The rise of alternative investments


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.

Surprising confidence?

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?

Source: http://www.slicedinvesting.com/learning/finance/yale-university-endowment-heavily-invests-in-alternatives-and-hedge-funds

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NicoleAndmaggie
NicoleAndmaggie
5 years ago

Marketplace morning report recently reported on a bet buffet made with a hedge fund guy that the s&p 500 would beat a fund of hedge funds. Buffet is winning.

Andrew
Andrew
5 years ago

Please do not follow this advice. This person expects you to follow his advice even though he keeps making horrendous investment mistakes. Buy and hold diversified indexes with low fees. Think Vanguard. You don’t have to “make up” your losses; just buy and hold and it will come back on it’s own. And you shouldn’t have to worry about “making it up” if you’re near retirement; then you should have an allocation of investments that is stable in the face of market fluctuations. The same kind of people who crashed the entire economy want you to follow this absurd advice… Read more »

Wiggles @FirstYouGetTheMoney
Wiggles @FirstYouGetTheMoney
5 years ago

You mentioned hedge funds have outperformed the S&P if you look a little farther since 1990. Do you have a link to a comparison to back this statement up? Also, I know you mentioned this, but the fees of hedge funds are ridiculously high compared to investing in index funds. These ridiculously high fees often times eat up any additional profits the hedge funds generate over and above the passively managed index funds.

Financial Samurai
Financial Samurai
5 years ago

The fees are definitely high. A lot of people who invest, invest for diversification, volatility dampening, and absolute return/protection in case the markets turn sour.

My original post had a chart by HFR attached to it showing results since 1990, but I’m not sure what happened to it. Maybe GRS can put the graph back up.

Linda
Linda
5 years ago

Very interesting that Yale University, with $25 billion or so has 50% of their investments in alternatives! A college endowments goals is to grow capital with as little volatility as possible.

That is very eye opening and something I had no idea. Most of us are in unprotected equity investments that are at risk if the markets crash.

Thank you!

Financial Samurai
Financial Samurai
5 years ago
Reply to  Linda

I was pretty surprised by the massive asset allocation for the university endowments as well. I never would have guessed it would be 50%. But, Yale must be doing something right given their growth and relative stability through the years.

Dean
Dean
5 years ago

If you want more detail on Hedge Funds, The Financial Times has been running a long series on the industry. They show pretty clearly the the slight benefit to funds is more than consumed by the additional fees. This was first shown in the great research paper titled ‘Where are the Customers’ Yachts?”

http://ftalphaville.ft.com/tag/hedge-funds/

Charles
Charles
5 years ago

I’ve been using a new alternative investment recently that I quite like, it’s a crowdfunding site called “Kickfurther.” It lets individual investors (you don’t have to be accredited aka RICH) invest in small businesses by helping them purchase inventory. These small companies usually take out a loan in order to help pay for new purchase orders, but the terms can be quite onerous. So on Kickfurther they can raise funds from us instead! In return for our help we get interest. The interest rates are like 20-30% per year! I’ve already gotten paid for one investment (it was a company… Read more »

Jon
Jon
5 years ago

Wow. Laying the sales pitch on thick with this one and using Yale as a sales tool no less. Comparing the average Americans retirement savings to Yale’s endowment doesn’t even come close to being similar. What is Yale’s time horizon? A century or more? GRS might want to fact check their authors while they are at it. Yale’s endowment is just shy of $24 billion, returned 20.2% in 2014, and “asset allocation” listed is the target not the true current allocation which is expected to earn a 6.3% real return over time – a number easily attainable with a solid,… Read more »

Financial Samurai
Financial Samurai
5 years ago
Reply to  Jon

Yale’s fiscal 2014 calendar year ends June, 2014. It’s been 7+ months since last june, and the S&P 500 is up over 5% since then. So it isn’t a stretch to say the AUM is about $25 billion vs. $23.9 billion in June 2014.

http://news.yale.edu/2014/09/24/investment-return-202-brings-yale-endowment-value-239-billion

Jon
Jon
5 years ago

It might be or it might not. What makes more sense — that Yale built their allocation model to track the S&P 500 or to diversify away from it? If Yale is dumb enough to build its allocation to track the S&P, then they’re spending hand over fist for a strategy they could get with a nearly free index fund. Care to comment on the rest of my points or is AUM all you got?

Harry
Harry
5 years ago
Reply to  Jon

Angry much? This is a great article that introduces new investment ideas that have never been discussed on GRS.

