When do alternatives make sense?

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MtnTravel
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When do alternatives make sense?

Post by MtnTravel »

As the title suggests, when do alternatives make sense in a portfolio? And by alternatives I'm specifically referring to things like private debt, private equity, hedge funds, etc.

I know some UHNW people who work with the big private banks and invest in alternatives. They have had very good returns and feel like this diversifies their portfolio and limits downside risk when the stock market gets hammered.

I know the sentiment on this forum is generally anti-alternative and a lot of people see no reason why anyone would hold anything other than VTI, but there has to be some logical reason that these alternatives exist/people like using them (other than the banks making money)? The people I know are very sophisticated investors, and not the type who are going to blindly follow what some advisor tells them or get sold a product that isn't going to benefit them.

Do these alternatives only make sense when you get the UHNW level? What purpose can they serve in a portfolio?
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nedsaid
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Re: When do alternatives make sense?

Post by nedsaid »

Wow. You have asked a really great question. This has been debated a lot here at Bogleheads. After having participated in a lot of these discussions, I wish I could give a definitive answer but the best that I can do is say that Alternative investments and the ideas behind them have merit. Each person or family has to decide if these kind of investments make sense in light the bigger picture of their lives and their particular situation. It is sort of a philosophical question, it boils down to whether you believe in these things or not. You can think this through, decide that some of these investments are appropriate, do your due diligence, and even then it is hit and miss.

I worked for a Financial Advisor for a couple years as an assistant, the Advisor believed in many of these types of investments, and most of these seemed to work out for the clients. Would I have purchased some of these myself? I did find myself open minded to them but for various reasons, I didn't consider these for my own purchase. A big issue is that semi-liquid or illiquid investments do tie up your money for a period of time, so these take a commitment.
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J295
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Re: When do alternatives make sense?

Post by J295 »

Potential for acceptable to higher returns
Some possible diversification (not a primary factor for many investors)

Subtle benefit is opportunity to consider/invest in subsequent opportunities and sometimes some network/ relationship building.

Edit to add. I’m primarily thinking of investments where the investor has a history with the project principal/ originator who invites the investor. This in contrast to having FA get you into a deal where you have no history/ relationship with project principal.
Last edited by J295 on Wed Oct 30, 2024 7:41 am, edited 1 time in total.
grok87
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Re: When do alternatives make sense?

Post by grok87 »

MtnTravel wrote: Wed Oct 30, 2024 6:06 am As the title suggests, when do alternatives make sense in a portfolio? And by alternatives I'm specifically referring to things like private debt, private equity, hedge funds, etc.

I know some UHNW people who work with the big private banks and invest in alternatives. They have had very good returns and feel like this diversifies their portfolio and limits downside risk when the stock market gets hammered.

I know the sentiment on this forum is generally anti-alternative and a lot of people see no reason why anyone would hold anything other than VTI, but there has to be some logical reason that these alternatives exist/people like using them (other than the banks making money)? The people I know are very sophisticated investors, and not the type who are going to blindly follow what some advisor tells them or get sold a product that isn't going to benefit them.

Do these alternatives only make sense when you get the UHNW level? What purpose can they serve in a portfolio?
there are a few of things to consider with regard to private equity and private debt (aka private credit):

1) returns: private equity has actually been underperforming the S&P 500 recently.
https://www.bloomberg.com/news/articles ... -two-years
i believe private credit (net of fees) has been outperforming public credit (bank loan etfs are the usual comparison)
https://www.youtube.com/watch?v=RzQHp3FR5J4
https://cliffwater.com/ResourceArticle?docId=24564
the figure given here is outperformance of about 4% per year over the last 10 years. the consensus is that this outperformance will likely be lower going forward as back in 2013 this market was much smaller and it is more saturated now.

2) volatility i.e. ('when the stock market gets hammered"). there is a lot of academic discussion about whether private assets really have lower volatility or whether this is just an accounting illusion. private assets are by definition not traded and do not have to "mark to market". so basically you have the same "equity market risk" exposure in private equity but it takes longer for it to bleed into private equity returns.

3) risks. one of the risks with private assets is that they generally are not 'registered securities" so there is less investor protection. it is worth reading about the Kirschner case as an example
https://www.chapman.com/publication-loa ... econfirmed

hope this helps
cheers,
grok
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WhyNotUs
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Re: When do alternatives make sense?

Post by WhyNotUs »

MtnTravel wrote: Wed Oct 30, 2024 6:06 am
Do these alternatives only make sense when you get the UHNW level? What purpose can they serve in a portfolio?
When you have enough money that it really doesn't matter how that portion of your investments perform.
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I am unaware of research that supports the statement about limiting downside risk over time. I have not really looked for it so maybe it exists. What are you basing that statement on?
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alex_686
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Re: When do alternatives make sense?

Post by alex_686 »

J295 wrote: Wed Oct 30, 2024 6:34 am Potential for acceptable to higher returns
Some possible diversification (not a primary factor for many investors)

Subtle benefit is opportunity to consider/invest in subsequent opportunities and sometimes some network/ relationship building.
Diversification is the primary reason. This is particularly true for commodities, illiquid assets, total return strategies (strategies that have large short positions so have low market exposure) and some high skill strategies (buying debt of bankrupt companies, investing in litigation financing).

I don’t know anyone who invest for networking, but I work in operations so I am not exactly on that cocktail circuit. However I doubt it.
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Trance
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Re: When do alternatives make sense?

Post by Trance »

I would say when they become large enough that they start competing with the current markets, stocks and bonds, and would probably base it on size. The bond market is $135 trillion and the global stock market is $100 trillion, while private equity is only $500 billion.

I think we'd have to consider them if the world ever shifts and suddenly private equity is a large competitor market cap wise. Another example is crypto. For all the hype it's only $2.5 trillion. And gold is $7.5 trillion.

