SKEPTIC’S GUIDE TO INVESTING
Straight Talk for All, Nonsense for None
About - Our podcast looks to help improve investing IQ. We share 15-30 minutes on finance, market and investment ideas. We bring experience and empathy to the complex process of financial wellness. Every journey is unique, so we look for ways our insights can help listeners. Also, we want to have fun😎
Your Hosts - Meet Steve Davenport, CFA and Clem Miller, CFA as they discus the latest in news, markets and investments. They each bring over 25 years in the investment industry to their discussions. Steve brings a domestic stock and quantitative emphasis, Clem has a more fundamental and international perspective. They hope to bring experience, honesty and humility to these podcasts. There are a lot of acronyms and financial terms which confuse more than they help. There are many entertainers versus analysts promoting get rich quick ideas. Let’s cut through the nonsense with straight talk!
Disclaimer - These podcasts are not intended as investment advice. Individuals please consult your own investment, tax and legal advisors. They provide these insights for educational purposes only.
SKEPTIC’S GUIDE TO INVESTING
The Messy Middle: Navigating Alternative Investments
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Alternative investments offer potential diversification but come with significant trade-offs in liquidity, transparency, and fees that many investors overlook. We explore why the famous "Yale approach" to investing that worked brilliantly in the 1980s and 1990s may not be appropriate for most investors today.
• Alternative investments lack daily market pricing, with most only valued quarterly
• The "messy middle" includes less liquid investments that lack transparency of public markets
• Private equity and venture capital investments typically involve significant lockup periods
• When financial crises hit, illiquid alternatives can't be accessed when you need cash most
• High fees (often "2 and 20") create significant performance hurdles for alternative managers
• Consider investing in public shares of PE firms like KKR or Apollo rather than direct private investments
• Warren Buffett's $360B cash position and Jamie Dimon selling JPM stock are market signals worth noting
• Most investors should limit alternative allocations to 10-20% of their portfolio
• True diversification requires maintaining adequate liquidity for short and medium-term needs
Join us next week as we welcome Stephen Gattuso to discuss the national debt, interest payments, and how these fiscal challenges will impact our financial futures.
Straight Talk for All - Nonsense for None
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Disclaimer - These podcasts are not intended as investment advice. Individuals please consult your own investment, tax and legal advisors. They provide these insights for educational purposes only.
Hello everybody and welcome to Skeptic's Guide to Investing. I'm here with Steve Davenport, I'm Clem Miller and we're going to be talking today about alts another way of saying alternatives which include things like hedge funds and private equity and private debt equity and private debt. And so, steve, I know that you've been getting a lot of calls recently about, about alts, and I know there's this sort of impression out there that you know alts may be, you know, are really a defined asset class that represents sort of, you know, as the name implies, an alternative to equity and debt. But what do you think? You're getting these calls, what are people looking for and really, how do you respond to them?
Steve Davenport:I kind of like the term I heard recently, which is, uh, diversification, um, I think that we always try to find something else to add to our portfolios because we think it's just too simple If I have 80% in the S and P and 20% in the uh, you know, lehman ag or I guess now it's the Barclay ag. So I look at this and I say is a simple approach, the best approach usually? So I think that alternatives have this strange method of trying to make themselves look more attractive because they're not priced the same as regular stocks and bonds are. There's not a daily market. So what happens is these assets get priced, usually on a quarterly basis, and so there's only quarterly liquidity. And when I look at people who are looking to get out of the chaos and the inflammatory markets we have, I look at them and they say well, I'm going into alternatives and I say are the best assets in the world necessarily going to be private, or would you, as a person who owns that asset, want to have as many people competing to buy your asset? They believe, when you're starting out, you want to keep it private so that you have more control and you have more. And my question would be. Don't you have less oversight? Don't you have less visibility? Don't you have less of an understanding of the asset because it's newer? So I really have trouble with this.
