282 | Do You Really Need Alternative Investments As Your Net Worth Grows?

[00:00:34] Hilary Hendershott: Well, hey there, Money Lover. Today we’re diving into a topic that’s been buzzing around the financial world for quite some time now, and that is alternative investments.

[00:00:42] So, I know that might sound like a fancy term to some of you, and some of you listening already have opinions, or maybe some of you listening are already invested in alternative investments. Whatever that is, stick with me because we’re going to break it down today, and I’m also going to share why we at Hendershott Wealth Management almost never use alternatives in our client accounts.

[00:01:04] So, what exactly are alternative investments? Well, they include just about everything other than publicly-traded stocks, bonds, and the products that package or bundle stocks and bonds, those being mutual funds and ETFs, for the most part. We’re talking about things like private limited partnerships, managed futures, angel investments, hedge funds, private equity, venture capital, even fine art, and cryptocurrencies.

[00:01:31] One thing alternative investments definitely have going for themselves is really simple, and it’s a really strong marketing strategy and an exclusive brand reputation that, in my experience, gives some investors forbidden fruit syndrome that makes them want it. It seems like a foregone conclusion that the more wealth you have, the more alternative investments you should also have. So, similar to how luxury brands like Louis Vuitton and Cartier can seem to go hand in hand with being wealthy. So, people think: The more money you have, the more you need both alternative investments AND $5,000 bags.

[00:02:10] Over the last 15 years or so, alternatives have really made their way into the common lexicon and I think their acceptance–because I actually have been in the industry the whole time alternatives have been rolling out to the mass investor public–I think their acceptance is due to two phenomena that happened mostly at the same time.

[00:02:30] First: a few investment managers – David Swenson at the Yale Endowment being one of them – made themselves famous managing billion-dollar endowments and published about how they produced outsized returns–they beat indexes while they did–with alternative investments that were selected and managed by VERY well pedigreed and well compensated teams.

[00:02:54] The second is that there are quite a few types of alternatives – almost no one is an expert on all of them – and you’d need a master’s degree to understand most of them. So, people just started buying into them without really understanding them. Wall Street sunk their teeth into this misunderstanding, which led to a marketing opportunity, and now more and more investors are compelled by the siren song of alts. Alts, by the way, is short for alternatives.

[00:03:22] So, Wall Street investment firms (and even these days, non-Wall Street investment firms) are getting on the bandwagon, started marketing them as exclusive wealth-building opportunities for high-net-worth investors. Alts usually come with the promise of high returns, risk reduction, and portfolio diversification. Sounds pretty good, right?

[00:03:40] But is this marketing hype or solid financial strategy?

[00:03:44] As a financial advisor who’s had this conversation many times, I’m here to tell you why these alternatives might NOT be the golden ticket they’re often marketed to be.

[00:03:54] First, we’re going to talk about the most important characteristic of an investment, and that is returns.

[00:04:01] So, alternative investments can earn high returns–but the real question is whether you, as an individual investor, can stomach the fees that those returns require. Because I’ve seen some of the bills, and let me tell you, they are not for the faint of heart.

[00:04:18] Many hedge funds and most private equity firms use what’s called a “2 and 20” fee structure, which includes a 2% annual management fee and 20% of profits taken by fund managers. And sometimes those fees are even higher!

[00:04:31] High fees significantly reduce investor returns, especially compared to a low-cost globally diversified index portfolio, which typically charge around one-tenth the fees that I just quoted you.

[00:04:44] So, how might that apply to you? Well, here’s a little math. If you invested $10 million in a hedge fund, charging 2% and 20%, you would pay $200,000 per year in fees plus 20% of profits, and I bet they don’t give you a refund if the fund loses money. If you invest $10 million in a low-cost index fund at, say, 0.26%, you’d pay $26,000 per year and keep all of your profits.

[00:05:13] So, even if an alternative fund’s investments outperform the general market, high fees often erode most or all of the extra returns.