I think if these market caps ever get to competitive levels with stocks and bonds, and hold that level for a decent amount of time like decade(s) then it would be worth considering. You never know what the future will look like.
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J295
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Re: When do alternatives make sense?

Post by J295 »

alex_686 wrote: Wed Oct 30, 2024 7:37 am
J295 wrote: Wed Oct 30, 2024 6:34 am Potential for acceptable to higher returns
Some possible diversification (not a primary factor for many investors)

Subtle benefit is opportunity to consider/invest in subsequent opportunities and sometimes some network/ relationship building.
Diversification is the primary reason. This is particularly true for commodities, illiquid assets, total return strategies (strategies that have large short positions so have low market exposure) and some high skill strategies (buying debt of bankrupt companies, investing in litigation financing).

I don’t know anyone who invest for networking, but I work in operations so I am not exactly on that cocktail circuit. However I doubt it.
I provided this edit to my answer above FYI
Edit to add. I’m primarily thinking of investments where the investor has a history with the project principal/ originator who invites the investor. This in contrast to having FA get you into a deal where you have no history/ relationship with project principal.

I believe you are right about the strategies you noted in your reply being principally for diversification.

I was considering a fact pattern of nonpublic equity investing that the OP actually was not describing.

The investors I am considering do not talk about their wealth or investments, so the whole country club cocktail circuit isn’t a thing. When they are putting together a new project it is a tight circle, and only those with personal relationships are given an opportunity. So it’s not investing for networking, but at least for these type of things here if you’re not in the circle you can’t invest even if you have the resources.
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Re: When do alternatives make sense?

Post by ScubaHogg »

Personally I look at private equity and private credit as mostly an accounting illusion. I mean, why *should* private equity have higher returns? You are still buying the earnings of a company. The customers purchasing the products don’t know the regulatory structure the equity is offered under? The only good explanation is that there *was* a market inefficiency and those companies were underpriced. But that’s a one time phenomenon that’s probably gone bye bye

But even if you do believe in them, how can you discern a good fund? A co-worker of mine once worked at a smaller hedge fund (a few billion AUM). They charged 1 and 20.

80% of the fund was in Berkshire Hathaway. Most the rest was in other companies that Berkshire was already holding

People were paying 1 and 20 for a Berkshire proxy fund they could hold for free

So buyer beware for sure
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normaldude
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Re: When do alternatives make sense?

Post by normaldude »

In general, people in the bottom 99.9% are focused on the "investment return". If you look at marketing material aimed at the general public, this is what is emphasized.

In general, ultra-wealthy people don't care as much about the return on their investments, because they have more money than they'll ever need. If you look at marketing material aimed at the ultra-wealthy (from private banking / private client groups at JP Morgan, Goldman Sachs, etc), you'll see that "investment return" is not the focus. Instead, there's a lot of focus on "investments of passion" (artwork, classic cars, wine, luxury watches, etc) along with alternative investments (private equity, venture capital, hedge funds, etc).

Just because you see a billionaire having fun buying Monets & Picassos at Sothebys & Christies art auctions, partying on private jets & megayachts, filling his wine cellar full of exotic wines, and investing in private equity, venture capital, hedge funds, doesn't mean that these decisions would make financial sense for the general public.

So when you have a net worth over $500 million, and you have a family office staffed with former private equity & hedge fund managers who now work for you, you can ask them (or your private client manager at JP Morgan or Goldman Sachs) to give you a presentation about potential alternative investments, including European castles, before you determine the next presidential election with your SuperPAC donations and K Street lobbyists.

Until then, it's probably best to just stick to a boglehead portfolio of index funds.
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Re: When do alternatives make sense?

Post by KlangFool »

MtnTravel wrote: Wed Oct 30, 2024 6:06 am
there has to be some logical reason that these alternatives exist/people like using them

The people I know are very sophisticated investors, and not the type who are going to blindly follow what some advisor tells them or get sold a product that isn't going to benefit them.
MtnTravel,

"The people I know are very sophisticated investors,"

A) There are no correlation between UHNW and intelligence. Especially, some of them gained their wealth by some kind of windfall.

B) They might be investing in those alternative with less than 1% of their portfolio.

C) Please explain how do you know that they are good investors.

D) This reminds me about the joke about how to make a million in winery. You invest 10 millions in a winery and you left with 1 million.

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Re: When do alternatives make sense?

Post by KlangFool »

OP,

Friend and family members do pooled money together to invest in some projects or start a business. This kind of alternative only available to people in the social circle. It is NOT only for the return. And, the amount of money invested is the amount that each person can afford to lose.

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Valuethinker
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Re: When do alternatives make sense?

Post by Valuethinker »

ScubaHogg wrote: Wed Oct 30, 2024 8:23 am Personally I look at private equity and private credit as mostly an accounting illusion. I mean, why *should* private equity have higher returns? You are still buying the earnings of a company. The customers purchasing the products don’t know the regulatory structure the equity is offered under? The only good explanation is that there *was* a market inefficiency and those companies were underpriced. But that’s a one time phenomenon that’s probably gone bye bye

But even if you do believe in them, how can you discern a good fund? A co-worker of mine once worked at a smaller hedge fund (a few billion AUM). They charged 1 and 20.

80% of the fund was in Berkshire Hathaway. Most the rest was in other companies that Berkshire was already holding

People were paying 1 and 20 for a Berkshire proxy fund they could hold for free

So buyer beware for sure
I think the bulk of academic evidence supports your contention.

It's been shown that private capital firms "smooth" their NAVs. They provide the estimates of valuation of portfolio companies &investments to the auditors, who can push back. But generally auditors do not have the time, expertise nor incentive to give their clients hassle like that.

Clifford Asness has written about this. It's kind of a "game" that both the private capital managers, and their institutional investors, know they are doing, which suits both of them.

On market inefficiency it arises from barriers to information/ information asymmetry that do not occur in public markets. One well documented one is IPO - venture capital backed IPOs have a record of underperformance post first day "pop". That value is transferred by the sponsor investment banks either to selling shareholders, or to their favoured institutional buy-side clients.