Steve Davenport:Let's call it the Yale approach. This let's call it the Yale approach. So Yale had an investment, a head of investments in Swenson, and he believed that you should have 60% in alts and only a little bit of exposure to the markets, because colleges have an unbelievably long duration they plan on lasting forever. So therefore you should be buying longer range assets and assets that are uncorrelated so that they can grow and because they don't need the money right away, they can succeed by being more patient. I think when he was doing that in the 80s and 90s and his returns were phenomenal he was on the forefront of something that was very important.
Steve Davenport:But what we've seen lately is more and more the democratization of alternatives. Alternatives are very sexy when you go to a party and you say I'm with hedge fund manager A, he's got some of the best ideas and the brightest PhDs and they're investing in commodities and futures of various currencies and they just know what they're doing. And I look at this and I'm like how do you know what the hedge fund's exposure is on a daily, monthly. You only see the top 10 holdings and some of these things on a quarterly basis and you're restricted from getting out and you're paying much higher fees. So the benefits of these I think existed 30 years ago, 20 years ago, 10 years ago. But I think that that benefit the more you have people chasing the same assets, the more you're going to have those assets start to reflect a much more efficient idea of pricing, and so if there was an advantage, some of that advantages started to disappear and I look at the Harvards and I look at some of the how they struggled in 2008 because, guess what, there was restrictions on getting to those assets. So when there is a financial crisis, you want liquidity 40% in markets you have to sell those assets first because your long-term assets that are in alternatives are going to be harder to get. You're going to take a haircut on that asset when you want to take it out, and so if you've got an asset that has an agreement that you need to wait three years, when you get to that three-year point, you really only can take out usually 5% a quarter. So it will take you a long time to get out of that asset.
Steve Davenport:So I think alternatives as a category is similar to. It's an even broader category than hedge funds. So when I look at alternatives, I think about private equity, which is investments in small startup companies, some even large startup companies, but they've got rounds of funding and you participate in those early rounds if you're lucky, secondary, tertiary rounds, and then usually there's an event where it goes public and then your private asset becomes a public asset and then you are competing with everyone else in the marketplace. And so, yes, if you can get an early round on a company that you think you know something about or you have some belief in their product or service, it could make sense to have some of your investment there. In the product or service, it could make sense to have some of your investment there. But should you have 60% like yielded? Absolutely not. What I would say is alternatives are a vehicle that you should think about.
Steve Davenport:I like to think about this as the messy middle. When we look at equities, we look at the riskiest and the safest equities and as we get into smaller, less followed areas small caps and emerging markets are too those areas become less and less clear. So there is more opportunity. The risk return is there, less and less clear. So there is more opportunity. The risk return is there. But when you go into private and private equity venture capital, private real estate, you're really into a space where there is no visibility, there is no way for you to really get a feel for is this company doing something? And then that opens up.
Steve Davenport:I've had cases where you know, I've heard about people investing in private equity firms that put in video protection for schools and shooters and, sure enough, this really wasn't a system that existed. They just had a control room. They brought people in to demo this and it was a you and it was a fraud. So the more you get into these, the more likely you are to get into something that gets on the border of fraud and can really be a very tangible loss to your assets. So I look at it as something you don't want to give up your liquidity. So there are some new things 40-act funds that have private equity in them. There have been these SPACs that are out there.
Steve Davenport:I don't think these are for the average investor. I don't think these are even for the sophisticated investor. I think these are things that you should look at. A sophisticated investor. I think these are things that you should look at and if you want to have a part of your portfolio that is what I'll call the speculative part, which is somewhere in that 10% in the middle between bonds and stocks, could you buy some private debt, could you buy some private real estate? Could you buy some private equity? Absolutely, but it shouldn't make up more than 10, maybe 20% of your portfolio. I don't think the alternative space has developed enough clarity, enough liquidity and enough understanding in the marketplace to warrant consideration as a way to get away from the market.
Clem Miller:The way to get away from the market.
Steve Davenport:The way to get away from the market. You can hedge your risk, you can sell. You can do things that make sense in terms of non-correlated assets. I don't think you necessarily want to give up one of your biggest assets, which is liquidity which is liquidity.
