We have previously written about the supposed demise of the classic 60/40 portfolio, a moderately balanced allocation of stocks and bonds. Here we will take a closer look at the solution usually proposed, the replacement of a portion of the conventional allocation with some mix of alternative asset classes or strategies. Some major endowments, such as Yale University’s, have used alternative investments with great success.
Is this an approach that ordinary investors, by which we mean middle wealth investors as opposed to ultra-high net worth investors, should emulate? The answer is, probably not or, at least not unless you possess the same advantages that have allowed Yale to succeed.
First, let’s recall what we mean by alternative investments. Traditional investments include stocks, bonds, and cash or cash equivalents like money market funds. Alternative investments are everything else. Alternatives include derivatives contracts, futures contracts, structured products, hedge funds, private equity, real estate and REITS, commodities, precious metals and other tangible assets, and cryptocurrencies.
In the past, most alternative investments could only be acquired with great difficulty because they are illiquid and do not trade on an exchange. Increasingly, however, alternative investments have been repackaged into mutual funds and exchange-traded funds such that many of these strategies now are readily accessible to individual investors.
Laurence Siegel, the director of research at the CFA Institute recently addressed this question in an essay called, “Alternatives for the Masses?” Mr. Siegel has been a major proponent of the endowment model of investing which has wholeheartedly adopted the use of alternative investments. He suggests, however, that the hurdle for individual investors thinking of using alternative investments is quite high.
According to Mr. Siegel, an investor needs at least five things before jumping into alternative investments:
- Lots of time
- High risk tolerance
- Money in reserve, and
- A very large portfolio.
Know-how. Let’s assume that our readers all come from the fictitious town of Lake Wobegon, where all children and presumably all adults, are above average. Yes, you may be smart, but that’s not enough. In addition to raw intelligence, you need expertise – the right sort of knowledge and a broad set of skills. For endowments, that usually means a large staff with specialized expertise in various niches who can delve into valuations, risk, and complex agreements. If you only have yourself, and no staff, alternative investments probably are a no-go.
Lots of time. Endowments are institutional and, in theory, have a perpetual time horizon. Individual investors, even high net worth investors, are mortal. For the typical individual investor, three years is a long time. It’s a bit like baseball: after one year of poor investment performance (strike 1), you’ll wait for the next pitch; a second year of poor performance (strike 2), you tighten your grip and sharpen your focus and again wait for the next pitch; but after a third year of poor performance (strike 3) most investors are ready to move on. Individual investors, especially retirees who need to fund retirement spending, tend to live in the present when it comes to investment losses.
High risk tolerance. Here we don’t mean the usual measure of risk, the volatility that comes with market ups and downs. We mean the risk of permanent loss of capital. Can you take the risk that the part of your portfolio invested in alternatives goes to zero in value?
Money in reserve. Even if you have the temperament to take on extra risk, you need to be able to weather the impact of substantial or permanent losses. An investor who relies on portfolio distributions to cover retirement spending has two basic options when investments dramatically underperform. The investor can reduce spending, or the investor can bring new money to the table. If your spending is largely fixed, there may not be enough slack in your budget to tighten your belt. And if you are retired and no longer earning an income, or if you are not fortunate enough to have other funds to bring into the portfolio, you may not be able to rebuild a portfolio that has experienced substantial or permanent losses.
A very large portfolio. Finally, Mr. Siegel advocates that only investors with very large portfolios can build a truly diversified portfolio that includes alternative investments. Yale’s endowment exceeds $40 billion. With rare exceptions, though, he does not believe that alternative investments belong in retirement-focused portfolios of less than $10 million.
The factors suggested above are significant hurdles for individual investors to overcome should they wish to add alternative investments to their portfolio. Add to that the higher fees and less transparency associated with alternative investments. And, finally, there is the matter of performance. Over the past dozen years, most alternative investments available in a mutual fund or ETF have significantly underperformed conventional stocks and bonds and would have been a drag on portfolio performance. Sure, past is not prologue, and a cycle of outperformance could be on the horizon for alternatives, but that is a long time for an individual investor to wait for a payoff.
Even among endowments and other institutional investors, Yale’s success has been an anomaly. Few other institutional investors have come close to Yale’s success with this approach.
Mr. Siegel points out that alternative investments offer “psychic benefits” for investors by making them feel “sophisticated and special.” Their psychic payoff might be better, however, if those investors cultivated a bit more humility about their capabilities. As an investor, complexity and cost are rarely your friends.
David Peartree JD, CFP® is an investment advisor with Brighton Securities Capital Management. This column is a collaborative work by David Peartree and Patricia Foster, Esq. Patricia Foster is a securities attorney focusing on the financial services industry. The information in this article is provided for educational purposes and does not constitute legal or investment advice.