MARK RIEPE: I'm Mark Riepe. I head up the Schwab Center for Financial Research, and this is Financial Decoder, an original podcast from Charles Schwab. It's a show about financial decision-making and the cognitive and emotional biases that can cloud our judgment.
We're going to talk about alternative investments today. And we get this question all the time: How much should I invest in alternatives? It's a deceptively complicated question. The reason it's complicated is that, as humans, we have a tendency to grab on to the simplest explanation when trying to get an answer to a problem or explain a phenomenon. Sometimes that works. Sometimes the simplest explanation is in fact the right one. But it can go awry when it comes to investing, and we lump a bunch of things into a category, stick a label on it, and say you need X percent of that thing without asking ourselves how similar all those things in the category are. Let me give you an example from biology because biologists like to classify life forms. At the top level are kingdoms, and one of those kingdoms is the animal kingdom. The next grouping is called the phylum, and vertebrates is an example of that. The next level down is the class, and mammals are an example of one of those.
Next up are the orders, and carnivores are one of those. Then we get down to the suborder, and cat-like is an example of a suborder. Then we get to the family, and one of those is Felidae, or cats. This contains everything from lions, tigers, and leopards to domestic cats. The system keeps going, but I think you get the idea. The point I want to make is at the family level, a 500-pound lion prowling the savanna and a 10-pound orange tabby walking across your keyboard are, in fact, in the same bucket of felines. But there are lot of differences, obviously.
Alternatives, in particular, are a lot like the cat family. Alternatives have some characteristics in common with each other, but they are not the same. There's still a lot of differences among them. You have to dig deeper to understand what you're investing in. Our tendency is to too often treat things as identical, which is often not the case. And my guest today can shed some light on those differences.
Ken Pennington is our director of alternative investments and manager research here at the Schwab Center for Financial Research. His career in alternative investments spans more than 20 years. He and his team look into private equity funds, private credit funds, real estate funds, hedge funds, and exchange funds. His team also evaluates alternative investment managers, and he's a Chartered Financial Analyst® with an MBA in finance.
Ken Pennington, welcome to Financial Decoder. Let's start with the basics. When someone says alternative investments, what does that actually mean in plain terms?
KEN PENNINGTON: I would say the classic definition of alternative investments, and to be clear, there are a lot of definitions of alternative investments, but I would say the classic definition is really anything that falls outside the realm of traditional investments like stocks, bonds, and cash. I will say that I think the definition of alternative investments varies over time, and I would say it's typically used for investments that are new and appear to be complex and potentially hard to understand.
As an example, once upon a time, derivatives such as equity futures and equity options were considered alternative investments because they were new, they were complex, and they were hard to understand. But I don't think that futures and options would be considered to be alternative investments today. Today, I think the definition would include private equity, private credit in all of its flavors, real assets such as real estate, infrastructure, hedge funds, digital assets, natural resources, and probably collectibles. I doubt I captured all of it, but that's probably the bulk of what I would consider to be alternative investments.
MARK: In the opening, I mentioned that the risk of broad categories is that investors think everything in the category is the same. And as you mentioned, this is in fact a broad category with hedge funds, private equity, credit, real estate, among others. Is there a good way to think about the alternative universe as a whole, or is it more useful to look at each piece on its own?
KEN: I think you definitely have to do both. Having an understanding of each asset class, meaning private equity, private credit, real estate, the various attributes of all the strategies within an asset class. So, private credit, for example, has myriad different strategies which fall under that umbrella and where each of the strategies lands on the risk-return spectrum, I think, is crucial to understand.
In private credit, for example, you have strategies that range from income-producing strategies with risk-return characteristics that are comparable to, but yet higher than, high-yield fixed income to strategies that produce equity-like returns with equity-like risk. So really kind of the full gamut of potential outcomes along the risk-return spectrum. However, I think it's also critical to understand how the asset classes, and the strategies within those classes, how they interact with each other, i.e., what their correlations are. Do they move together? Do they not move together? Do they diversify each other? I think those are also crucial elements to understand when you're trying to incorporate alternative investments into some type of portfolio.
MARK: Let's start with hedge funds. They have this mystique around them. Can you walk us through how they operate and what kinds of strategies they actually use in practice?
KEN: I think the irony is hedge funds are not really an asset class. They're considered an asset class, but they're actually a structure. Generalizing is dangerous because there are always exceptions to the rule, and hedge funds do have free rein to invest in pretty much anything. But speaking generally, hedge funds tend to invest, I would say, predominantly in publicly traded securities and their associated derivatives.
