Should You Invest in Alternatives?

I don't really hear much about hedge funds as much anymore. It's kind of more of private equity has taken over, sort of that FOMO type of. Yeah, it is, you know. And, of course, really the results of hedge funds have been disappointing. And because of that, they're no longer the shiny object that everybody wants access to. And so they've kind of diminished in their interest. Private equity is the new shiny object. And private equity has merit, but again, you have to think about what's my net outcome going to be after all fees and expenses. And that's not necessarily a positive expected outcome. So, you know, it's very possible that private equity could be the next version of the last hedge fund process. Welcome to "The Informed Investor," the podcast that brings you research and insights to help separate the news from the noise. Welcome everybody to "The Informed Investor." Today we are talking alternative investments and if they belong in my portfolio. The show is brought to you by Dimensional Fund Advisors, a trillion dollar global asset manager, bringing financial science to investing. I'm Mark Gochnour, and today we have a very special guest on the show, Jeff Coyle, a longtime advisor, who's gonna walk us through a framework he uses to think through alternative investments. Jeff Coyle, welcome to the show. Well, thank you, Mark. It's nice to be here. It is great to have you here. And I must say for our audience, we are clearly not doing this in Austin. No. We are out in our Santa Monica, California office, by the palm trees and the ocean. And you live in Southern California. I do. So you get these glorious days all the time. These are normal days for me. Yeah, yeah. But it's good to be here. Beautiful day out here. It's always great to come back to Santa Monica. And I lived here for eight years, with Dimensional as well before moving to Austin. So fun to be back out and get this weather again, especially summertime in Austin. Yeah. Yes, absolutely. Alright, I mentioned your career. You have been in the wealth management space over 30 years. A big part of that, the majority of that, you worked with ultra high net worth investors. Maybe walk us a little bit through your career, and your background. Oh, sure, sure. I would say that for most of my career, most of my career was spent working with the most affluent families, and managing multi-generational wealth. And I founded a few firms that focus on those types of clients, but I also built systems for managing that complexity. And the reason for that, of course, is those systems didn't exist. And so I wanted to build systems that enabled us to do better work. And so ultimately today, I retired from working with clients a couple of years ago. Today, I focus on the company that really is dedicated to building those types of systems. We have professional development programs and communication materials that support it. That's a little bit about me. Well, then that company now is Libretto. Yes. And you developed that platform when you had your own advisory business, right, to help you manage all the various complexities for the families you served. And now you take that out to other financial professionals. That's exactly right. Yeah. Let's define ultra high net worth just to give a sense. Is that a family $50 million and higher? Where do you kinda put a break point on that? First of all, it's anybody's definition. I would think of mass affluent being less than five million, affluent being five million to 20 million, high net worth maybe up to 75 million, and ultra high net worth maybe north of 100 million. And then you get into enterprise families, that would be north of a billion. And so it's really a function of, you know, wealth can be significant, but the way that you approach each of those different segments would be different. Alright, and we'll get into some of that, but certainly a big part of what you are always reviewing and working with these different families on is this idea of alternative investments. Sure. And where does that come into play? So let's define that when we're gonna use the term here today, alternatives, what should the audience be thinking about? I think simplistically, things that really aren't available in the public markets. And I think people normally think of alternatives as venture capital, non-venture private equity, private real estate, natural resources, hedge funds, those types of assets. And so I would say people generally think of alternatives in those terms and that's kind of traditionally what it's thought of. So anything that's really not a stock or bond trading on an exchange globally? Yeah, exactly. Yeah. Alright, so before we get into it, one of the things we do on the show here is we like to read a few headlines. Sure. So I've got a couple of headlines for you, and then I'll get your reaction and then we'll dive into it here so I got to get my glasses on. Alright, two of them. The first one, access to alternative investments is opening up, do clients care. The second one, alternatives face mounting scrutiny and skepticism. Do you have a reaction to either one of those? I think those two comments are problematic. They're opening up and they're facing broader scrutiny. If facing broader scrutiny, you would hope that it would go the other direction and maybe think more critically about the assets. So yeah, I would highlight a bit of concern with those two conflicting headlines. Yeah, and I'm going to come back to the accessibility of some of these alternatives as you move down from it used to be institutions and to the ultra high net worth and it keeps going down now to possibly 401 plans. So I'll come back to that because I definitely want to get your thoughts on that one. But let's get into it here. As you think about alternatives, what was the approach you took historically working with clients when that came up as an option? Really when building solutions, really what you're doing is. I guess I'll step back from this, and say when you're building a solution for a client, you want to think of their total wealth. So when you're actually building a portfolio, you actually want to think about their human capital, their homes, their mortgages, their social security, the operating businesses that they own, their properties, other private assets, estate inflows, insurance payoffs. So when you think about a portfolio, the portfolio really behaves like a completion fund. It recognizes those other resources, and then fills in a void to create a comprehensive solution. So now you're thinking about a portfolio, and addressing your question, now you're thinking about alternatives. Well, how do alternatives contribute to that portfolio? And part of the answer to that question is a recognition of those other assets. So if you have somebody that has significant illiquidity, an alternative is probably not an ideal asset, and that's just forgetting the underlying merit of the alternatives themselves. So I would think about it in context of the total wealth first and then think about it as an asset class that may contribute to the investible portfolio. And you mentioned