Clem Miller:So, steve, there's a lot to unpack and we're not going to have enough time to go through everything that you just said, but I would make one point well, a couple of points maybe, but one point in particular, which is that why not just invest in the stocks of the private equity companies? You know, invest in KKR. Kkr has a stock, it has a ticker. You can invest in KKR. You can invest in Apollo Global, apo, right, you know, carlyle, you can invest in, you can invest in any one of these as a company, and you know that their assets, their business operations, are supporting the stock that you're investing in.
Steve Davenport:I agree with you, clem. So I agree with you, clem. I like investing in the managers because in my mind they're going to have one or two bad funds but they're going to have most of them that are run well, and higher returns mean the higher stock price because they're going to be collecting more profits, so I think it's a good idea.
Clem Miller:Even Berkshire Hathaway is, in part, like that as well.
Steve Davenport:Correct. I mean, I think there are aggregators out there, like Berkshire, like Apollo, like Carlisle, that make sense for us, just as though you know there are public. If you knew public equities were going to do well and you just didn't know where would BlackRock make sense? Absolutely. I mean, I think that when we look at assets and we look at companies, we try to figure out what is their area of expertise and what do they add. You can make a good point that some of these managers are a good place to go.
Steve Davenport:I think the problem is that you just don't know relative to everyone.
Steve Davenport:It's an active risk that you've got to understand and I like the fact that, one, they are liquid and two, some of them are paying pretty good dividends.
Steve Davenport:Yeah, so, yes, I think that if I said dividends, so yes, I think that if I said I'm going to have this area called the messy middle and I'm going to put REITs which don't really fit clearly and they're like a small cap equity but they're also like a bond Some managers of different funds of private equity funds, different funds of private equity funds I think that REITs there and some of the real estate exposure can be good.
Steve Davenport:Some of it can be infrastructure real estate that gets very close to utilities and has pretty good control over the income you're receiving. So, yeah, there are things out there that belong in that messy middle and I think what it comes down to is what's your yield requirement for the portfolio? How important is yield? How important is growth? If you say I want a little bit more growth but I still don't want to sacrifice all my yield, I think that this instead of buying a private equity company or exposure to a private equity company, buying one of the companies that manages private equity is a good way for you to get that exposure but still have the liquidity and the needs and the income needs satisfied.
Clem Miller:I mean, if you have so, there's transparency in that and there's liquidity in that and there's diversification with that.
Steve Davenport:And the fees are. You know, these managers usually charge 120 basis points and 20% of upside.
Clem Miller:Yeah, so they're generating a lot of fee income.
Steve Davenport:Correct, and my mind is you're not paying any fee to own that stock. Yeah, exactly, so you're not paying an ETF fee. Paying any fee to own that stock, so you're not paying an ETF fee. So some of these and I agree with the investors who have had the run with Berkshire and, just as another note, we've been following Berkshire and you look at the cash position in Berkshire. Last night, I saw that Jamie Dimon sold 31 million of his JP Morgan stock and the question was why is JP Morgan, the head of the largest US bank, finding now to be the time that he wants to sell? And I think he asked the same question of why is Warren Buffett with a $360 billion cash position. I think these people are making statements and I think the market has too much noise and people aren't listening. Why do you think these people want to have cash today, len, instead of staying invested in their companies or buying more other companies?
Clem Miller:Well, I mean, I think there's two reasons. Well, three maybe right.
Steve Davenport:I think it could be hundreds of reasons?
Clem Miller:Yeah Well, one clearly is that they're positioning themselves for future purchases that they think might be more attractive than the ones they're continuing to hold. So I think that's one. I think another one is that they fear that the market in general is going to go way down, and so it's much better to hold cash than it is to stay invested. And also, this is kind of related to the first one, but they just don't see their current holdings as being that much better than cash.
