Alts and the Complexity Trap

We, the financial planners and wealth managers of the world, are told with some great regularity that investors are demanding “alts.” Now the word “alts” probably doesn’t mean much to you, in fact, it probably looks like a typo, or if it’s a word, it’s barely a word. Yet, “alt” is a term that encompasses a large variety of investment assets. Everything from private equity or venture capital to privately syndicated real estate investments that are too small to be in real estate investment trusts (“REITs”) or simply have an “unconventional” business structure; anything that could be considered an “alternative investment” to more commonplace securities and assets.

Alts are fundamentally targeted at “accredited investors,” those people who have passed the somewhat arbitrary hurdles set by Federal Regulations back in 1933 and last updated in 2020 to include professionals with a certain level of expertise (e.g., professional investment managers and financial planners), and last updated for income and liquid net worth requirements in 2011. Today, to be an accredited investor requires that you have a liquid net worth of $1 million, or that your income exceeds $200,000 if Single or $300,000 if married for the past two years. For reference, that equates to about 12% of the population when analyzed by the assorted measurements.

Whether you’re an accredited investor or not, you might wonder why such investments are so aggressively marketed to wealth managers if the market for them is so small relative to the total population. It’s a fair question, and one even I, as a financial planner, have to ask. So today, we’re talking about alts, what they are, why they’re being marketed, and what risks exist for those interested in “alternative assets.”

The Temptation of Shiny Objects

There’s an old maxim in investing: “A good investment should be as exciting as watching the grass grow.” While you might fixate on the metaphor, the point it’s trying to drive home is that slow, steady, and reliable are apt to win the race; whereas investments in high-risk or speculative assets might be far more entertaining, but ultimately substantially less productive from a financial standpoint. If such wisdom is so commonly held, then why is there a marketplace for alts in the first place?

Well, simply put, human beings are good at moving the goal post. In fact, research on the subject of happiness has led to the observation of the “hedonic treadmill,” the phenomenon by which we observe that people generally live as an “average” of long term happiness, from which all positive or negative deviations eventually lapse back to the average (e.g., you do not become permanently happy or unhappy based on current events.) Thus, while we might start our lives thinking it would be incredible to be a millionaire, by the time we’re a 7-figure millionaire, it’s not so uncommon to start eyeing the 8-figure millionaire status and wondering what it would take to get there.

All of that put as simply as possible? We get bored. Human beings want things to be more interesting and exciting, and even though the grass-growing approach to finance is generally considered the most reliable for the accomplishment of long-term outcomes, we often find ourselves wishing it could just be a bit more interesting. Never mind that our social media and relationships are saturated with imagery of other people living their best lives, tempting us into believing that if we’re not constantly on a beach somewhere or driving a new luxury car, we must still need to work harder to catch up.

Enter the temptation of alts.

Unlike a “boring” portfolio of the 500 largest US companies as measured by their value (the S&P 500), or a generously diverse portfolio of every publicly traded company in the world (total stock market indexes, whether domestic or international), alts present a tangible and flashy form of wealth pursuit. You’re not buying an investment product that represents a diverse basket of well-capitalized companies; You’re developing condos in an up-and-coming part of Austin! You’re not waiting on coupon interest payments from some municipal bonds; you’re financing the next wave of cancer treatments! You’re not collecting dividends from local power utilities; you’re funding exploration of new energy sources in an exotic locale!

What’s More, It’s Un-American!

Buying alts is un-American? No! Far from it! In fact, a growing number of influencers and congressmen seem very interested in getting more of the public into alternative investments, and their arguments aren’t completely laughable. “These are the type of investments the ultra-wealthy have access to, and they’re gatekeeping it from you so they can make the big money and leave you out of it.” Or so goes the argument, and never mind the big sponsorships to those influencers and donations to those congressmen’s campaigns!

To some extent, they’re not wrong. Accredited investor rules do create a world of the affluent and non-affluent, giving access to some investments to some and not to others. Yet, the basis for these rules wasn’t to give the wealthy an opportunity to get further ahead. Rather, it was to protect everyday people from the very real risks presented by alternative and private investments. You see, while it’s not impossible, it’s considered reasonably improbable that the 500 largest companies in the United States are going to go belly-up. And while it’s a possibility that AAA-credit-rated corporate bonds could be issued by companies that go bankrupt before the bonds mature, it’s fairly unlikely. That degree of “you could lose money, but probably not all your money” is the presumptive guardrail dividing up investments that require accredited investor status and normal publicly traded stocks, bonds, and the commonplace investment products that hold them.

But investments in alternatives are far riskier by nature, and consequently, regulations have existed for a long time to protect the average Joe. Investments in the public arena are required to make regular and ample disclosures of their financial status and performance, and to report that data in uniform and consistent ways to the public. Alternatives and private investments, on the other hand, open the door to more lax rules around how performance is calculated and reported and what information is or isn’t shared with accredited investors. Why?