human capital. Just for the audience, you're talking mostly about somebody's career and their earnings, potential over their working career? Certainly, certainly. So human capital is really, it's the value of your future earnings is really what human capital is. And so if you work for a large technology company, and the value of your human capital dominates your wealth, which it probably would for most mass affluent families, you don't necessarily want to load up on large growth securities. You already have more than you need in the form of your human capital. So those are the types of things you want to be thinking about. Okay, and then I guess the opposite stream, you might have a professor, let's say they have tenure in a very stable, reliable income stream over time. So maybe you could maybe be a little more aggressive on the equity side perhaps. Without question. Okay. Without question. Yeah. Alright, so alternatives. Do you mind if I digress? Oh yeah, yeah. But the other thing about a professor is a professor is also likely going to have a pretty significant pension. And when you think about that pension, what the pension really is, it's an illiquid bond. And so when you're thinking about their total wealth, that illiquid bond in the form of their pension is going to dominate their protective assets. And when you think about the liquid investible portfolio, its job is really just to fill in a void that the pension isn't covering. So this is kind of getting back to whether it's an alternative asset or a pension, or someone's human capital, each of them folds into the total wealth structure in an important way and that's coordinating a personalized solution. And that's really the platform you built, Libretto, to be able to manage and bring all those together from the advanced planning, asset allocation, risk management, all those things come together. All those things together. Yeah. Okay alright, so part of that is evaluating obviously publicly traded securities, stocks and bonds, and then you move into non-publicly traded, which gets into the alternatives. Yep. And that was a prominent part in many of the affluent families too, right? Not necessarily they owned it or they're always probably getting approached by the various entities out there. What were those conversations like when you would talk to somebody about these potential alternatives? Well, first of all, I should say that Libretto is agnostic to the investments that an advisor would use with a client solution. The reason we're talking about this is I've spent my career managing very affluent people. Alternatives are a critical part of that process. So I've spent an enormous amount of time conducting empirical research, basically evaluating the merits of alternatives. So where I'm coming from today, is thinking of from an advisor perspective, how do I think about alternatives within the context of implementing a client? And so that's really where I come from on alternatives. When you think about alternatives, you want to step back from it and really say, "Well, are these something I should incorporate into a portfolio?" And the answer is going to be different for different people. However, there's a basic framework that you can use that really kind of enables you to approach the puzzle. And the first part of that framework would really be to consider what are the source of returns? What are driving returns? And you can really break that down into three things, at least I have found it helpful. And the first one is enterprise risk. It's a fundamental risk of an operating business. If you're going to loan them your capital, what are you going to charge that business to access your capital? The second one of which is financial engineering. You can take that same business, you can leverage it, you can buy in an illiquid form, you can re-engineer it. And then the third of which would be skill. Does a manager have an ability to add value to the enterprise risk and the financial engineering by selecting securities, re-engineering a business, we call that activism as an example, timing markets. And so when you deconstruct it and you think about alternatives, the first thing I would say is, well, where are the returns coming from? How much is coming from enterprise risk? How much is coming from financial engineering? How much is coming from skill? Because you have different confidences in each one of those. So Jeff, I love that framework and you're always so good in the way you think about things and articulate with a framework like that. And the way you broke that into those three components, right? The enterprise, you got the financial engineering and then skill. How do we apply that to this idea of alternatives, which is a pretty big umbrella. You think about all the different things that kind of fall under that. So maybe walk us through how you apply those to the different types of alternatives that are out there. Oh, sure, sure. So think about venture capital. What is venture capital? I mean, really you're investing in early stage companies with a new idea, a new product. And when you think about venture, it's really two things. It's a very high exposure to enterprise risk, because these are really risky businesses. So a primary driver of venture capital is the enterprise risk associated with those really risky businesses. And then of course the skill of the underlying managers to bring these ideas to market and capitalize on them. So venture capital, strong enterprise risk and skill, not much engineering. We think about private equity, simplistically what private equity has done historically, they buy small to mid-cap value companies, they put leverage on them, they re-engineer the operations, and product lines, rationalize the product lines, and then they try and sell them to somebody else. And so there's a skill attached to that, not only in selecting the underlying security, but the re-engineering and the operations and so on. So when you think about private equity, again, a heavy dose of enterprise risk, the biggest component of it, and that enterprise risk is then augmented with financial and engineering in the form of leverage and others, and then also the ability to add skill. Now you move into real estate. It's very similar, just similar to venture and private equity. When you think about you can buy a public REIT in the market and buy real estate through a security like a public REIT, or you can move into the private markets and there's a category called value enhanced. And what they basically do is they buy, I'll call it ugly real estate. Think of that as a small to mid-cap value company in the public markets, but in this case, it's an ugly piece of real estate. They put a new coat of paint on it, and they turn around and sell it to somebody else. And that is something that has a heavy dose, of enterprise risk attached to it. And then there's the financial engineering about the new paint and then the skill of the manager to manage that process and bring it to market. And then there's a form called opportunistic real estate. And from somewhat analogous to venture, it's not, but it's somewhat, but you buy a piece of