[00:05:23] So you’re thinking, okay, Hilary, but what about access to the wealth I’m building? And the thing I think most investors don’t really grapple with is a characteristic of your investment called liquidity. Basically, can you get access to your funds? And investors who want the high promised returns of alternatives when they’re making the investment are willing to say, “Yeah, I’ll sign up for five or seven or ten years of lack of access to my funds.” Again, that’s called liquidity in the investment.

[00:05:53] But then you’re five or seven or eight or nine years in, and what happens if you need that money? And that really is another major strike against alts. Almost all alternative investments require you to keep your money locked up. That means you can’t even access your capital if you need it. Here’s just a few examples.

[00:06:13] Private equity and venture capital often have 10 and greater year lockup periods. Hedge funds might limit withdrawals or impose exit penalties. Fine art, real estate, and private deals can be difficult; sometimes impossible to sell. I mean, imagine owning an investment and not being able to sell it. Like, it doesn’t even have a stated illiquidity period. It’s just like, “can’t sell it, don’t know when you will be able to.” And this happens in the category of investments called alternatives.

[00:06:43] If you need liquidity for life, changes, opportunities, or emergencies, which I always make sure my clients can access their money for those reasons, alternative investments can create real problems for you.

[00:06:56] I’m not sure if you’re familiar with the investment writer, Jason Zweig, but he recently commented on this in his own scathing review of alts in The Wall Street Journal, where he called out the fact that–and I quote–”When publicly traded stocks and bonds fall, you’d want to sell some of your alternatives so you can rebalance, or restore your stakes in all your holdings to your preset target levels. But unfortunately, while some alternative funds may allow you to buy daily or monthly, you generally can sell only at specific times–say once a quarter. And the fund can limit redemptions.”

[00:07:33] That is not something I’d want you to have to count on.

[00:07:37] Clearly, when you’re making the investment, you’re not thinking, “Oh, I’m going to need to access a quarter or half of this money because I’m going to have some life emergency,” but these things do come up. I’ve seen it. And so, lack of liquidity is something I’m really wary of, both for myself and my clients.

[00:07:51] Next, let’s talk about an issue we take very seriously when it comes to investing and financial management, and that is transparency.

[00:08:00] So, publicly traded investments are subject to really strict reporting requirements. Those reporting requirements give you, the public, the investor, a clear picture of their value on a daily and, in the case of the stock market, even up-to-the-minute basis, assuming the stock market is trading that day. Alternatives are not subject to these requirements.

[00:08:20] Private companies often–I say often but really it’s almost always–lack transparency, and the valuations of things like fine art can be incredibly subjective, and of course are subject to significant market volatility or business cycle volatility. And that opacity or lack of transparency makes it sometimes really difficult to know the value of your holdings.

[00:08:44] To quote Mr. Zweig again, “With alternative funds valuing their holdings outside the public spotlight and those underlying assets not trading in liquid markets, financial advisors telling investors that alternatives have ‘lower volatility’ than publicly traded investments isn’t like comparing apples and oranges–it’s like comparing apples and asteroids.” And this is why I’ve never been comfortable telling anyone, especially my clients, that alternatives have lower volatility because it’s kind of fake.

[00:09:15] I mean, during the COVID-19 market crash, the S&P 500 fell over 30%, yet many private equity and venture capital funds reported almost no losses, like minimal losses.

[00:09:26] So, were those investments really immune to the pandemic? Probably not.

[00:09:32] Lack of transparency also tends to leave the door wide open for fraud–in broad daylight.

[00:09:39] Everyone listening has heard Bernie Madoff’s name, right?

[00:09:41] Madoff was really well respected on Wall Street. He’s a former Chairman of NASDAQ, yet he managed to steal billions of dollars from his investors over a few decades in a $65 billion hedge fund Ponzi scheme.