But, generally, it's not clear that the market for private companies is informationally inefficient. Most businesses are sold by competitive auction, where 4-5 main bidders have access to all the same information.

Similarly, funding "rounds" for Venture Capital backed companies are conducted somewhat like auctions, with investors in earlier stage rounds working to increase the valuation of the company. Swensen showed that the added value for VC funds was negative for the vast majority of them (underperforming the NASDAQ) - it's really only a handful of top partnerships that consistently outperform. Unless you have privileged access to their funds, you are not going to be an investor in successful VC funds.

A lot of it comes down to leverage. A private equity company buyer can use more leverage than a public company buyer. That provides a tax shield which benefits equity investors --the additional interest is tax deductible. Again, that's not an anomaly which only some PE firms have access to.

There's lots of things about Berkshire Hathaway that are quite unique to that company.
Last edited by Valuethinker on Wed Oct 30, 2024 8:48 am, edited 1 time in total.
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Re: When do alternatives make sense?

Post by nisiprius »

It only makes sense for advisors to sell most alternatives to "accredited" investors. That means $300,000 in income for a couple, or $1 million net worth (aha! that's why people keep asking what things count in their "net worth") or "Has certain professional certifications or designations, such as being in good standing with the Series 7, Series 65, or Series 82 licenses."

That probably goes a long way to explaining why it is typically high-net-worth investors who own them.

As to when it makes sense to buy them, it makes sense if you have a great deal of personal knowledge of, and interest in, the specific kind of investment--so that you are not relying on blind trust in your advisor--and the investment will leave you with more than enough in traditional investments to cover any likely future urgent need for ready cash.

The argument from "there must be a good reason for popularity" is weak. There "must be some reason" why an estimated 5% of all U.S. households own at least one print by Thomas Kinkade, Painter of Light®. That in itself is not a reason why I should own one.
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Re: When do alternatives make sense?

Post by TipsQuestions »

There's this idea, promoted by the investment industry, that once you're wealthy enough you get to "graduate" to the types of illiquid, less regulated, high fee investments you mention. I'm not buying it (or them). These products come with definite drawbacks but only speculative benefits. My investment needs are fully satisfied through stocks, bonds, cash, and real estate.
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Re: When do alternatives make sense?

Post by SubPar »

grok87 wrote: Wed Oct 30, 2024 7:20 am 2) volatility i.e. ('when the stock market gets hammered"). there is a lot of academic discussion about whether private assets really have lower volatility or whether this is just an accounting illusion. private assets are by definition not traded and do not have to "mark to market". so basically you have the same "equity market risk" exposure in private equity but it takes longer for it to bleed into private equity returns.
One point of clarification...investment companies require fair value (mark-to-market) accounting under GAAP (ASC 946). When there's not a public market for a specific asset, the fair value is most often determined via independent valuation. Though, inputs driving that valuation can often be somewhat subjective and/or based on stale/illiquid market data, so your comment about the potential for volatility smoothing is accurate.
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Re: When do alternatives make sense?

Post by Valuethinker »

SubPar wrote: Wed Oct 30, 2024 10:21 am
grok87 wrote: Wed Oct 30, 2024 7:20 am 2) volatility i.e. ('when the stock market gets hammered"). there is a lot of academic discussion about whether private assets really have lower volatility or whether this is just an accounting illusion. private assets are by definition not traded and do not have to "mark to market". so basically you have the same "equity market risk" exposure in private equity but it takes longer for it to bleed into private equity returns.
One point of clarification...investment companies require fair value (mark-to-market) accounting under GAAP (ASC 946). When there's not a public market for a specific asset, the fair value is most often determined via independent valuation. Though, inputs driving that valuation can often be somewhat subjective and/or based on stale/illiquid market data, so your comment about the potential for volatility smoothing is accurate.
1. there's been plenty of empirical evidence they "smooth" their NAVs

2. if you think about the relationship between a fund and its auditors, and who has the informational balance of power, you can see how that might play out

What Clifford Asness has added is the observation that the institutional investors know this is happening, and actually prefer it. Because in turn their Trustees and plan members prefer lower volatility to higher.
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Re: When do alternatives make sense?

Post by Sandtrap »

Already excellent input, "nisiprius", "valuethinker", "nedsaid", "klang", etc.

Great question.
Lot's of pros and cons and contradixcktions fore eavery pro and eevry con.

Generally, There's no getting away from seeking yield and avoiding increased volatility when doing so.
Even if an allocation remains the same, when parsing out the underlying funds for gain, then you introduce volatility. So, it becomes like "herding cats".

Read:
TAYLOR LARIMORE ON “SIMPLICTY”
https://www.bogleheads.org/forum/viewt ... p?t=156505

j
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Re: When do alternatives make sense?

Post by AlohaBill »

For my family: NEVER!
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SubPar
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Re: When do alternatives make sense?

Post by SubPar »

Valuethinker wrote: Wed Oct 30, 2024 10:30 am
SubPar wrote: Wed Oct 30, 2024 10:21 am

One point of clarification...investment companies require fair value (mark-to-market) accounting under GAAP (ASC 946). When there's not a public market for a specific asset, the fair value is most often determined via independent valuation. Though, inputs driving that valuation can often be somewhat subjective and/or based on stale/illiquid market data, so your comment about the potential for volatility smoothing is accurate.
1. there's been plenty of empirical evidence they "smooth" their NAVs

2. if you think about the relationship between a fund and its auditors, and who has the informational balance of power, you can see how that might play out

What Clifford Asness has added is the observation that the institutional investors know this is happening, and actually prefer it. Because in turn their Trustees and plan members prefer lower volatility to higher.
100% agree -- not arguing that at all. Was just clarifying that these investment firms do still technically mark private investments to market. Most auditors don't have enough first-hand knowledge to push back unless there's some obviously egregious (and material) assumptions being made.