property in the middle of nowhere and you hope that over time civilization encroaches upon it and now you can put a Home Depot and a bunch of homes around it, and make an awful lot of money. And there are other forms of opportunistic. You just have to have the funds to get you to that point. You have to have the funds to get to. From however many years that is down the road. Yeah, there are examples of where people have purchased farms, and they farm the property for years, until take Central Valley in California, we're in California, until civilization grows from Sacramento out to this farm, and now all of a sudden they're going to put homes in a Home Depot. And so the value of that property dramatically increased. And these are different types of investments. And so there's skill attached, a lot of skill. So that opportunistic real estate has an enormous amount of enterprise risk. That's a really risky opportunity. And so the cost of capital's going to be high, but there's an awful lot of skill attached to it as well. And so you can use these tools. And the final one is really hedge funds, which is really most difficult of all because really hedge funds, it's not really an asset class. I mean, you can find a hedge fund that does almost anything you can think about. And so it's almost more like a compensation structure than really an asset class. Well, sorry. I was going to say maybe describe the hedge fund in the sense of what are they buying? It's mostly publicly traded securities. Yeah I mean, that is what you can say that's common about hedge funds. Most of them are buying publicly traded securities. So when you deconstruct a hedge fund, in general, they own publicly traded securities. And that could be stocks and bonds, of course it could be futures. Could be stock and bonds, sorry, options. It could be futures, options, stocks, bonds, but they're publicly traded securities, and they will often apply financial engineering in the form of leverage, illiquidity. They might buy more illiquid companies in the public markets that may have a liquidity premium attached to it. They might buy securities that have optionality. A mortgage has optionality. And so in a mortgage, the person who has the mortgage, they have the right to pay it off at any time. So if interest rates decline, they pay off their mortgage and they refinance. To the owner of that mortgage, that's a negative characteristic. And if they're going to loan you money, they're going to charge you more for it. So that's what you call optionality. And so hedge funds engage in all kinds of optionality. But when you think about it, you summarize it, they're investing in the public markets, they're applying a lot of financial engineering, and you hope that they have some skill, in the work that they're doing. So hedge funds are heavily loaded towards financial engineering and skill. And so you want to evaluate, well, what's the outcome expected to be? And if you step back that and think about it intuitively, bought a large pool of hedge funds, it basically looks like a balance fund. You've got equities, you've got fixed income embedded into a different security. Looks like a large balance fund. And what would you expect the return of a large balance fund to be after fees and expenses that look like two and 20, as an example? Not all that good. And by the way, that's exactly what has happened. And that's a typical fee structure and hedge funds similar to private equity. Yeah, typical fee structure, very high fee structures and hedge funds. And not surprisingly, the results over time, have not measured up to what people had hoped. Well, and so I'm glad you brought up hedge funds because that used to be the rage. We hear about them all the time about, "Well, I got to invest in hedge funds." I don't really hear much about hedge funds as much anymore. It's kind of more of private equity has taken over sort of that FOMO type of. Yeah, it is. And of course, really the results of hedge funds have been disappointing. And because of that, they're no longer the shiny object that everybody wants access to. And so they've kind of diminished in their interest. Private equity is the new shiny object, and private equity has merit, but again, you have to think about what's my net outcome going to be after all fees and expenses. And that's not necessarily a positive expected outcome. So it's very possible that private equity could be the next version of the last hedge fund process. That's a great overview. Thanks for that. And with that said then, how would you assess sort of the contribution of each one of those as you were thinking about then say an expected return from whatever that investment might have been? Well, it's interesting when you think about it, there's very little difference. There's few differences between a public and a private company. So when you think about enterprise risk, it's a final more risk of an operating business. It doesn't matter if it's a public company or private company. And there are things that actually cause systematic risk to price the cost of capital, which over time becomes the investment return minus some default. And those characteristics are present in both public and private companies. So when you think about an alternative, well, I can access enterprise risk far more cheaply, and more tax efficiently in the public markets. I then really have to step back from and say, "Well, why would I access it in private markets where my fee structure and the tax efficiency is so much reduced?" So what you really back up into thinking is, well, then the primary reason I'm thinking about alternatives is the potential value of financial engineering. Is it valuable to apply leverage or illiquidity, and the potential for skill? And so it helps you to break it apart, and think about the puzzle to identify, well, how confident am I that I'm going to come out with a positive solution? The public, the private would have similar, I guess, expected returns potentially as an operating company, but then how would you think about the engineering side of that? Maybe the private has more leverage perhaps in a public company. That what you're talking about, maybe risks are different, expected returns are different? Well, it's going to elevate the expected return when you leverage and because you're applying leverage to it, but it's also elevating the risk. So it's elevating the likelihood of failure too in stressful environments. So both of those things are happening with leverage. Illiquidity, most people, if you think about it rationally, if somebody, if you loaned a dollar to a public company and you could get it back tomorrow versus you loaned a dollar to a private company, you had to wait for another 10 years to get it back, you'd probably charge more for that dollar. And that's what there's a liquidity premium that's associated with that. So I'm using two examples, leverage and illiquidity as forms of financial engineering. There's others and you can evaluate that. The other side of it is then to think about skill. Often what happens in private equity is they tend simplistically, private equity tends to buy, or at least historically, small