Understand fiscal calendar years too. The markets are up a lot from June 2014.

I was once jealous and close minded like you. But then I made an effort to learn more, grew my knowledge, and made some investments due to my knowledge.

If you are frustrated with your wealth, do something about it instead of nitpick on things.

Diane
Diane
5 years ago
Reply to  Harry

Come now Harry. Who is really trolling here. Jon made some valid points, but the author only addressed one. You didn’t add much to the discussion either. Fiscal calendar year doesn’t matter. The info in the post doesn’t fit with the link in the author’s reply. Someone with your proclaimed knowledge should have noticed the obvious discrepancy.

Jackie Chan
Jackie Chan
5 years ago

I’ve currently got about 15% of my investments allocated towards alternatives, and it has worked out fine. I have over $5 million in investments, and like to have a hedge. My investment horizon is 5 years.

Once you build your fortune, you want to protect it at all costs.

People who attack alternatives don’t invest in alternatives and don’t understand alternatives. Go to any private wealth manager (JPM Chase, GSAM, Citi Asset Mgmt) and they all have 10-30% alternative investment allocation.

Financial Samurai
Financial Samurai
5 years ago
Reply to  Jackie Chan

Jackie, congrats on your net worth growth. Principal protection is the biggest reason why so much money has flooded towards this asset group. I know a lot of people who have done well in the past 10-15 years with their investments. They aren’t looking for the 20% annual returns. 5%+ is just fine.

Jon
Jon
5 years ago

It might be or it might not. What makes more sense – that Yale built their allocation model to track the S&P 500 or to diversify away from it? If Yale is dumb enough to build its allocation to track the S&P, then they’re spending hand over fist for a strategy they could get with a nearly free index fund. Care to comment on the rest of my points or is AUM all you got?

Harry
Harry
5 years ago
Reply to  Jon

Are you a troll? Yale is not dumb. They grew their AUM from $3.5 billion to $25 billion in 20 years. Why are you so angry? Not everybody can get into Yale, only 6.5% acceptance rate. And not everybody can grow wealthy. If you are frustrated, do something about your situation.

Ace
Ace
5 years ago

I shuddered when I read that you moved out of the market after you had lost 30% of the value in your after-tax holdings. Way to lock in those losses! What a terrible decision! Why would you sell after such a huge drop? I thought this site was supposed to give people financial advice.

Financial Samurai
Financial Samurai
5 years ago
Reply to  Ace

Not sure how telling people in retrospect that I bought at the bottom is better financial advice.

But, if it helps, I did buy a property in SF after the dotcom burst for $580,000 and just got an offer for $1,025,000. I basically transferred some of my assets from the stock market and put $150,000 down on the condo instead. I figure, if I’m going to lose money, I better gain some utility out of it!

Thankfully, things turned out alright.

Harry
Harry
5 years ago

It’s so funny. Everybody like Ace thinks they are a genius in a bull market.

Frank
Frank
5 years ago

I like Sam and have read many good articles from his other site. I don’t mind the hedge fund review and his added personal comments. I think a more explicit cost-structure warning and a disclaimer of any conflicting interests may have been in order. I have a completely different complaint than others. I REALLY like “alternative investments!” I think they have a genuine place is a DIVERSIFIED portfolio, at least as the portfolio has grown to any size. Everybody and their brother talks about stocks and bonds and that is fine. Greater than 90% of all investing and personal finance… Read more »

TrixieLou
TrixieLou
5 years ago

an article by “Sam” – I would think a full name would be required to take someone’s advice seriously.

William Cowie
William Cowie
5 years ago
Reply to  TrixieLou

A quick Google of “financial samurai” should lay any fears to rest: Sam is someone who knows what he talks about, and well worth listening to. He is one of the most respected names in the personal finance space. Hey, if Madonna can get away with a single name… 🙂

Harry
Harry
5 years ago

This is a great article. Thanks for showing us what other investment alternatives are out there. This is why I love your site and your writing. You don’t write the same old stuff. You can’t grow your wealth without expanding your mind and knowledge.

It’s obviously Jon #7 is not wealthy, and will never be wealthy. He doesn’t even understand calendar years, and attacks other people to make up for his lack of wealth.

Nick @ Millionaires Giving Money
Nick @ Millionaires Giving Money
5 years ago

Hedge funds are now becoming more accessible as some of the newer financial sites are offering peer to peer hedge funds where you can buy a slice of the action for $10,000. I have not personally invested in Hedge Funds as I prefer the conservative approach of options. Thanks for sharing.

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