I'm seeing it play out in the real estate world right now. There have been cavernous bid-ask spreads for real estate generally, which translated to significantly lower transaction volume. Lower transaction volume means there are far fewer market comps (be it cap rates or whatever) to leverage for ascribing an accurate value to the given property. That can yield valuations based on stale data, or open up the ability for a fund manager to employ more subjective (favorable) valuation inputs.
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Re: When do alternatives make sense?

Post by Valuethinker »

SubPar wrote: Wed Oct 30, 2024 10:54 am
Valuethinker wrote: Wed Oct 30, 2024 10:30 am

1. there's been plenty of empirical evidence they "smooth" their NAVs

2. if you think about the relationship between a fund and its auditors, and who has the informational balance of power, you can see how that might play out

What Clifford Asness has added is the observation that the institutional investors know this is happening, and actually prefer it. Because in turn their Trustees and plan members prefer lower volatility to higher.
100% agree -- not arguing that at all. Was just clarifying that these investment firms do still technically mark private investments to market. Most auditors don't have enough first-hand knowledge to push back unless there's some obviously egregious (and material) assumptions being made.

I'm seeing it play out in the real estate world right now. There have been cavernous bid-ask spreads for real estate generally, which translated to significantly lower transaction volume. Lower transaction volume means there are far fewer market comps (be it cap rates or whatever) to leverage for ascribing an accurate value to the given property. That can yield valuations based on stale data, or open up the ability for a fund manager to employ more subjective (favorable) valuation inputs.
I should have made it more clear that I fundamentally agree with you ...

"mark to market" just doesn't mean what people who are only familiar with public markets might think it means.

(It occurs to me, thinking aloud, that private credit funds will have the same issues. Unless the loans are actually non-paying/ impaired, it's difficult to know what the chance of default/ recovery is).

Real estate. The problem - at least for city center real estate - is that post pandemic I don't think there's any clear idea what the stuff is worth? The traditional tenants (banks, professional service firms etc) just need less space. (It's hilarious when C-Suite say we should be in work more often - we have only about 60% of the desks we had pre Covid; and most of us come into the office to sit on MS Teams calls - there are never enough meeting rooms). Retailers of course we all know.

Conversion of a modern office building to alternative uses (residential) is difficult or impossible. Oddly, I think older office buildings (which had structural perimeter walls, and offices & corridors inside) may be better.

But of course this creates opportunities - as you outline. For the brave, or the skilful. Napoleon to his generals "First. You must be lucky".
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Re: When do alternatives make sense?

Post by Tramper Al »

I think this is a case where size/scale makes a difference.

Sure, I'd like to invest the way the Harvard endowment does - such an effort at diversification via alternative and correlated asset classes.

But since I'm not an Ivy League endowment, instead of a huge diversified real estate portfolio I own TIAA Real Estate, or worse yet VNQ. Instead of owning a forest of timber, I have to settle for the 3 timber REITs that trade publicly. Instead of private equity, I'm left with PSP or similar, really several steps away from the real thing. Gold, commodity futures I can own, but with layers of fees the endowments don't see. And again publicly traded.

So the biggest problems I have with many of the alternatives is fees, separation between what I can own and what I'd like to own, and that most everything is publicly traded so it correlates more with "the market" aka the rest of the portfolio more than I'd like.

But yes, I include many alternatives, despite these problems. Have for years.
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Re: When do alternatives make sense?

Post by grok87 »

Valuethinker wrote: Wed Oct 30, 2024 10:30 am
SubPar wrote: Wed Oct 30, 2024 10:21 am

One point of clarification...investment companies require fair value (mark-to-market) accounting under GAAP (ASC 946). When there's not a public market for a specific asset, the fair value is most often determined via independent valuation. Though, inputs driving that valuation can often be somewhat subjective and/or based on stale/illiquid market data, so your comment about the potential for volatility smoothing is accurate.
1. there's been plenty of empirical evidence they "smooth" their NAVs

2. if you think about the relationship between a fund and its auditors, and who has the informational balance of power, you can see how that might play out

What Clifford Asness has added is the observation that the institutional investors know this is happening, and actually prefer it. Because in turn their Trustees and plan members prefer lower volatility to higher.
agree
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Re: When do alternatives make sense?

Post by grok87 »

SubPar wrote: Wed Oct 30, 2024 10:21 am
grok87 wrote: Wed Oct 30, 2024 7:20 am 2) volatility i.e. ('when the stock market gets hammered"). there is a lot of academic discussion about whether private assets really have lower volatility or whether this is just an accounting illusion. private assets are by definition not traded and do not have to "mark to market". so basically you have the same "equity market risk" exposure in private equity but it takes longer for it to bleed into private equity returns.
One point of clarification...investment companies require fair value (mark-to-market) accounting under GAAP (ASC 946). When there's not a public market for a specific asset, the fair value is most often determined via independent valuation. Though, inputs driving that valuation can often be somewhat subjective and/or based on stale/illiquid market data, so your comment about the potential for volatility smoothing is accurate.
agree
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Re: When do alternatives make sense?

Post by Cannoli »

Keep in mind Warren Buffets famous bet that a group of hedge funds would not outperform the S and P 500 over a 10 year period. Also keep in mind who won.
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Re: When do alternatives make sense?

Post by TomatoTomahto »

There is one alternative investment that I would put a large amount of our assets into, but they don’t want our money. They are doing fine without us.
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Re: When do alternatives make sense?

Post by mbouck »

MtnTravel wrote: Wed Oct 30, 2024 6:06 am As the title suggests, when do alternatives make sense in a portfolio? And by alternatives I'm specifically referring to things like private debt, private equity, hedge funds, etc.

I know some UHNW people who work with the big private banks and invest in alternatives. They have had very good returns and feel like this diversifies their portfolio and limits downside risk when the stock market gets hammered.