to mid-cap value companies, and they leverage them and they try and re-engineer the businesses. And when you re-engineer the businesses, you might call that skill. And because they're getting in there, and they're trying to improve the operations, and the financial structure and all of those things so they can turn around and sell to somebody else at a higher price. And that's a potential example of skill. Another example of skill is identifying a good company before other people do or a product line that's different. It could be timing the market. It can be other things. And so these are the things that you can deconstruct, and really kind of get a good handle on. I guess how do you know the reliability, as you assess the return and the risk relationship in each of those different three? I guess the enterprise one is a little easier, because you're saying, hey, it's similar to a public company. So we've got a ream history of data around that. How do you think about getting reliable data in the other part around engineering and skill? Well, you think about, it's difficult. Alternatives are opaque. People are normally, the more typical way of investing, they're investing in a fund managed by a private equity manager. The private equity manager buys a number of companies, inside of that fund. And there's some information, but it's not fully transparent. It's not like you're buying a public company. So there's a certain amount of a belief you must have in the private equity managers in order to do that. So you probably don't have a great sense of the underlying leverage of the companies that they're buying and the use of leverage of it. And you do have good sense of the illiquidity because you don't have it, but you don't have a good sense of the leverage. And so it's more difficult. So really when you start to analyze this, you can back up and think in kind of another, a second set of frameworks is start by thinking where the source of return, what's driving the return, enterprise risk, financial engineering or skill. The second side is then step back and evaluate and say, well, what does the performance look like? Have they actually delivered value through time? Do they add diversification value to a portfolio? Are these unique sources of return that compliment a larger portfolio in such a way that it adds value? And then thirdly is, is there purpose? Is there a non-investment reason, that you might actually want to own private equity? And then lastly, at least from an advisor's perspective, is this something that adds value in the business? Is it adding value to the client? Does it add value to the business? Those four things you can evaluate. So when you ask about, can you evaluate leverage inside of the underlying leverage, you can probably get some information, probably not as much as you want. Private equity typically has a lot more leverage than public markets do, so you do know that. What you can do is you can evaluate the net results of private equity, and that's something you can do. And by that, you're just talking about the returns of this particular pool of assets. You've done a lot of work around that, both on looking at the academic side, and probably as a practitioner too, looking at live managers. How do you gauge in rank? Because it's a volunteer database for the most part, isn't it, in the return stream of these, particularly around private equity? Yeah, actually it has been. In fact, there's been a lot of empirical work done on alternatives for decades. It's just the quality of the information I would say, was poor to begin with and it's been improving ever since. But there is actually a pretty good database out there. It's been known as called the Burgess database. It was regionally purchased by a larger company. But what they do is they basically look at the underlying returns of the limited partners themselves. And in this way, they're able to avoid issues like survivorship bias and backfill bias, and those types of things. So you can actually get to some pretty good data today. And there have been a lot of studies, that have been done recently, including Hendrix and Medhat, here at Dimensional actually, that really do a deep dive evaluation of the performance merits of alternative investments. And it's not necessarily all that attractive. So expand on that, not necessarily attractive. And you used a term earlier about assessing if it adds value. And what are you comparing it to, a publicly traded market when you talk about adding value? Yeah, so as an example, the reason I think enterprise risk is important is I can go out and buy a small to mid-cap value company in the public markets and expensive, tax efficient. And so the question is, if I buy something similar in private equity, why am I doing that? And I guess the argument in this case would be, well, because they're applying financial engineering and potentially skill and those two things are going to add up to something that has value from a performance perspective. And so when you think about this, by the way, intuitively, you would anticipate, well, the gross return of private equity, it should be higher than the public markets. They're leveraged, they're illiquid. There's an illiquidity premium. They're generally investing in riskier businesses. So there's a lot of reasons why the gross return expectation should be higher. But the key question though is, is there a net return after all fees, expenses and taxes? And that's where it becomes more problematic. Typical fee structure in private equity is 2% of value, and 20% of the profits. That's an enormous hurdle to overcome. And so what the Hendrix and Medhat paper basically highlighted is private. I'll talk about private equity. Private equity basically produced returns slightly above the S&P 500, but when you risk adjust it, and compare it to a risk adjusted benchmark, they tend to either equal the public markets, or slightly underperform in some cases. And by the way, that makes a ton of sense, because you do have a higher expected return, but all that excess return is really going to the managers. It's not really being left over for the investors. The cost structure is so high. Cost structure's so high. Now what about after tax? You mentioned taxes a couple times. Compare and contrast some of the tax burden you might have in alternatives. Yeah, and this is kind of an interesting puzzle or an interesting piece because when you think about alternatives, part of the alternatives, they're buying companies, they're selling companies, you're going to be realizing these gains through time. So you're thinking about, well, what's the after tax return of the alternative? What if on the other hand, I'm being simple, I went out and bought that small cap value ETF. If I never sell it, it's going to get a step up in basis through my estate. Most people investing in alternatives have more wealth than they'll consume during their lifetime. And so most of the time, a lot of those assets will get a step up in basis. And so what you realize is you're actually comparing the pre-tax return of a public market investment to the after tax return of a private market