MARK: Two-part question for you, Ken. First part, ETFs are a structure, and so are mutual funds. How do you differentiate them from hedge funds? And the second part of my question, what kinds of strategies do hedge funds follow?
KEN: I will say that there are three things that make hedge funds different from more traditional investment vehicles that also house publicly traded assets like mutual funds and ETFs. And those three things are the fact that, A, hedge funds tend to make extensive use of derivatives. B, hedge funds can sell securities short. And C, the fact that hedge funds tend to use leverage to help create their returns.
There are myriad different hedge fund strategies, but they tend to get bucketed into four what I'll call strategy groups, equity long/short, event driven, relative value, and macro.
MARK: OK, let's go through each one of those, starting with equity long/short.
KEN: Equity long/short has also, as do all of these strategy groupings, they all have numerous sub-strategies, but each equity long/short sub-strategy tends to be characterized by being both long and short stocks and their associated derivatives. Derivatives meaning futures and options, primarily options I would say, and potentially equity swaps.
Some of these sub-strategies have more beta. Some have less beta. Some try to have no beta. These are called equity market neutral. And then there are still other strategies which actually try to be net short beta, meaning they're actually somewhat short the market.
MARK: Ken, let me chime in there with a jargon alert. Beta is a way of measuring how an investment's change in performance is influenced by the broader market. So let's just keep going with event-driven strategies.
KEN: Event-driven strategies, they tend to be categorized by returns that are generated by some type of catalyst or some type of event that creates value. I think examples are something like a merger or an acquisition of a company. That sub-strategy would be called merger arbitrage. Or something like financial distress or bankruptcy—it's called distressed is the sub-strategy.
Relative value strategies, they actually seek to create their returns from the differences in the pricing of securities that in some fashion are typically related to each other. They could be related companies, such as, say, Ford and GM. They could even be securities within the same company, different parts of the capital structure, say, equity versus something like fixed income.
An example of a relative value strategy is convertible arbitrage, where the typical trade is that you buy the convertible bond. And then what you do is you sell short the underlying common stock of the same company. And then finally, we have macro strategies. Macro strategies are, I would say, different from the other three. The other three strategies are very much individual company or individual security focused.
Macro strategies, on the other hand, they tend to focus on profiting from macroeconomic analysis and geopolitical trends and events. Rather than trading individual company stocks and bonds, they tend to trade broad asset classes to express their views. So they trade things such as equity indices, fixed income sovereign bonds, currencies, commodities.
There are, really, there are two broad flavors of macro strategies. There's discretionary macro, where funds typically use fundamental top-down research to help determine which investments they want to make. And then there are systematic global macro funds that utilize computer models to generate buy and sell signals rather than utilizing fundamental research.
MARK: Private equity and private credit get talked about a lot these days, especially with more access for wealthy individuals. What's the appeal of these private capital strategies, and what makes them fundamentally different from public investing?
KEN: So I'll start with the appeal. Private equity, for example, has historically provided higher returns than public equities, and private credit has historically provided higher returns than even the highest-yielding public market fixed income asset classes, such as high-yield bonds or emerging-market debt.
So that's the appeal of private equity and private credit. It's that you invest in these what I'll call less liquid or illiquid asset classes. And because you are investing in illiquid assets, they have what's called an illiquidity premium. And it's that illiquidity premium that really creates the outperformance relative to public market asset classes.
Having said that, so that's the appeal part, but private investing is very, very different from investing in public markets, such as common stocks, or public fixed income, such as Treasuries or corporate bonds. In the public market, buying or selling an individual stock, an individual bond, an ETF, or a mutual fund is very straightforward. Pricing is transparent, and transacting is very easy. Private markets are very, very different. Prices are negotiated between parties. They're not available to the general public. And in fact, there may be little or no information at all available to prospective investors.
And in addition to that, private investments are frequently limited to individuals who meet certain financial criteria and are not available to everybody the way stocks, bonds, ETFs, and mutual funds are.
MARK: Ken, there are no free lunches. What kinds of trade-offs are people making when they get into alternatives between, let's say, liquidity, transparency, fees, etc.? What should investors really be prepared for?
KEN: Yeah, so this is crucial. If you decide to take the plunge and invest in alternative investments, there are a number of trade-offs that investors need to be prepared for. First and foremost is liquidity. Investors really need to understand that alternative investments, especially private market investments like private equity, private credit, real estate, and infrastructure are designed to be long-term holdings. Even funds that do provide periodic liquidity that invest in these asset classes should not be construed as short-term investments. Because even if you put private investments in a more liquid structure, it does not change the characteristics of the underlying investments. The underlying investments are still highly illiquid.