I know the sentiment on this forum is generally anti-alternative and a lot of people see no reason why anyone would hold anything other than VTI, but there has to be some logical reason that these alternatives exist/people like using them (other than the banks making money)? The people I know are very sophisticated investors, and not the type who are going to blindly follow what some advisor tells them or get sold a product that isn't going to benefit them.

Do these alternatives only make sense when you get the UHNW level? What purpose can they serve in a portfolio?
When do alternatives make sense? When does adding additional uncorrelated risk premia (return streams) make sense? Almost always.

It’s understandable why alternatives can be viewed skeptically. Traditionally, many "alternatives" were private and came with high fees or limited liquidity. However, the newer category of liquid alternatives offers access to uncorrelated risk premia in public, accessible vehicles like ETFs and mutual funds.

The key reason to consider liquid alternatives is their low correlation with traditional stock and bond assets. This can add true diversification benefits to a portfolio—something a traditional international stock fund may not fully achieve since global equities often remain highly correlated with U.S. markets, especially during downturns.

For instance:
  • Managed Futures can thrive in trending markets, including during equity downturns.
  • Market-Neutral and Long-Short Equity strategies seek to generate returns independent of market direction.
  • Global Macro strategies take advantage of macroeconomic trends across asset classes worldwide.
These strategies aim to provide different sources of return that don’t rely on stock or bond performance, enhancing overall portfolio resilience. A few resources that break down the concept and options available are:

How to Use Alternatives in Your Portfolio (Morningstar)
AQR Capital’s "Alternative Thinking" series on alternative risk premia.
Newfound Research’s blog on liquid alternatives and portable beta, which covers various diversification approaches and portfolio construction techniques.

Exploring these strategies doesn’t mean they’re right for everyone, but they offer a modern take on diversification that can strengthen traditional portfolios without relying on private funds or high fees.
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Re: When do alternatives make sense?

Post by Gaston »

I saw this over at the Rationale Reminder forum. I believe it’s from David Swensen’s book Unconventional Success.

In Mr. Swensen’s words, “Non-core asset classes (hedge funds, leveraged buy-out funds, venture capital funds, private credit funds, etc) provide investors with a broad range of superficially appealing but ultimately performance-damaging investment alternatives.”
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Re: When do alternatives make sense?

Post by Gecko10x »

Gaston wrote: Thu Oct 31, 2024 5:01 pm I saw this over at the Rationale Reminder forum. I believe it’s from David Swensen’s book Unconventional Success.

In Mr. Swensen’s words, “Non-core asset classes (hedge funds, leveraged buy-out funds, venture capital funds, private credit funds, etc) provide investors with a broad range of superficially appealing but ultimately performance-damaging investment alternatives.”
That book was published 20 years ago. To the point mbouck made just above, there are now many more assets cheaply accessible to the average investor that could be considered.
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Re: When do alternatives make sense?

Post by ScubaHogg »

Gecko10x wrote: Thu Oct 31, 2024 5:49 pm That book was published 20 years ago. To the point mbouck made just above, there are now many more assets cheaply accessible to the average investor that could be considered.
See my post above about why that "access" may not be the slam dunk for the actual end investor it might appear to be
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Re: When do alternatives make sense?

Post by Gaston »

KlangFool wrote: Wed Oct 30, 2024 8:31 am This reminds me about the joke about how to make a million in winery. You invest 10 millions in a winery and you left with 1 million.
The same joke is told in the art world. Want to own a painting worth $1 million? It’s easy. Just buy one for $10 million.
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Re: When do alternatives make sense?

Post by Geologist »

Gecko10x wrote: Thu Oct 31, 2024 5:49 pm
Gaston wrote: Thu Oct 31, 2024 5:01 pm I saw this over at the Rationale Reminder forum. I believe it’s from David Swensen’s book Unconventional Success.

In Mr. Swensen’s words, “Non-core asset classes (hedge funds, leveraged buy-out funds, venture capital funds, private credit funds, etc) provide investors with a broad range of superficially appealing but ultimately performance-damaging investment alternatives.”
That book was published 20 years ago. To the point mbouck made just above, there are now many more assets cheaply accessible to the average investor that could be considered.
William Bernstein makes exactly the same point as Swenson in the second edition of The Four Pillars of Investing and that book was published in 2023. He specifically mentions that about the high fees of these alternative investments (compared to index investing), so he is unimpressed by ideas of cheap alternative investments (and he runs a firm that advises individual investors).
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Re: When do alternatives make sense?

Post by MrBobcat »

When you have enough money to go to the top of a windy hill, throw it in the air and not care if it comes back.
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Re: When do alternatives make sense?

Post by rogue_economist »

I'm not sure if you are counting gold as an alternative, but I would say it makes sense starting at a much lower net worth than private debt, private equity, hedge funds and the like.
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Re: When do alternatives make sense?

Post by Kinkelly »

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Re: When do alternatives make sense?

Post by moneyflowin »

ScubaHogg wrote: Wed Oct 30, 2024 8:23 am Personally I look at private equity and private credit as mostly an accounting illusion. I mean, why *should* private equity have higher returns? You are still buying the earnings of a company. The customers purchasing the products don’t know the regulatory structure the equity is offered under? The only good explanation is that there *was* a market inefficiency and those companies were underpriced. But that’s a one time phenomenon that’s probably gone bye bye
Alt investments should have higher returns because of the illiquidity premium. If someone were to invest in (say) a private RE fund with a 10-year lockup period, it better return a lot more than a publicly traded REIT or else who would invest in it? Similarly, PE has very long lockups.

The illiquidity of alt assets reduces demand from investors. Companies seeking capital must pay higher returns to attract the limited pool of investors
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Re: When do alternatives make sense?

Post by Valuethinker »

TomatoTomahto wrote: Wed Oct 30, 2024 5:44 pm There is one alternative investment that I would put a large amount of our assets into, but they don’t want our money. They are doing fine without us.
"The greatest lie is that we have time ..."