investment. So if you start the puzzle thinking that pre-taxes, private equity earns a return, something very similar to the public markets, after tax is going to be something measurably lower. And so from a performance perspective, it's not that compelling. You got the hassles of tax reporting, K-1s. Usually from a lot of these, I can get just a nuisance trying to track those down. A lot of it's income oriented. I'll have you expand on that, but then also I want to go back to a question you mentioned on if you get the step up in basis as it flows to the estate. Do a lot of those funds return your capital though after a certain number of years to where you may not have the luxury of holding it, that long so it goes through estate? The alternatives, yes. Alternatives. Yeah. Oh, absolutely. And that's part of it. So what in the structure of an alternative investment is, is the typical structure is you're investing in a fund, you commit a dollar, and they draw that dollar incrementally from you over a couple of years, the investment period. Now that dollar is invested, but it took a couple of years to get there. And then during that time, the companies are maturing, they're preparing them, they're selling them off, and that's the distribution period. And so that typically is the full period of your lack of liquidity is somewhere between 10 to 12 years, before you get your last dollar back. So it's a long time. Okay, and then how is that taxed when you get your distributions? Long term gains? Long term capital gains. Okay. Usually it could be short, but that would be unusual. In order for it to be short, they'd have to buy a company and flip it and sell it quickly. That would be unusual, but most of the time it's long-term capital gains. Okay. Whereas in the case of that ETF, the ETF is managing tax efficiently. There's almost no, in this case, capital gains distributions. And so if that ETF is held, and passed through their estate, they'll never pay the tax on that. So that's what I mean by in certain circumstances, you can be comparing the pre-tax return of the public market with the after-tax return of alternatives, and it makes the comparison not so positive. Got it. Alright, you mentioned diversification, and that's one of the things you often hear about alternatives in this case quite often about private equity or private credit that it's just a smoother investment ride. Now, it's smoother because it's probably not mark to market. Those are my accounting terms I like to use, or properly valued where you publicly traded market every minute of the day, the exchange is open, it's getting repriced and revalued. So expand on that a little bit. Sure well, first of all, intuitively, is there diversification in a private equity investment different from a public market investment? And I'll get to that in a minute. But the key thing though is historically, you go back decades as an example, people were thinking alternatives, private equity, I'll use private equity, private equity was a strong diversifier. And one of the reasons for that is private equity, over the decades, it usually used an appraisal based method of valuation, a lot of discretion involved in there, and it's valued every quarter. So when you apply an appraisal based valuation methodology, it's applied on a quarterly basis, it's going to have the appearance of very smooth returns. It's not going to actually demonstrate the actual volatility that's under the economic volatility that's associated with that company like a public market company would. And because of that, there was this view that, oh, these are diversifying. Low volatility means you have a low correlation to public markets. Low correlation means you've got this wonderful diversifier. And a lot of things have advanced in valuation methodology. I don't know, 15 years ago, there was a move to fair value accounting. And with fair value accounting, it's a better effort to value private equity so that it's more closely aligned with public markets. It's a better effort, but it's not a perfect effort. And when fair value accounting showed up, all of a sudden the correlations just ramped up dramatically. There's a study out there that basically identified that institutional investors thought that the correlation coefficient for private equity, which is a measure of their, I'll call it diversification value, it was something like 0.3, 0.35 a couple decades ago, and fair value accounting comes in and now it ramps up to 0.8, and starts to look an awful lot like public markets. So I would say that thinking that they have diversification value, you have to have a bit of humility associated with that. They probably do, and if I were to argue why they do, is when you take a, I'll take a public market equivalent, you add leverage, you change it a little bit. It's going to have more volatility, not less by the way, it's going to have more volatility. There might be deal structures that are involved that might be different. You might have a manager that's basically trying to re-engineer the company, rationalize their business operations and their financial structure. These are things that can add value, but not massive drivers of diversification value. And so I would walk into this thinking with a bit of humility about their ability to add diversification. The caveat I would say is right now we're talking about traditional private equity, even venture capital as an example, private real estate. Their public market equivalents are very similar. There are some assets that are very different though. You can have contractual cash flows, you can have the earning streams of a pool of professional athletes, you can have disaster insurance payoffs, and these don't relate to the public markets. And those I would argue would have diversification value, but you'd still want to do a critical evaluation. Where's that return coming from, and how much am I paying for it to get it, and what taxes are associated with doing so? Yeah so let's say you're buying real estate, some of this private real estate or private equity, different companies in addition to your publicly traded securities. So you're expanding your holding set, which is a diversification play. So that could be a positive from diversification, but I'll go back to the comment about the correlation comment you made. So let's go back to that widget company we're talking about, one on the left side, the public company, one on the right side. They're both exposed to economic variables, interest rates, tariffs, whatever you want to call it. And that's kind of where it makes sense that, that correlation would rise when you think about more fair value. Yeah, there's agreed. Again, when you solve for enterprise risk and you have two things that look roughly the same, you would not anticipate diversification. There is an argument that says, well, there's a recognition since I think the 1990s, a lot of public market companies have been taken private. So there's a lot of private companies out in the world. And so do I need access to those private companies to get diversification? And that's one argument. And I would step back from it and think though, well, how