The second trade-off is transparency. Unlike with mutual funds or ETFs or managed accounts, there may be little to no information available for the positions in an alternative investment fund.
The third trade-off is fees. As a rule, fees tend to be much higher for alternative investment funds than for traditional investments such as mutual funds or ETFs. And there can also be many more types of fees than you find in traditional investment funds.
And the fourth trade-off is valuation. Unlike publicly traded securities, like stocks and bonds, where there's constant price transparency in terms of what you'll pay to buy or sell something, private investments do not trade on an exchange, and their valuations are typically estimated. And in fact, those estimates may actually understate or even overstate the true value of an asset when you actually go to sell.
MARK: Let's talk about liquidity in particular. Why are so many alternative investments so illiquid?
KEN: So alternative investments, especially private investments, are not bought and sold on exchanges like public securities are. And so it can be very time consuming to buy and sell them. If you think about private equity, private credit, real estate, you cannot sell a building, you cannot sell a private loan, or you cannot sell a private company at a moment's notice.
MARK: Do you get the sense that illiquidity is important to investors, and is it a feature, or is it a bug?
KEN: In investor surveys, illiquidity has frequently been mentioned as the number one reason why individual investors do not invest in alternative investments. And to be honest, it's not entirely clear to me why they do have such an aversion to illiquidity. I mean, even if 10% of your portfolio is in illiquid assets, that still means that 90% of your portfolio is liquid and should, if necessary, be able to be converted to cash in a relatively short period of time.
So since there is a return premium to be gained from this illiquidity, but there are also, you know, obviously substantial risks associated with it, I think what is most important is that potential investors be thoroughly educated on both the potential benefits as well as the possible risks so that each investor can really make the best decision for his or her circumstances.
MARK: Then for the fee conversation, alts tend to be expensive and complicated. What should investors be watching for when it comes to how they're charged, especially with things like performance fees, carried interest, or fund layers?
KEN: Yeah I mean, look, there is no question that alternative investments have more types of fees and that their fees tend to be much higher than the fees that you find on traditional investments such as mutual funds and ETFs. And it's obviously crucially important that investors understand all the various fees that they are being charged and the expected impact on the gross returns of any portfolio they're invested in.
At the end of the day, however, investor portfolios receive net returns. So in my mind, that is what truly matters. However, and I'll use multi-strategy hedge fund returns as an example here, risk-adjusted returns for multi-strategy hedge funds can actually be quite attractive, even though fees may end up consuming more than 50% of gross returns.
And so the question that each investor really would have to ask themselves is, "Do I want to focus on the net return? And is that attractive? And does that suffice? Or do I feel that even though the net return is attractive, the fact that fees are eating up over half of my gross return is just something that is unacceptable to me?" And I can see looking at it both ways. And there are investors out there that do look at it both ways.
For some, the net returns will be acceptable despite the fact that the fees are eating so much of the gross returns. And for other investors, it'll simply be unacceptable to say, look, anything, any investment where 50% of my gross return goes to fees is just unacceptable. I really don't care at the end of the day what the net return is.
MARK: Evaluating alts can be tricky since they don't always track the S&P 500® or other familiar benchmarks. How do investors actually measure performance in this space, and what makes those metrics useful?
KEN: Right. So if you look at traditional fund structures that have been used by institutional investors for investing in private markets, they do use different performance metrics than the metric that is used in traditional investments such as mutual funds and ETFs. And that metric is called the time-weighted return.
In private markets, the two primary metrics that are used are … one is the internal rate of return, or IRR, and the other is called multiple on investment capital, M-O-I-C, or MOIC. There's also another metric which is used, which is called a public market equivalent, or PME, that is used to compare the performance of private investments to public markets.
MARK: Are these performance measures, or should I say the method by which the performance is measured, directly comparable to what people would see when they invest in a public market vehicle like, let's say, a mutual fund?
KEN: They are not directly comparable to public market performance metrics. And it can, as a result, it can actually be difficult to discern, you know, what is good performance versus what isn't. And in addition, it makes it difficult to impossible to incorporate private market funds into a portfolio that also contain public market investments to get kind of a total portfolio performance picture because the metrics are different.
With the introduction of evergreen funds that do house private equity, private credit, and private real estate, and that do cater more to retail investors, these types of funds actually do use the same traditional performance metric, this time-weighted rate of return, which I talked about earlier, which is used in the public markets. And so therefore, that makes it much easier to compare performance to traditional assets and to also then include them in portfolio total return calculations.
MARK: What kind of investor goals are alts typically trying to help with? Is it about just return potential? Is it downside protection, income generation, or something else entirely?