Time. That's what you invested. And that's really the most important thing that you can give them - that the budget is absolutely finite on. I shall always be grateful to my parents for that.

I have a friend who has ... not always done well with their life. Complicated story. But one thing that is clear is that their investment banker parents may have provided for them materially - top private schools etc - but starved them of affection. That deficiency has shaped some bad (or maybe just unlucky) life choices and problems in both marriage and career.

OTOH my wealthiest friend from high school - father came from "old money" and was CEO of a major engineering company**. Really quirky and laid back family - in a nice way. Gave him a robustness to carry him through some really tough times - early divorce (just married an inappropriate woman, I think a Russian emigre who was very taken with family status and wealth), failure of business (but the next one succeeded unbelievably well) etc.

** full beaver fur coat, had belonged to his late grandfather, with same initials on the silk lining. You get the picture.
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Re: When do alternatives make sense?

Post by ScubaHogg »

moneyflowin wrote: Fri Nov 01, 2024 5:17 am
Alt investments should have higher returns because of the illiquidity premium. If someone were to invest in (say) a private RE fund with a 10-year lockup period, it better return a lot more than a publicly traded REIT or else who would invest in it? Similarly, PE has very long lockups.

The illiquidity of alt assets reduces demand from investors. Companies seeking capital must pay higher returns to attract the limited pool of investors
Antti Ilmanen has a different take. Namely that endowments, pensions, etc., will actually pay a premium for illiquidity. The lack of daily mark-to-market is extremely valuable to them. So valuable they’ll actually accept lower returns to get it
The 43-year window 1978–2020 is also the longest history we have to estimate the illiquidity premium in private assets – and there is no sign of it. Rather the reverse, as the more liquid REITs trounced the illiquid NCREIF (7% versus 4% compound return over cash).
- investing amid low expected returns
A common investor preference for smooth returns may offset a large part of the fair illiquidity premium that would otherwise be required for locking the money away for a long period (Ilmanen 2020).15 Asness (2019b) even raises the possibility that the sign gets flipped and PE funds may offer an illiquidity discount – that is, lower expected returns than public equity in exchange for their lack of mark-to-market volatility.
- investing amid low expected returns
“You can have a stable principal value or a stable income stream but not both" | - In Pursuit of the Perfect Portfolio
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Re: When do alternatives make sense?

Post by CloseEnough »

mbouck wrote: Thu Oct 31, 2024 4:48 pm
MtnTravel wrote: Wed Oct 30, 2024 6:06 am As the title suggests, when do alternatives make sense in a portfolio? And by alternatives I'm specifically referring to things like private debt, private equity, hedge funds, etc.

I know some UHNW people who work with the big private banks and invest in alternatives. They have had very good returns and feel like this diversifies their portfolio and limits downside risk when the stock market gets hammered.

I know the sentiment on this forum is generally anti-alternative and a lot of people see no reason why anyone would hold anything other than VTI, but there has to be some logical reason that these alternatives exist/people like using them (other than the banks making money)? The people I know are very sophisticated investors, and not the type who are going to blindly follow what some advisor tells them or get sold a product that isn't going to benefit them.

Do these alternatives only make sense when you get the UHNW level? What purpose can they serve in a portfolio?
When do alternatives make sense? When does adding additional uncorrelated risk premia (return streams) make sense? Almost always.

It’s understandable why alternatives can be viewed skeptically. Traditionally, many "alternatives" were private and came with high fees or limited liquidity. However, the newer category of liquid alternatives offers access to uncorrelated risk premia in public, accessible vehicles like ETFs and mutual funds.

The key reason to consider liquid alternatives is their low correlation with traditional stock and bond assets. This can add true diversification benefits to a portfolio—something a traditional international stock fund may not fully achieve since global equities often remain highly correlated with U.S. markets, especially during downturns.

For instance:
  • Managed Futures can thrive in trending markets, including during equity downturns.
  • Market-Neutral and Long-Short Equity strategies seek to generate returns independent of market direction.
  • Global Macro strategies take advantage of macroeconomic trends across asset classes worldwide.
These strategies aim to provide different sources of return that don’t rely on stock or bond performance, enhancing overall portfolio resilience. A few resources that break down the concept and options available are:

How to Use Alternatives in Your Portfolio (Morningstar)
AQR Capital’s "Alternative Thinking" series on alternative risk premia.
Newfound Research’s blog on liquid alternatives and portable beta, which covers various diversification approaches and portfolio construction techniques.

Exploring these strategies doesn’t mean they’re right for everyone, but they offer a modern take on diversification that can strengthen traditional portfolios without relying on private funds or high fees.
I agree with your post, especially the point that the main reason is diversification. One question, since you seem knowledgeable: what is the best way to invest in alternatives? The Morningstar article you linked suggests hedge funds for accredited investors and public alternative funds for those who are not. Many here are accredited, so I am wondering if it is better for those to seek out a hedge fund, or just invest in one of these public ETF alternative investments? And, if a hedge fund, how do you find it, for someone not using an advisor? OK, two questions: how much of a diversified portfolio would you allocate to alternatives: probably depends somewhat on the absolute amounts, but I would guess somewhere in the 15-20% of total invested assets. Oops, question 3: where to hold, in tax deferred or taxable? Thanks.
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Re: When do alternatives make sense?