many securities do you need to own to have diversification? So if you were to go out and buy a total market portfolio today, probably has 2,500 companies in it, that's a lot of companies. That's a lot of diversification. If you expand that globally, you probably have north of 12,000 companies in that portfolio. So does adding private equity add meaningfully to the diversification of a portfolio with 12,000 companies in it? Probably not. I guess we get back to how much you allocate to the private equity sleeve of a portfolio. You know what I mean? Yeah. Is it 5% of the overall portfolio? Is it 20%? How do you think about that? I think it's fully discretionary. If private markets earn similar returns to public markets pre-tax and less return after tax, there's not a strong argument from a performance perspective to add them into a portfolio. If they have limited diversification value, probably not a strong argument to add them to a portfolio. So how much? I think they're fully discretionary. I've worked with very affluent families for a long time, and I spent a long time doing this work. And as you share an empirical evaluation with people, it's very uncommon to get a response back. I've always thought that to be true. Nobody's ever told me that though. And so investors are actually looking for counsel, they're looking for judgment from advisors. And when you share judgment with them, it creates an enormous amount of value. So I would say alternatives are discretionary. Now having said that, there are reasons to invest in alternatives that may have nothing to do with performance or diversification. Some families just want to invest in venture capital being exposed to innovation. This gets back to your purpose comment, right? It gets back to purpose, yeah. So there are other reasons. So what is the purpose of it? Maybe they want access to innovation by investing in early venture companies, or they like to affect society or the environment in positive ways and invest in companies that are dedicated to solving social or environmental types of problems. That's called impact investing. Another example of purpose really has to do with estate planning because when you take an illiquid asset, like an alternative asset where the investor and put it into a structure, where the investor has limited control, the IRS generally will allow you to discount the value of that security and that discount can be utilized in a wealth transfer. And the logic of that discount, by the way, is if you had an investment that was illiquid, and you lacked control and you went out and tried to sell that to somebody on the street, what would they pay you for it? Well, they wouldn't pay you for the full dollar of that. They'd pay you for a subset, to discount its value, by liquidity and lack of control. So that discount can be used effectively in wealth transfer strategies. Now, on the other hand, when you're thinking about that, that may be a value, but in a lot of wealthy families, they're paying taxes. So you still need to back up and say, "Well, okay, I'm getting this discount value opportunity, but now I need to compare it to a public market equivalent where I might get a step up in basis through the estate and never pay the tax." So it's more nuanced. It gets complex very quickly, doesn't it? Yeah, But it's not complicated. It's a step-by-step process of thinking through it. Or it's fun. Some people just say, "You know what? I just want to go have some fun with it. I got a buddy starting a company and why not give him a little something, something to help out?" By the way, and I think that's completely legitimate. One of my favorite clients of all time, he invested in private equity because he loved it. He liked to talk to the managers, and dig through the companies intellectually, and it was part of his hobby. He loved it. And he understood the results. We analyzed his results. He was basically getting public market outcomes, but that was fine with him. And that's completely other reason to think about it, but an unusual one, but a good one, yeah. Alright, I love the framework you have there. Okay, think about the sources of return for any one of these potential alternative investments, right? From the enterprise, the financial engineering, and then the skill potentially from the manager, and then get into more of the nitty gritty, the performance, the cost, the taxes, the purpose, diversification benefits. Alright, Now I'm going to ask you, I got some just specific questions. I'm going to put you on the hot seat. Sure. And I'm just going to go from there with that groundwork laid for it. Alright. Who's this appropriate for? Meaning, is there a size of a state, a $2 million person, a $1 million investor, 10 million? Where does it make sense to get into some of these potential investments that may have liquidity issues, longer tie up, stuff like that? Traditionally, it would be for people with significant affluence. And the reason for that is these are illiquid assets, and you want to be cognizant of liquidity in your financial plan because a lot of people fail not because they lack sufficient assets. A lot of people can fail because they lack liquidity. So you want to think about liquidity. So generally, I would say typically it would relate to ultra affluent families that have excess resources, that they can lock up for long periods of time. In a traditional private equity exposure, you want to have at least a 20-year time horizon in order to make these investments. Why is that the case? Well, because when you start, you kind of ladder into a private equity program. You invest in fund A, and by the way, when you invest in fund A, it has a certain characteristic that it's looking at. Let's say you're in venture, maybe you're investing in biotech, because that's what's hot today. Or then AI is in the next cycle, or information technology is in the next cycle. So it takes time to get diversification both by securities, by industry, and by time. And so it takes 20 plus years to do that. Now there's the advent of a lot of evergreen funds today, which are basically trying to create vehicles that enable people to have liquidity. And that would argue that it could be available for people of lesser levels of wealth. But also think about when we started the conversation talking about performance, under traditional structures, alternatives really produce returns that are very similar to the markets. If you have another layer of fees on top of that in the form of an evergreen fund, the performance of course is going to be diminished fairly measurably by those additional fees. So while it makes it accessible, it makes it a lot less desirable. And so I wouldn't say for most people that our alternatives are a great solution unless there's a purpose reason, and they're intellectually interested and they want to dedicate capital to it. And if you do dedicate capital, dedicate it enough that it's not going to hurt you. Yeah. Okay. Yeah. What do you do if you've got a friend that comes up and knows you have some assets and wants you to invest in the company? Is there a polite way to, assuming you're not interested in