Summary of "Alternative Investing: Promise and Performance!"

Summary of Finance-Specific Content from Alternative Investing: Promise and Performance!

Key Themes

Definition and scope of alternative investments
Traditional portfolio construction vs. alternative investing
Theoretical benefits of alternatives: diversification (low correlation) and alpha generation
Real-world performance and challenges of alternative investments
Practical recommendations and cautions for investors

Alternative Investments Overview

Traditional investing primarily focuses on publicly traded stocks (e.g., S&P 500) and bonds, with cash serving as a liquidity buffer.

Alternative investing includes assets and strategies outside traditional public stocks and bonds, such as:

Long-short strategies: Hedge funds using short selling to alter return distributions
Public vs. private divide:
- Private equity (PE)
- Venture capital (VC)
- Private credit
Non-traded asset classes:
- Real estate (mostly private, some REITs)
- Collectibles (art, gold)
- Cryptocurrencies (Bitcoin, NFTs)

Historically, alternatives were limited to wealthy and institutional investors but are now increasingly accessible to individuals.

Portfolio Construction & Methodology

Traditional portfolio allocation mixes stocks, bonds, and cash based on risk tolerance and market views.

Adding alternatives aims to improve portfolio risk-return tradeoffs by:

Diversification: Incorporating assets with low correlation to stocks and bonds
Alpha: Exploiting market inefficiencies in less transparent, illiquid markets

Key dimensions to consider in alternatives include:

Long-only vs. long-short (hedge funds)
Public vs. private markets
Traded vs. non-traded assets

Correlation & Performance Metrics

Correlation matrices show many alternative assets have correlations well below 1 with stocks, implying diversification benefits.
Adding alternatives to a traditional portfolio can:
- Increase expected returns
- Improve Sharpe ratios (return per unit risk)
Example: Early-stage venture capital median returns are approximately 13%, compared to about 10% for the S&P 500 over a similar period.
However, there is large dispersion in returns within alternative asset classes, especially VC and PE.
Unlike public markets, top-performing alternative managers tend to sustain performance over time.

Institutional Adoption & Trends

Pension funds’ allocation to alternatives grew from less than 10% in 2001 to about 30% by 2022.
Foundations and family offices have even higher allocations, around 52%.
The Yale Endowment, led by David Swensen, is a notable early adopter that benefited significantly from alternatives.
Data from Cambridge Associates shows endowments with more than 20–30% alternatives have historically achieved better Sharpe ratios.

Challenges & Criticisms

A 2022 CFA Magazine paper and other studies highlight that adding hedge funds to traditional portfolios often does not improve Sharpe ratios or reduce maximum drawdowns in practice, despite low correlations.

Reasons for underperformance or lack of expected benefits include:

Misleading correlations:
- Private assets are appraised, not marked to market daily, causing lagged and understated correlations.
- During crises, correlations spike close to 1, reducing diversification benefits.
Illiquidity and opacity:
- Alternatives are less liquid and less transparent.
- This can hurt returns during market stress due to forced selling and higher transaction costs.
Alpha erosion:
- The alternative investment industry has grown massively, diluting skill and returns.
- Increased competition, better data, and passive ETFs copying hedge fund strategies have flattened alpha opportunities.
- Hedge fund alpha has declined since 2007; the recent decade’s hedge fund returns often underperform passive benchmarks.
- Private equity outperformance over public equity has also diminished post-2007.
High fees:
- The classic “2 and 20” fee structure (2% management + 20% performance fee) remains expensive despite some fee compression (now approximately 1.37% and 16.4%).
- High fees consume much of the alpha.

Explicit Recommendations & Cautions

Be selective with alternatives:
- Prioritize low-correlation assets over chasing alpha.
- Private equity and venture capital increasingly behave like public markets and are less attractive for diversification.
- Hedge funds with genuine long-short strategies that hedge public equity risk may add value.
- Gold, collectibles, and possibly Bitcoin (if it decouples from risky stocks) can offer diversification.
Avoid high-cost vehicles:
- Fees like 2 and 20 are difficult to justify; institutional investors paying these fees should reconsider.
Be realistic about liquidity and time horizon:
- Liquidity needs often increase during crises, despite claims of long-term horizons.
- Illiquidity and opacity risks become critical during market stress.
Be cautious relying on historical data:
- Correlations and alpha estimates may be overstated or lagged.
- The recent fading of alpha means past performance is not a reliable guide.

Key Numbers & Data Points

Early-stage VC median return: ~13% (vs. ~10% S&P 500)
Pension fund alternative allocation: <10% (2001) → ~30% (2022)
Family capital alternatives allocation: ~52%
Hedge fund fee compression: 2% → 1.37%, 20% → 16.4%
Hedge fund alpha faded significantly post-2007; recent decade underperformance relative to passive benchmarks
Correlations of hedge funds with stocks: historically as low as 0.002 to 0.34 but spike during crises

Disclaimers

This summary is not financial advice.

Alternative investing carries illiquidity, opacity, and higher fees. Historical data on alternatives should be interpreted with caution due to appraisal lags and changing market dynamics.

Presenters / Sources

Unnamed presenter (likely a finance professor or investment expert)
Data references: Cambridge Associates, CFA Institute, Yale Endowment (David Swensen), academic papers by Frajakis, Ryan, Marco, and critiques by Richard Ennis

Summary

Alternative investments encompass hedge funds, private equity, venture capital, private credit, real estate, collectibles, and cryptocurrencies. They promise diversification benefits (low correlation) and alpha generation, attracting institutional investors and increasingly individuals. However, empirical evidence suggests these benefits are overstated due to illiquidity, opaque pricing, fading alpha, and high fees. Investors should be selective, focus on genuine diversification, avoid expensive vehicles, and be mindful of liquidity and time horizons. Historical correlations and alpha should be treated skeptically.