Post by nisiprius »

ScubaHogg wrote: Fri Nov 01, 2024 6:44 am Antti Ilmanen has a different take. Namely that endowments, pensions, etc., will actually pay a premium for illiquidity. The lack of daily mark-to-market is extremely valuable to them. So valuable they’ll actually accept lower returns to get it
The 43-year window 1978–2020 is also the longest history we have to estimate the illiquidity premium in private assets – and there is no sign of it. Rather the reverse, as the more liquid REITs trounced the illiquid NCREIF (7% versus 4% compound return over cash).
- investing amid low expected returns
A common investor preference for smooth returns may offset a large part of the fair illiquidity premium that would otherwise be required for locking the money away for a long period (Ilmanen 2020).15 Asness (2019b) even raises the possibility that the sign gets flipped and PE funds may offer an illiquidity discount – that is, lower expected returns than public equity in exchange for their lack of mark-to-market volatility.
- investing amid low expected returns
That sounds like a joke. Aren't these "smooth returns" illusory? Or is this saying that money managers will pay for lack of accountability--that nobody overseeing them has a way to get an independent measure of their performance, nobody can prove that they are not getting smooth returns?
Last edited by nisiprius on Fri Nov 01, 2024 6:55 am, edited 1 time in total.
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Re: When do alternatives make sense?

Post by Valuethinker »

ScubaHogg wrote: Thu Oct 31, 2024 6:11 pm
Gecko10x wrote: Thu Oct 31, 2024 5:49 pm That book was published 20 years ago. To the point mbouck made just above, there are now many more assets cheaply accessible to the average investor that could be considered.
See my post above about why that "access" may not be the slam dunk for the actual end investor it might appear to be
William Bernstein makes the point, and it's really an analysis that the political economist Thorsten Veblen made around 1900 (coined the term "conspicuous consumption"). See also Robert Frank "Positional Arms races".

What you have are "status goods" which are (in economic terms) rivalrous in consumption (like having a reserved parking spot at work). I doubt many people know very much about wine - to justify the kind of money that is paid for wine. But if you are a Chinese multi multi millionaire, say - in a culture that doesn't have a history of wine drinking - then you pay someone to tell you what very expensive bottles to buy. Blind taste tests of "experts" in wine show that they don't necessarily predict cheap v expensive wine at anything better than random guessing.**

Investing in hedge funds or private equity or whatever is a status good. You can't stand around at cocktail parties talking about your Vanguard index funds (if you want to get invited again, anyways).

I would put much of Modern Art in the same category. The explosion in prices of modern art was about hedge fund managers, PE managers etc suddenly having lots and lots of money to spend - as markets exploded since 1980, and marginal tax rates were cut. Particularly since 2000.

If you want to be a member of an "exclusive" club, then you'd better be prepared to pay the fee.

And humans are hard-wired to compete on "status anxiety". This seems innate to human social psychology. It certainly is for an troop of Great Apes - the status pecking order. It explains a huge amount about our politics, and what we find important or valuable in life. Whether it is sending our kids to an Ivy League University (the British angst about Oxford and Cambridge is a concentration of that in a very pure, unadulterated form of meritocratic competition), or some other form of social competition ...

** there was a very skilled wind-up merchant here on BH. Who had some great, great, great threads about expensive watches. For sophisticated trolling, they really were pieces of art. The mirror of "the answer is Toyota Corolla" to any car question mentality here is a distaste for conspicuous consumption, generally which can get quite vituperative.
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Re: When do alternatives make sense?

Post by nisiprius »

Important paintings are being bought as investments, and, for tax reasons, being crated and shipped and stored in warehouses in "freeports" where nobody, including their owners ever sees them.
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Re: When do alternatives make sense?

Post by ScubaHogg »

nisiprius wrote: Fri Nov 01, 2024 6:51 am That sounds like a joke. Aren't these "smooth returns" illusory? Or is this saying that money managers will pay for lack of accountability--that nobody overseeing them has a way to get an independent measure of their performance, nobody can prove that they are not getting smooth returns?
I think that is exactly what he is saying. Something like an endowment wants something that doesn’t show huge swings that they then have to justify to various stakeholders
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Re: When do alternatives make sense?

Post by Valuethinker »

nisiprius wrote: Fri Nov 01, 2024 6:51 am
ScubaHogg wrote: Fri Nov 01, 2024 6:44 am Antti Ilmanen has a different take. Namely that endowments, pensions, etc., will actually pay a premium for illiquidity. The lack of daily mark-to-market is extremely valuable to them. So valuable they’ll actually accept lower returns to get it



That sounds like a joke. Aren't these "smooth returns" illusory?
ScubaHogg has nailed it. I was crediting Cliff Asness before Ilmanen, but doesn't the latter work for the former?

So thing is this is another Principal-Agent problem, aka the Economics of Imperfect Information.

(Kenneth Arrow invented the field of Healthcare Economics in a brilliant, non-mathematical, paper, in about 1960, showing the fact that the patient doesn't know the best medical treatments but the practitioners do, and may have perverse incentives to recommend treatments, upends all the conventional assumptions about Supply & Demand etc).

Imperfect information is the driver of just about every "real world" economic phenomenon you can think of. In the case of P-A, it's that I cannot write a complete contract so that you, my Agent, will always behave in my best interests, over your own. It's the centre of Corporate Governance research, for example. Or anything to do with Corporate Finance.

So the thing is:

- if I work as CIO of a university endowment or pension fund, *this is not my money*. It belongs to someone else, represented by appointed representatives or Trustees.

And the *members* don't like to see volatility. Because it causes them to worry about their financial position in retirement/ in the future.

So we engage in mutual kabuki-dance, where my "Alternatives" manager knows that the NAV isn't really smooth - but jumps around just like stocks do, and to a lesser extent bonds. And I know that. And maybe the Trustees know that. But *no one* wants to get flak from plan members, or CFOs, about volatility in values.

As a result of that the apparent correlations also decline. Which makes it even better from the sort of Sharpe/ Sortino Ratios etc that the Consultants spit out to make their recommendations to the client. So the Consultants are in on the bezzle, too.

The really successful people are, like all salespeople, the ones who believe what they are saying to their clients (at least when they say it).

It's a wonderful arrangement. That serves everyone's best interests.

