Private credit was in the headlines earlier this year as software loans came under scrutiny because of the risk of AI disruption. The essential idea was: how viable are small SaaS companies in the face of ever-helpful AI? Will we be able to vibe-code websites, CRMs, and accounting software via LLMs? The debt taken out by these SaaS companies was looked at with skepticism. Then people asked for their money back, but redemptions were “gated,” and investors learned a critical lesson about illiquid assets.
Does the investing public now have a reasonable understanding of alternative investment vehicles? The episode earlier this year felt informative, but by and large, it feels like the answer is still no. So, what are the most relevant facts surrounding alternatives?
A recent pitch for an alternative income investment serves as a worthwhile example. This firm shows a chart and table that compares the investment to well-known public bond indexes. The simple insinuation is, “Look how much better you could have done with us!” Not only that, but the trendline for performance is smooth as a baby’s bottom. A smooth line for investment performance leaves little doubt about the proposition: “This has delivered and will continue to deliver.”
This should set off the warning flashers. Who determines the shape of the lines? For the public bond indexes, the market determines the shape. The bonds that make up the index trade daily and move around in price based on all kinds of factors. Those public bond indexes, when compared to the alternative income investment, seem to bounce all over creation. Their return-to-standard-deviation ratio leaves much to be desired. It’s the only logical conclusion one can come to when reviewing the graphics.
And yet, there is an inconvenient truth that’s left out.
The managers that run these alternative vehicles sometimes determine internally what their investments are worth. You can imagine that this creates a conflict, because if they say an asset is worth $1B that’s actually worth closer to $750M, they get to clip a fee on the $250M difference. To mitigate this conflict, the managers often hire third-party firms to value private or thinly traded assets. A skeptic might say this improves the situation, but still, the third party is paid by the manager, so they have an incentive to favor the manager’s preferences.
In either situation, there are major selling points to be skeptical of when considering alternative investments. The most misleading among them is low correlation relative to the stock and bond market. Some will say to look no further than the line on the page or the standard deviation number: clearly this alternative bounces around a heck of a lot less! It must be different.
Imagine if your house had a real-time value in front of it for 6.5 hours, 5 days a week. A string of burglaries in your neighborhood, price drops. A new park being built, price rises. But you don’t see that. We don’t think about that. Because the price of your house isn’t plastered on the news, the newspaper, social media, and online forums. The same is true for alternative assets: their price doesn’t bounce around because they don’t trade regularly. There is no market-clearing price showing up day in and day out; the assets change hands at best every few years. Does that mean their values are stagnant the whole time? Of course not. They are still influenced by changing consumer preferences, the Fed, geopolitical tensions, inflation, and countless other factors. A smooth line thus far does not mean an investment carries less risk or low correlation; it may only tell you that the assets rarely trade hands.
Does that mean they don’t belong in a portfolio? No, they still may play a role. But the marketing spin on alternative investments is a bit out of hand.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” — Mark Twain
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CONSIDER
Regarding pundits, Charlie Munger had the final word:
“Other people will say, ‘That guy on TV, he’s an expert in every company, every time.’ That’s crazy. He’s an expert in saying something that’s mildly plausible.”
When I watch a sports commentator, market commentator, or news anchor, I find myself admiring their ability to go on live air and say something mildly plausible time and time again. It is a skill that few have. That doesn’t mean they are an expert in the topic du jour that came up today.
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Let’s get after it this week!
Brooks
The examples provided are hypothetical and for illustrative purposes only. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. The information presented should not be construed as investment advice or a recommendation to buy or sell any security or implement a particular strategy.
Advisory services are offered through Root Financial Partners, LLC, an SEC registered investment adviser.