investing, is there a polite way to sort, of get out of having to do that? Well, the first thing, Yeah IS there a polite way to say no. Yeah, there is a polite way to say that and just say, a good way of. First of all, when you invest in, somebody asks you, to invest in a restaurant, a private business, whatever these kind of friends of friends types of things, those are really, when you think about it, those are speculations. You're buying one company. So it's not diversified, it's highly speculative, it's highly illiquid. There's a lot of risk there. Is that suitable for most people? Probably not. Probably not. And how would you try and avoid that? Well, just to say, "Hey, we have an investment program and we really can't afford the lack of liquidity." That's what I would focus on. We don't afford the lack of liquidity and because of that, we generally stay in the public markets. How would you answer some of the themes out there now in the marketplace of, "Hey, you're the average investor, you've never had access to this type of investment before. It's always been for the institutions or the really uber wealthy, but now we figured out how you can have it, and get part of the action too." Yeah. It's really interesting because that's a business question too, because there's substantial demand from investors, or consumers for alternatives. And one of the reasons is everybody thinks of it, as an exclusive access and exclusivity is inherently appealing to people. So what you get is this, you get this collision of an empirical review of alternatives is not all that positive, but with a demand that's coming from the population and the population, it's not what they do. People don't spend their time evaluating alternatives and reading research. And so you have this issue. And so the question is for an advisor or for a client, do you buy alternatives, or do you make alternatives available to your clients because they're asking for it, or do you spend time demystifying it, kind of having a conversation like we're having, and think through it and well, where are the returns coming from? Is the performance expectation a positive one? What does that look like after tax? Is there diversification value? Is there purpose to it? And when you demystify something like that, what you're doing is you're applying judgment. And ultimately investors appreciate somebody can actually deconstruct something that they're not that familiar with, and you might be able to save them from hurting themselves over a long period of time. So I would say it's a question, do you give people what they want, or do you help them to want what they need? That's another way of saying it. Well said. Yeah. Great answer. How about real estate? Oftentimes people will say, "Well, I'm just going to go buy some properties. Maybe they want to flip them. Maybe they just want rental income properties, and I'm going to get all the upside of owning the property. I'm going to make a bunch of money, rental income in between." What's some of your experiences around that? Because I always think the people that do really well with it, they make it look easy, but it's not easy. No, no. It's a business. It's an enormous amount of work. I mean, if you're in real estate, it's make it your business because you buy a rental property, and now you need to maintain it, and now you need to make sure it's constantly occupied, and address people's concerns and wishes. And I mean, it's all the administrative bill payment, and managing vendors and all of, it's an enormous job. And so if you're buying real estate, be sure you want to be in that business because it is a business. For most people that have regular jobs to buy real estate, and to have another business called real estate in addition to that, it's an awful lot. But by the way, that's a choice though. Just go in with your eyes wide open. Yeah, so much of this is focused on the individual investor, but a lot of this got started in the institutional space. These huge pension plans, endowments perhaps really got into a lot more of the illiquid assets, private equity, timber, some of these different things. And I think that's where some of that exclusivity came from they were talking about earlier. How has that worked for many of these institutions? Has it been really effective? Because some of them have a pretty big chunk of that endowment into these illiquid assets. They do. Have you done much research around that area? Yeah, we have. In fact, what we've been talking about, we've really been kind of laying out a philosophical framework for thinking about alternatives. But on the other hand, one of the things we do also is there's what's known as the NACUBO study, and it's a study of the results of endowments in the United States. And the reason that's kind of an interesting study is capturing the actual results of these endowments. And endowments have traditionally had the best access to alternatives of anybody. They're the first dollar into the private equity funds of choice because they're stable, consistent capital. And simplistically, probably half, a little bit more than half of a typical endowment is held in some form of an alternative investment. So if you were expecting to see positive outcomes coming from alternatives, you would see it in endowments, but that's not what happens. So if you were to look at the trailing 25-year performance of these endowments through the NACUBO study, and compare it to a public market equivalent, the endowments actually underperformed by a little bit more than 1% a year from that public market equivalent. And that's pre-tax, let alone after tax. And of course, endowments don't pay tax, but private investors do. Right, and that's public data, right? These endowments have to file certain tax forms and things like that, yeah, it's all public data. Yeah, it's all public. So you can track that. And I guess that in performance probably largely is just the heavy fees that are part of all those different investments. It's exactly what's happening. I mean, get back to first principles. The expectation for a higher gross return is there. You've got enterprise risk, they're applying leverage, illiquidity premiums, and they're aggressively trying to improve these businesses. And I would say, sorry to interrupt, but they're the ones that would have the access to the most skilled managers out there probably too. The endowments, you mean? The endowments. Yeah, absolutely. Absolutely, and the reason they are is when you think about it from a take venture, ventures is typically very difficult to get into. The venture capital manager, when you think about it from their perspective, what they want is they have a limited pool of capital, because they can only deploy so much. They want the best, highest quality, stable investors, to provide capital to their venture fund. And endowments probably meet the bill better than anybody does. And because of that, they've historically gotten the best access. Places like Yale and Stanford were also the very early investors in venture capital. And because of that, they also had, they still have very excellent access to what you would call the top tier