I am reminded of the consumption of alcohol. It turns out alcohol consumption is always bad. There are no significant health benefits. And risk of cancer etc is scaled to dose, there's no apparent threshold effect. But it suits just about all of us (in western society) to ignore that and persuade ourselves that it is otherwise (or at worst that it's not too harmful) - hence the popularity of research which appeared to show consuming a glass of red wine every day reduced your risk of heart disease (spoiler: it doesn't appear that it actually does).

(People who consume moderate amounts of alcohol are generally in better health than people who consume excessively. And even people who do not consume alcohol at all, in western societies, may have other health reasons for not doing so. So there's correlation there, but not causation, between alcohol and reasonable health).
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Re: When do alternatives make sense?

Post by Valuethinker »

ScubaHogg wrote: Fri Nov 01, 2024 7:00 am
nisiprius wrote: Fri Nov 01, 2024 6:51 am That sounds like a joke. Aren't these "smooth returns" illusory? Or is this saying that money managers will pay for lack of accountability--that nobody overseeing them has a way to get an independent measure of their performance, nobody can prove that they are not getting smooth returns?
I think that is exactly what he is saying. Something like an endowment wants something that doesn’t show huge swings that they then have to justify to various stakeholders
Much more succinctly put than I managed!
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Re: When do alternatives make sense?

Post by Gaston »

ScubaHogg wrote: Fri Nov 01, 2024 6:44 am Antti Ilmanen has a different take. Namely that endowments, pensions, etc., will actually pay a premium for illiquidity. The lack of daily mark-to-market is extremely valuable to them. So valuable they’ll actually accept lower returns to get it.
Yes, what used to be a "bug" is now often seen as a "feature". And PE has somehow convinced investors to pay a premium for this feature.

To add a bit more, every academic paper I've read on PE (eg. Kurtović 2023, Gray 2023) arrives as the same conclusion, which tends to be stated something like this: "Listed PE firms grossly underperform [the market], as markets penalize the riskiness and lack of transparency inherent in PE investments. The problems are likely greater in privately held PEs, where performance is self-reported, not audited, and illiquidity periods last up to 10 or 12 years."

Many of the papers go on to say that the allure of PE among retail investors likely stems from FOMO. What these investors fail to realize is that the big money is made by those who sell PE, not by those who buy it.
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Re: When do alternatives make sense?

Post by Jaylat »

The subjective valuations in PE can be quite insidious, especially when the exit is a sale to another PE firm. I went to a talk by a large PE investor who invested in a number of PE funds. He complained about the following scenario, which apparently happens fairly often:

Large PE investor invests in PE Funds A and B;
PE Fund A buys target Company One and charges an origination fee;
PE Fund A subsequently sells Company One to PE Fund B at a higher valuation;
PE Fund A charges their investors 2 and 20 for the increase in value of Company One;
PE Fund B charges their investors an origination fee for the purchase of Company One;
And on and on…

From the PE Investor’s point of view, there is no change in their investment portfolio – they owned Company One all along. But they end up paying fees on both sides of a buy and sell transaction and are left with the same investment, minus the fees.
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Re: When do alternatives make sense?

Post by BrooklynInvest »

Great question. For me there's a bit of a catch 22 embedded.

To invest in alternatives in a way that's even remotely (and not to boglehead standards) cost effective wrt fees it would have to be at a very large scale - $10 million say.

If $10 million bucks was an amount I could afford to make illiquid for a few years with the hope - but definitely no guarantee - of generating a bit more return than I could with public equities I wouldn't bother - who needs that hassle? I'm already rich.... in this hypothetical scenario obviously.
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Re: When do alternatives make sense?

Post by bikechuck »

nedsaid wrote: Wed Oct 30, 2024 6:25 am Wow. You have asked a really great question. This has been debated a lot here at Bogleheads. After having participated in a lot of these discussions, I wish I could give a definitive answer but the best that I can do is say that Alternative investments and the ideas behind them have merit. Each person or family has to decide if these kind of investments make sense in light the bigger picture of their lives and their particular situation. It is sort of a philosophical question, it boils down to whether you believe in these things or not. You can think this through, decide that some of these investments are appropriate, do your due diligence, and even then it is hit and miss.

I worked for a Financial Advisor for a couple years as an assistant, the Advisor believed in many of these types of investments, and most of these seemed to work out for the clients. Would I have purchased some of these myself? I did find myself open minded to them but for various reasons, I didn't consider these for my own purchase. A big issue is that semi-liquid or illiquid investments do tie up your money for a period of time, so these take a commitment.
You are one of the Forum's treasures, I always find your posts to thoughtful and equally important you consistently express yourself in a polite and respectful manner.
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Re: When do alternatives make sense?

Post by Valuethinker »

nisiprius wrote: Fri Nov 01, 2024 6:57 am Important paintings are being bought as investments, and, for tax reasons, being crated and shipped and stored in warehouses in "freeports" where nobody, including their owners ever sees them.
Yes there's a warehouse outside of Zurich that does this.

One of the BBC art programmes was allowed to look at a painting in it.

What's interesting (a BBC series called "Fake or Fortune" in which a gallery owner and a senior BBC news presenter, seek to prove/ disprove the authenticity of lost art treasures - been running for something like 17 years) is how often these great works of art turn out to have - dubious origin stories.

The Holocaust in particular allowed a lot of great art to "disappear" and then be "rediscovered" -- or in other words, forged.

In Karnak (or Luxor), in Egypt, there's a museum of statues found in the last 40 years or so. The old Egypt was dying, and the Roman Empire was going Christian. The Christians were in the business of destroying as much pagan art and sculpture as they could - as being non-Christian. Out with the old religions, in with the new. So the priest must have had all the statues - and there are some gorgeous ones - of the old Gods - gathered up and thrown i a pit. To be discovered 1500 years or so later.

Maybe that's what will happen. A Canticle for St Leibowitz style. In 2000 years some archaeologist will discover one of these repositories of lost art.

Channeling that - I hope some future archaeologist is well mystified by my grocery shopping list!
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