Steve Davenport:Yeah, I mean. I think that it makes sense to diversify and it makes sense that when you have a place to put assets. My question is is these people are making a statement about what they feel about? You know, why isn't Berkshire, if it has all this cash, just buying its own stock? Cash just buying its own stock? Is it because the price of it's gone up enough that they feel like maybe my relationship to book value isn't as good as it should be, maybe we're overpriced?
Steve Davenport:And so I think that we need to look for signals around us, because we can all say, six months from now, if the market's down 10, 15, 20, oh, it was clear that this was going on. Or we could say I didn't see anything. And I would like us, as skeptics, to be able to say we were skeptical when we saw some of these things and we acted. We didn't act perfectly. We are not going to find the peak or the bottom, but we did things in ways that made us feel more comfortable in the market and better positioned to take advantage of a downturn when it occurs. End of sentence. We don't want perfection. We're not trying to time markets. What we're trying to do is adjust our allocation so that it's positioned for what we think the near-term outlook is. And we could be wrong. It could be that there are going to be 90 agreements signed in the first 90 days and all of the tariff things are going to be resolved, and then we're going to resolve the budget. Then we're going to resolve the budget and we're going to increase the tax cuts and we're going to increase the debt ceiling.
Steve Davenport:And you know, I think that someone, some writer, recently made a comment that Trump must have magic beans that he's going to, you know, put on, the, put in the ground and those beans are going to take them to the promised land. I don't think there are magic beans. I don't think there are clear indications that alternatives are better than the stocks you can own publicly. I think what you need to do is put it in perspective and say, I do realize there are $17 trillion in equity assets and I think there are $3 trillion in the private assets that are available for sale, and we're going to say, ok, there is a proportion I should have, maybe too private, but I'm going to still be conscious of fees, liquidity and the things that matter to me, so that I don't get surprised by something that occurs here.
Steve Davenport:As long as you understand what you're getting in terms of lockups and you can live with that, I think that you could have a good opportunity in some of these assets. Is it the thing that should be 40% to 60% of your portfolio? I will say convincingly no. You shouldn't no. So I think that that might be a good point, to kind of call it a day. Any other comments? Clem on alternatives, do you ever get desire to own like a startup company that's based in Baltimore or Maryland and could be the home run you've always dreamed of.
Clem Miller:So let me just tell one quick story, and I'm going to fuzz up the details a little bit. But you know, there was a time there was an instance where, because of my international experience, I was brought in to try to and my international experience I was brought into try to, and my workout experience I was brought into a particular circumstance and it was. It involves loans that were unsecured to some Latin American commodity companies, commodity producers, commodity companies, commodity producers and why, for the life of me, anybody would make unsecured loans working capital loans to Latin American commodity producers, I don't know. But you know that was something that happened and investors were sort of caught up in that and there were some losses. So I mean, as an investor, you should know that you, you should be aware that you're getting into something like that, and if you are unconvinced that you can avoid something like that, then I would just stay away from that particular hedge fund or private equity.
Steve Davenport:Yeah, I think that there are good actors and bad actors out there, and I think that the more you can have information sunlight usually helps you understand a lot of things. When things are obscure, when things are difficult to understand, when things are made particularly difficult for you to get information on that should serve as a little bit of a warning to you that perhaps this is something I don't fully grasp and therefore this alternative could result in de-worsification. We want to avoid de-worsification. We want to make things better, not worse, and in doing that, we want to make sure that we have enough liquidity, enough assets in place to cover what our short-term and medium-term needs are and then allow ourselves the opportunity to invest in things that we feel good about and we have good clarity and information about.
Steve Davenport:So I appreciate everybody listening and I want to tell everyone that our next podcast is going to be with Stephen Gattuso, who is doing a lot of work on debt, the national debt and interest payments and how we are going to try to manage our way out of it. So we talked to him next week and we look forward to that, as all of these discussions around taxes and government and what's happening start to really matter to our pocketbooks, so I think our information and the way we approach it is a good way for individuals to try to gain more understanding and improve their financial IQ. Thanks for listening and please give us some support and likes and we look forward to talking to you again next week. Thank you, have a good Easter weekend.
