Back during the dotcom collapse of 2000, I was losing money in the stock market like a champ. I was a second-year financial analyst who had a serious case of confusing brains with a bull market. When I turned to my VP and told him I was still bullish about the stock market, he almost slapped me upside the head. “We're in a bear market, son. Get used to it and stop dreaming!”
After losing about 30 percent in my after-tax portfolio, my dreams of stock market riches finally faded. I cried “uncle” and moved my money into more conservative investments. The funny part was that my 401k was actually up in 2000 and in 2001 because I had allocated 50 percent of my assets into a hedge fund called Andor Capital Management that went short the market.
Normally, only accredited investors — those who earn $200,000 a year or more or who have a net worth of over $1 million or more (excluding their primary residence) — can invest in hedge funds. But my firm had a partnership with Andor that gave us peons access to invest as well.
After I left my firm, I never invested in another hedge fund again. I didn't have the enormous $500,000 to $1 million minimum to invest, nor did I want to pay their fees based on 2 percent of assets and 20 percent of profits. But when the 2008-2010 financial crisis hit, oh, how I wished I was able to replicate what happened in 2000 and 2001 with my 401k. By this time, I had a lot more money to lose, and lose a lot I did.
What is fueling the growth of hedge funds?
A hedge fund's objective is to try and make positive returns during both good times and bad times with their private pool of money. The media loves to skewer hedge funds due to the huge profits earned by some hedge fund managers who make successful investments for their clients. There are also some notable collapses of hedge funds due to being overly levered, such as Long Term Capital Management in 2000.
But for the most part, hedge funds are extremely focused on risk management given their objectives of providing absolute returns no matter what market they are in. Due to the hedging activities of hedge funds, they tend to underperform during a bull market and outperform during a bear market. Of course, no hedge fund is the same.
Despite underperformance over the past six years, the pool of assets investing in hedge funds has grown to $2.8 trillion according to Hedge Fund Research (HFR). Why is this? First of all, hedge funds have outperformed the S&P 500 index if you look a little farther since 1990. They can't always underperform; otherwise nobody would ever invest in them.
The second reason for the increase in hedge fund assets has to do with the incredible wealth being created by Americans in the stock market, real estate market, and private equity market. A rising tide lifts all boats as they say; and with the stock market at record highs, plenty of investors have gotten wealthy.
Once you build a large financial nest egg, the most important thing an investor can do is to protect that nest egg. Losing 30 percent on a $10,000 portfolio can be overcome through savings for a median $40,000-a-year income earner. But losing 30 percent on a $1 million portfolio is a painful experience that is hard to make up, especially for older investors looking to retire. Hedge funds tend to reduce portfolio volatility while aiming for absolute returns.
The final reason why hedge funds continue to gain assets has to do with increased access. In the past, not even the typical accredited investor could gain access to a hedge fund since the minimums were so high. But with the proliferation of smaller hedge funds, minimums and fees have decreased.
Furthermore, due to the rise of crowd-funding, there are firms like Sliced Investing, a San Francisco-based startup that is providing greater access to hedge funds for as low as $20,000 due to their crowd-sourcing model. They essentially pool together investor money in order to meet the higher minimum through a fund of funds. Other companies such as CircleUp and Realty Mogul do the same, but for private companies and real estate.
What are alternative investments?
Hedge funds are just one type of alternative investment. Besides hedge funds, alternative investments also include private equity and real estate.
Private equity includes getting in on Uber or AirBnB's latest round of funding at ever-higher valuations. Private equity firms will sometimes pool funds together to take very large public companies private. Many private equity firms conduct what are known as leveraged buyouts (LBOs), where large amounts of debt are issued to fund a large purchase. Private equity firms will then try to improve the financial results and prospects of the company in the hope of reselling the company to another firm or cashing out via an IPO.
Private equity real estate funds generally follow core, core-plus, value-added, or opportunistic strategies when making investments. These funds typically have a 10-year life span consisting of a two- to three-year investment period during which properties are acquired and a holding period during which active asset management will be carried out and the properties will be sold.
All these types of alternative investments may seem strange compared to good, old index investing. If so, you may be surprised to learn that our nation's largest college endowments have massive exposure to alternative investments.
Take a look at Yale University's 2015 asset allocation below. They grew their endowment from $3.5 billion to roughly $25 billion over the past 20 years thanks to alternative investments. In 2014, Yale's endowment returned roughly 24 percent.
Yale University 2015 asset allocation
Private equity: 31 percent
Absolute return: 20 percent
Real estate: 17 percent
Foreign equity: 13 percent
Natural resources: 8 percent
Domestic equity: 6 percent
Bonds and cash: 5 percent
Yale's 68 percent exposure to private equity, absolute return (hedge funds), and real estate shows how confident they are in alternative investments. Even if you talk to private wealth managers about their recommended asset allocation, the majority have at most 20 percent for alternative investments. Yale has been investing in alternatives since 1990 when they first let a hedge fund named Farallon Capital manage their money.
Managing an endowment is a huge responsibility. Yale's endowment is used to fund operations, pay for professor salaries, maintain infrastructure, and protect the long-term viability of their respective institutions. The endowment managers aren't looking to hit homeruns. Too much is at stake. Instead, endowment CIOs are looking to manage risk and carefully grow their endowments during good times and bad times.
A misunderstood asset class
Alternative investments are a misunderstood asset class because so few people have access. The JOBS act was supposed to help democratize investment access in private investments for all, yet private investments are still only accessible to accredited investors.
With the rise of crowd-funding initiatives, alternative investments are growing in popularity. We can't all manage billions of dollars like Yale University and other institutional investors. But we can pool our resources and consider allocating a portion of our investments in alternatives to help smooth out returns and diversify our exposure.
Readers, do any of you invest in alternative investments? What are your thoughts on crowd-funding companies providing more access to investors? Should the government dictate what you can and cannot buy based on your level of income and net worth?
Author: Financial Samurai
Sam spent 13 years working on Wall Street in the equities department at a couple bulge bracket firms before deciding to focus full time on Financial Samurai, a personal finance site that helps you slice through money's mysteries. Sam received his MBA from UC Berkeley's Haas School of Business and his Bachelor of Arts in economics from The College of William & Mary. He is a registered representative (Series 7 and Series 63).
Sam is based in San Francisco, California, and enjoys playing league tennis, poker, and anything that deals with the great outdoors. Sam's goal is to live a location-independent lifestyle by generating enough passive income to take care of a family of four.