I’m bored” more times than you can count. 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. Take me, for example. When I was little, my brother and I would have bottle rocket fights to see who we could hit first. Luckily for us, we never hit each other. But for adults, especially when it comes to personal finances and investments, the stakes are much higher. Boredom can lead us down unexpected paths, and in the world of finance, these paths can often be treacherous.
In the investment world, patience is often touted as a virtue. Warren Buffett, known for his disciplined approach, advises investors to buy quality companies and hold them for the long term. However, not everyone follows this sage advice. Some investors, akin to kids searching for excitement, closely follow market headlines, making impulsive decisions when boredom strikes. This impatience can lead to chasing trends and risking financial security. They too can get themselves in trouble.
Over the past few years, there's been a huge buzz about alternative investing. Some 75% of high-net-worth investors between the ages of 21 and 42, compared to 32% of investors over 43-years-old, don’t expect “above-average returns” solely from traditional stocks and bond[1]. So they are seeking alternative investments. The allure lies in the promise of improved portfolio diversification, reduced risk, and uncorrelated returns.
I, however, don’t see it the same way (shocker!). I see a lot of confusion, a lack of history, and a lot of people not truly understanding what they're potentially investing in. They can’t see the pros and cons clearly and they aren’t keeping it simple (KISS) or prescribing to the Time + (Discipline)2 mantra that is tried and true.
So what is the truth about alternative investments? What exactly are they and should you include them in your portfolio? In this post, I won’t cover all of them (there are simply too many, it seems like Baskin-Robbins!) but I will explore the most common alternative investments that are often being discussed today.
PRIVATE EQUITY: BEHIND CLOSED DOORS
Let's start with Private equity. Private equity is simply pooling money together to buy a business that is privately owned. This means it's not traded on a public exchange, like the New York Stock Exchange, or the NASDAQ. Public equities are companies like Apple, Google, or GE. You can buy shares (or stocks) in these businesses, but in most cases, you have little or no say in the operations of these businesses (unless you manage to purchase a significant amount of shares).
When it comes to private equity, you’re using private capital to purchase a private asset. This could be a piece of real estate, but typically, the private equity playbook revolves around flipping a business. Often times loading the acquired business with a bunch of debt and a small amount of equity they think they can “fix” then turn around and sell for a return within 3-5 years (this is, of course, a generalization).
The private equity industry has blown up recently, in terms of size. The industry as a whole in 2020 employed about 11.7 million people[2], which is nearly 3 million more than just 2 years earlier. As of 2021, there are more than 18,000 Private Equity funds[3], a nearly 60% increase in just the last five years.
Venture Capital: The Stark Reality of Start-ups
Next on the list, we have venture capital. What is venture capital? Venture capital is a form of equity financing or capital that is invested, typically, for minority stakes in startup companies. Companies that are “poised for significant growth.” While private equity typically puts its money into more mature businesses, venture capital typically invests in startups.
Just like private equity, venture capital has grown in the wake of big tech. 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 fund the next Google or Facebook and get in on the ground floor.” However, the truth of the matter is that many of these big dreams don’t become a reality. It has been found that up to 75% of venture-backed startups fail.[4]. And, 95% do not meet their expected return on investment[4], according to a study by Shikhar Ghosh, a senior lecturer at Harvard Business School.
Despite these figures, the venture capital space has grown almost as rapidly as private equity. According to Ernst and Young, in 2010, there were about $33 billion of venture capital-backed deals. Fast forward to 2021, that number grew by almost 11x. These are the deals in the industry, not your returns. So, ask yourself, who is getting the expected returns you or the VC industry?
Hedge Funds Unmasked: Strategies and Speculation
Now let's go into hedge funds. Hedge funds, traditionally seen as vehicles for sophisticated investors, employ a wide range of strategies. Some venture into non-traditional assets, aiming for above-average returns, while others bet against companies, hoping for market declines. The term "hedging" originated from this practice. Despite the allure of flexibility, the complexities within hedge funds can lead to significant risks.