On the optimistic side, it’s the idea that more affluent investors have access to professional help that can help evaluate the quality of these high-risk-high-reward offerings, and thus help them make educated investments; or, that the investors themselves are the professionals who know what they’re doing. On the pessimistic side? Well, it’s rather simple: If you have a million dollars in liquid net worth or are earning a couple hundred thousand dollars a year, the assumption is that you can afford to take a total loss on an investment here or there. Not necessarily a “no harm, no foul” approach, but more of a “you’ll live” type of approach.

But Really, What Could Go Wrong?

In a succinct sense, the basic answer is: “You lose 100% of what you invested.” While many of us often find ourselves thinking about our investments or the money we save as somewhat esoteric or abstract, we are still aware at a foundational level that we are deferring present goods and services in service of the idea that we will need goods and services later, and that by saving and investing we can afford those things. But most of us invest with a baseline level of faith that if we save and invest, we’re going to end up better for it. That belief is foundational to the very process of saving and investing!

So what’s an example of what can go wrong? Well, let me share not one, but two examples from a very sophisticated client (shared with their permission). This client has decades of experience in finance, including being in leadership in some large and very well-known financial institutions. Consequently, this client has both the personal knowledge and experience to evaluate investments as a professional accredited investor, but also the financial means to afford the losses an accredited investment can generate. This individual over the past several years has invested in a wide variety of assets, including conventional stocks, bonds, and funds, but also a handful of private equity offerings and real estate deals. We’ll focus on two of the real estate deals for this example.

Without getting too far into the details, private real estate investing often happens in three major phases: Raise capital to build out or renovate a property, get a high level of tenancy in the property generating a profitable level of cash flow, and then sell the property at an enhanced value over what you paid for it. This is typically done with a mixture of investment money and borrowed money, since banks will happily lend money for commercial real estate development or tangible improvements that can be collateralized against the money borrowed. But, often these loans are short-term, only a few years, after which the balance becomes due or, as is common practice, the investors refinance the loans. So, with that context in mind, what went wrong for this sophisticated investor and these sophisticated investments?

Well, simply put: interest rates rose more than the investors had anticipated. The result? Two of the real estate investments made a capital call, aka, “asked for more money” from the investors. What would happen if they didn’t chip in an extra 20%-30% in each case? In one instance, their shares of ownership would be diluted down so that their return would be much smaller or secondary to those who paid into the capital call, such that they’d receive a smaller payout or possibly not receive one, depending on the final exit from the investments. In the second instance, the outlook was far more dire: You can pay in and you might get 2/3rds of your money back, or you can not pay in and you’re probably getting nothing back. A risk of a total 100% loss of capital. Despite the accredited investor status of the participants in each of the real estate deals and the professional expertise of those managing the investment projects themselves, both investments are likely to turn a loss simply because of interest rate risk.

Risk is Risk, So What?

Well, the other issue that arises in alts is that they are much less standardized in their structure and regulation. While a product like an exchange traded fund (“ETF”) must follow strict regulatory guidelines in how it markets itself, what fees it charges, and how it reports performance, alts are… well, much more “caveat emptor” about this sort of thing. For example, an article in the Wall Street Journal last week by Jason Zweig reported on a particular fund’s recent change of its fee structure.

The alt fund’s structure originally charged both a normal management fee and a performance fee for returns exceeding certain thresholds. Previously, the fund could only charge performance fees on completed deals. In other words, the fund could only collect a bonus if it genuinely delivered an outsized return on an asset that it had invested in. But, the fund asked its investors to change the definition of performance, permitting it to charge the fee on assets or deals still held by the fund or in progress. This permitted the fund’s management to start receiving bonuses for performance almost instantly at the start of a project, because nothing in the fund’s structure or rules prohibited it from buying something for X, then immediately marking its value up by 10% or 20%, thus “immediately” creating “returns” that qualified it for the performance-based fees, even though it had literally just purchased the asset for X and done nothing to create the 10% or 20% increases in value it was suddenly claiming on the assets.

And even in cases where the assets aren’t being shiftily repriced overnight or performance fees aren’t being charged, alts present an unconventional asset and consequently can command unconventional fees. While it would be commonplace for many portfolio managers to raise an eyebrow at an investment product that cost more than a quarter of a percent a year these days (e.g., anything more than 0.25% annually), alt funds regularly charge north of 1% and even 2% before accounting for commissions, revenue sharing, or performance fees. Simply put, the margins are enormous, and thus, Wall Street is interested in selling the products to willing buyers.

So, to Alt or not to Alt?

I can’t, in the strictest sense, say that there is no reason to invest in alts or that no one should ever invest in alts. Someone, somewhere, is investing in a “high-risk opportunity” right now that will end up turning into the next Google, Facebook, or Nvidia. The odds that you’ll pick that tiny private business out of obscurity and ride it from angel round to IPO are pretty small, but they’re not zero. So, should you take the risk?

Let me answer the question for you the way I would for any client about any investment they want to make, even when it’s a perfectly conventional S&P 500 index fund or treasury bond: “Is the investment you want to make able to produce a rate of return adequate to fund your objectives in life without taking on any more risk than is necessary?”

If the answer is yes? Then it’s worth looking at.

If the answer is no? Whether it’s because it’s too risky, it can’t produce the return you need, or it’s simply too complicated to answer the question easily? You’re probably better off skipping this particular opportunity.