KEN: We've talked about the fact that different alternative investment asset classes do different things for investors. Private equity can provide higher returns. Real estate and hedge funds can provide diversification. Real estate can provide inflation protection. But I think what's most important is really for the individual to understand what his or her investment objectives are and then understand whether investing in an alternative investment may help to meet those objectives, given all the risks and the drawbacks that we've touched on earlier in the conversation.
MARK: Some people hear about alts and think, "Well, I can't access that unless I'm worth, say $5 million dollars." Are there still ways to get, let's say, similar exposure or outcomes without going fully into the private market?
KEN: The $5 million, or what is called qualified purchaser, that requirement is not a requirement for all funds that invest in alternative investments. There are funds that are available for investors who are called accredited investors, which means they have a million dollars of net worth and an expectation to earn at least $200,000 in the next year, which I realize is, you know, those are still pretty lofty financial levels. But then there are also funds that are available to what are called mass affluent, so individuals with a net worth of $250,000 or net income of $70,000 and net worth of $70,000. And then there are even funds that are available with no financial requirements, meaning they can be bought by anybody.
So there are funds that are available kind of across the entire wealth spectrum, all the way from the highest level, which is qualified purchaser, all the way down to what are called non-accredited or just regular retail investors.
MARK: Ken, I've got a couple of more questions for you. First off, if someone's curious about dipping a toe into alternatives, where do they actually start, and what questions should they be asking their advisor or themselves before doing anything?
KEN: So look, I mean, there's a lot of research that individuals can do on their own, but in my opinion, the first conversation should always be with an advisor. The initial conversation should really focus on the client, the investor. What are the client's investment objectives? What is their risk tolerance? What are some of the constraints they're facing? What are their liquidity needs? What is their tolerance for liquidity risk? And then, how might investing in alternative investments help them to achieve their investment objectives without taking on too much risk, taking on too much illiquidity risk? I think that would be the initial conversation.
And then if the decision is made that yes, alternative investments might be suitable for this client, then the conversation should really switch over to asset allocation. I think, what alternative investment asset classes should the client invest in and why? What purpose in the portfolio will that allocation serve? Is it designed to produce higher returns? Is it designed to produce higher yields, higher income? Is it designed to provide diversification? And then of course, how much of a client's portfolio should be allocated to each of those asset classes to help achieve those objectives?
MARK: Ken Pennington is a director here at the Schwab Center for Financial Research, and he heads up our alternative investment research team. Thanks for being here, Ken, and I've got one last question for you. Where do you see the space going? Are we heading toward broader access and innovation, or will alternatives always be somewhat exclusive by design?
KEN: So it's really asset management industry that is driving innovation and broader access to alternative investments. Asset management firms really view alternative investments for retail as the next frontier.
Institutions, which have historically provided the overwhelming majority of capital for alternative investments, estimates are that 86% of the capital invested in alternative investments has been invested by institutions. In a lot of cases, they're maxed out on their allocations. They're not really planning on investing more. They're already investing 20%, 25%, 30%, even up to 50% in alternative investments. Meanwhile, the asset management industry sees retail investors as being very under-allocated to alternative investments, especially compared to institutions, and their goal is really to have retail investors increase their portfolio allocations to alternatives.
In addition, I think the return gap between good and bad funds in alternative investments is much, much wider than it is in public markets, and if you choose the wrong fund, you can actually end up with returns that lag the public markets, possibly by a really wide margin, rather than exceeding them. So therefore, I think a client really needs to completely understand both the benefits and the risks and the drawbacks of any potential investment before taking that plunge.
MARK: We started off this episode talking about how we like to classify things into categories and look for easy answers. Alternative investments are a good case study. It makes sense to put them into their own category. But, as Ken described, there are many, many different types of investments that fall into that same overarching category. Just like the family of cats from the animal kingdom is incredibly broad, the same applies to alternatives, what with things like hedge funds, private equity, and real estate all thrown into the same bucket.
Just like any investment, make sure you understand the investment, and make sure you understand what role the investment is playing in your portfolio. We have great resources at schwab.com/alternative-investments to help you get started, and we'll link to that webpage in the show notes.
I'll be back in a couple of weeks. If you'd like to hear more from me, you can follow me on my LinkedIn page or at X @MarkRiepe. That's M-A-R-K-R-I-E-P-E. And if you like the show, please consider leaving us a rating or review on Apple Podcasts or comment on the show if you listen to it on Spotify. We always like new listeners, so if you know someone who might like the show, please tell them about it and how they can follow us for free in their favorite podcasting app. Thanks for listening, and see you next time.
For important disclosures, see the show notes and schwab.com/FinancialDecoder.