Weighing the Risks: Pros and Cons
So, now that you understand some of the more common alternative investments, you may be wondering whether they’re a good idea for you. There is a lot of confusion in the market, especially when it comes to alternative investments. Perhaps it’s the chance to “strike it big,” “get in on a golden opportunity,” or make the returns that you’ve been dreaming of. Whatever the narrative, it always seems to boil down to a fear of not missing out. Which is something that gets very enticing when you’re bored and impatient.
When looking at alternatives, there is a lot to consider. The potential returns, the levels of risk, who is managing these investments, the track record, and liquidity to name a few. Ultimately, it’s a decision that comes with a lot of pros, cons, and serious considerations to mull over. So let’s draw your attention to a couple important factors that I believe need to be addressed.
Understanding the Shift: Factors of Regime Change
As we continue our journey through the world of alternative investments, it's crucial to consider the concept of regime change. When contemplating investment opportunities, the notion of a regime change becomes paramount. It prompts us to question whether the future period for achieving returns aligns with the past, upon which we base our assumptions regarding returns and risks. If it doesn't, we're facing a regime change, and in my view, the current and prospective landscape differs significantly from what we've experienced in the past.
First and foremost, we must acknowledge the shifting interest rate environment. In recent history, we've been accustomed to a zero interest rate policy, with interest rates maintained at historically low levels. However, this scenario is changing rapidly. Interest rates are on the rise and approaching more normalized levels. The Federal Reserve has indicated its intention to refrain from lowering interest rates in the foreseeable future.
Why does this matter? For many private equity and venture capital endeavors, leverage and access to capital are fundamental. With higher interest rates, financing costs escalate, impacting the returns for equity holders. Moreover, elevated financing costs could potentially reduce the expected return probability. Additionally, it influences the multiples that investors are willing to pay for businesses. As interest rates climb, all else being equal, multiples are likely to decrease. If you've invested with the assumption of buying at a specific multiple and selling for a higher one in the future, you may need to reassess this strategy, given the evolving interest rate landscape.
The Impact of Influx: A Flood of New Capital
As discussed earlier, the alternative investment arena has seen an influx of capital over the past few years, attracting increasing attention from investors. However, economics teaches us a fundamental principle: when more money competes for the same opportunities, return expectations tend to decline.
This abundance of capital results in more participants vying for the same deals, all chasing returns. Consequently, your informational advantages, liquidity advantages, and pricing advantages may diminish. With the copious amounts of money now circulating in the industry, it's reasonable to anticipate that expected returns will adjust accordingly, given the heightened competition and greater availability of information on investment opportunities.
Don’t go it alone
First, you need to understand your motives from considering these in the first place. Are you simply bored? Are you growing impatient with your current strategy and portfolio? Are you looking for a quick score or the chance to beat the market and prove yourself? Second, you need to carefully consider any alternative investment that may present itself, and ask if is this truly right for you. Not all investments are made equal and not every investment is right for every person. This is why you need someone in your corner. Someone who understands the numbers, someone who has your best interests at heart and seeks to keep you on the right path.
At Julius Wealth Advisors, our goal is to help you accomplish yours. If you succeed, we genuinely feel as if we succeeded. Just like when I played offensive line, all 5 of the linemen had to win for the play to be effective. Not just 1. Which is why we take the approach to investing that we do.
As tempting as some alternative investments may be, in our opinion, they are no substitute for the proven formula of sustainable wealth. If you need someone on your team to watch over your financial future and keep you on the right track, get in touch with us today. And, if you want to dive into this topic in even more detail, I discussed it in Episode 19 of The Big Bo $how.
References:
Private Equity & the Economic Recovery- AmericanInvestmentCouncil.org
Startup Failure - Inc.com
Disclosures:
This piece contains general information that is not suitable for everyone and was prepared for informational purposes only. Nothing contained herein should be construed as a solicitation to buy or sell any security or as an offer to provide investment advice. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. Past performance does not guarantee any future results. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. For additional information about Julius Wealth Advisors, including its services and fees, contact us or visit adviserinfo.sec.gov.