firms. And so therefore, if there was going to be a positive result, then you would see it in those endowments, but you don't. When you compare it to public market equivalent, they still underperform the public markets. In aggregate. In aggregate, they still underperform, right? Yeah now, by the way, I digressed on something there, and that is, is that these endowments would be getting access to the most appealing or attractive managers. And that's kind of a critical thing, because when we were talking about performance a bit ago, in general, private equity earns returns look something similar to the public markets, but the top quartile returns earn things, that are substantially higher. And so if you could get access to the top quartile returns, now that becomes an interesting argument, because the returns are so much different. Now, that is something that would be appealing, but on the other hand, you also have to think about, well, are the returns of the top performing managers today going to be the same in the future as they were in the past? And that's a term called persistence. So do the prior winners persist into the future? Now, simplistically, and I'll use venture because it has the most notable results, is the answer is yes, they do persist, but it's not practical. And let me explain why. Is if you knew the entire return outcome of a venture capital fund and you were able to use that to buy the next fund, it would give you information about whether they were going to be good or bad. The problem though is a fund has a life of 10 to 12 years. So fund one comes out and then you invest in, or there is a fund one. And now fund two comes out. It usually comes out a couple of years later, but all you know is the first couple of years of that fund's investment, really the investment period, and most of it is being appraisal or fair market valued. There's not a lot of information to give you information about whether they're going to be good in the next one. And so you're making a decision based upon completely inadequate information. And when you make that decision, there's no persistence. And so there is persistence if you looked in the rear view mirror, but there's not persistence at the time you're actually committing capital, so it's not useful to you. So the idea of capturing that top quartile manager, and getting access to it, I would approach that with an awful lot of humility. It's challenging. And I guess that's one of the things where I get concerned about this movement of getting a lot of the alternatives, in this case, some private equity into like 401 plans, and things like that is the managers that, let's say the top endowments have access to aren't the managers a person in a 401k plan getting access to. There's just no chance. Well, first I want to dispel, I mean, no. In fact, there's a limited pool of capital that the venture capital market absorbs anyway. So there's a limited pool and most people can't get access to the "top tier firms." Now, I would argue it doesn't necessarily matter, because you can't really identify the future top tier firms. But when you put it in a 401, you've just basically democratized it. And it means that all capital is there. And I would argue that that's probably a terrible place for alternatives to be inside of someone's 401 k. All right. I'm going to wrap up with a couple comments and then you can supplement what I missed there. And I'm going to go back to the original question I had when we started the episode, which is alternatives, does it fit in your portfolio? And it sounds like maybe, it's just know the sources of return. And you identified that really well, I think with your enterprise engineering, and then the skill aspect of it. And then know the components in how you assess that, whether it's diversification benefit, the costs, the tax implications, the purpose. Maybe it's fun, maybe there's something else to it. So if you can address all of those, and you've got the wherewithal to survive some of the illiquidity requirements, maybe it does fit, but maybe it doesn't as well for other investors out there. Yeah. I think if you're strictly looking for a performance and diversification reason, probably not. If you're looking at true alternatives, not necessarily private equity as an example, that looks an awful lot like a public market, and you're buying insurance payoffs or professional athlete or future earnings in a diversified pool. These are risks that are very, very different than the public markets that it does add diversification value. So I think those are places where alternatives, alternatives are an overly big word, but there are places that do add diversification and can potentially add value, but I would always value every one of those potential investments through a lens of where's the return coming from and how much am I paying for it? When you say how much am I paying for it, not only to the manager, but also in the form of taxation. And then what would be my expectation on that relative to a publicly traded security? Exactly. Okay. I mean, ultimately that's what it compares to. That's your alternative is, or your base case is a public market equivalent. If I can get a better, more confident result in the public markets and maintain full liquidity, then it's a better solution. Okay, so we've known each other 28 years. That when I started Dimensional, I know you've worked with Dimensional longer than that in your career. And I just always love talking to you. I always learn so much about investments, the industry, working with individual investors. And so thank you for all of that. You're just a wealth of knowledge and so articulate on this stuff. So I appreciate you joining the show. Oh, thanks, Mark. And the other thing too is for the financial professionals that are listening in, I want to go back to Libretto and you have a whole source of information there on the website, right? You do various workshops and different webcasts and things like that as well. Yeah, absolutely. We, you know, in addition to the technology we provide to help advisors manage wealth, we also have professional development programs. We have sessions on alternatives, demystifying alternatives, this is an example of one. And then we have materials, both materials to help communicate, also papers. We have a paper on this topic as well that basically lays out this framework. So all of those things are available. We also do webinars and those are generally continuing education web webinars. And you can also join those as well. Alright, Jeff. Thanks so much. Alright. Great seeing you. Great to be here in sunny Southern California as well. Oh, it's a pleasure. Thanks, Mark. Appreciate it. And thanks to all of you for joining "The Informed Investor." We appreciate your time here today. Great session with Jeff, as it always is when you get to hear him talk about these things. And also be sure to check out the book, "Stay Calm." It's by David Booth, our founder here at Dimensional and chairman as well. Just great guidance as you think about investing. Great guidance on life in general as well. Thanks everybody. Take care. Have a great rest of the day.