[00:09:54] More recently than that, Sam Bankman-Fried, founder of the cryptocurrency exchange, FTX, and the cryptocurrency trading firm, Alameda Research, misappropriated billions of dollars of customer funds deposited with FTX and–this is straight from the Department of Justice’s press release announcing his 25-year prison sentence–he defrauded investors in FTX of more than $1.7 billion, and defrauded lenders to Alameda of more than $1.3 billion.

[00:10:22] Another example, maybe lesser known to you but significant nonetheless, a company called Knoedler & Co. This was a New York City art gallery that opened before the Metropolitan Museum of Art was founded (in fact, before California became a state) and knowingly sold $80 million of forged art to collectors.

[00:10:42] So, let’s just say the fact that all these professionals and institutions were at one time considered leaders, again well respected, was very little solace to their defrauded investors – and fraud is even more common in smaller groups of investment, like alternative investment professionals.

[00:10:58] So, high fees, liquidity risks, and predisposition to fraud aside, what can I say about the performance of alternative investments?

[00:11:08] Again, alts are marketed as exclusive wealth building opportunities for high net worth investors with one of the biggest promises being that of high returns. And those are supposedly returns average investors whose account sizes don’t quite qualify can’t get access to, right? So, “Hilary, I’m earning more money. I’m saving more money. I went through an IPO. I sold a business. I got massive wealth now. Now, I really need alts.”

[00:11:34] But here’s the deal. Even large institutions with massive resources tend to underperform when they focus on alternatives compared to simple, low-cost index investing.

[00:11:47] To evidence that, let’s look at a case study comparing the Teacher Retirement System of Texas (TRS) with the Public Employees’ Retirement System of Nevada (PERS).

[00:12:01] In the case of the Texas TRS, which manages $240 billion, its well-respected investing team takes an active approach, and they include hedge funds, private equity, and other alternative investments.

[00:12:13] Over the past 10 years, Texas’s TRS returned 7.2% annually. Meanwhile, Nevada’s PERS, which manages $58 billion, used only low-cost index funds with no alternative investments. Over the past 10 years, Nevada’s PERS returned 9.1% annually, which outperformed even the Harvard Endowment Fund.

[00:12:42] That might not sound like much, but 1.9% of additional returns over 20 years of employment is a significant dollar amount.

[00:12:50] To make that real for you, let’s just say you’re an employee of a company for 20 years and you’re contributing to the 401(k) plan. That extra 1.9% of annual return inside your account would be the difference between your $1 of savings turning into $4 and $1 of your savings turning into $5.39. That delta between $4 and $5.39 gives you one-third higher retirement income. That’s real money.

[00:13:16] As for reducing risk, the Texas TRS’s lower returns don’t reflect lower risk either. The fund’s annual returns over the past decade are slightly more volatile than Nevada’s PERS.

[00:13:28] All this makes a curious investor wonder, if a well-funded institution with teams of analysts and billions of dollars can’t beat index investing or reduce risk with alternatives, why would individuals be able to do better?

[00:13:42] And the answer is they typically can’t, and they typically don’t, which explains why when I see 20-somethings teaching stock options trading, I cringe and I shake my head. This is just a certain batch of overconfident young people who think there’s something their elders don’t understand about the stock market.

[00:14:01] Finally, let’s talk about some straight-up failures of alts.

[00:14:04] These stories are anecdotal, they come from my personal/professional experience, and they actually changed my life if you can believe that.

[00:14:11] See, before I founded Hendershott Wealth Management, of course, I worked for other financial advisors. I was an employee and I was learning the business. And in one role, we worked heavily with alternatives.

[00:14:22] Here are some examples of the failures I saw happen, and that turned me away from, or you could say against, using alternatives in client portfolios.

[00:14:34] First, there was an angel investment with a very high-end artist. You have probably heard of this person’s primary competitor. This was the kind of art they sell for tens of thousands of dollars in luxury malls and other very high traffic areas. This art was gorgeous, we invested client monies into it, we were purchasing the art for ourselves and saying it was going to go up in value, the whole 9, we were all in.

[00:14:56] Long story short, the artist invested millions into a very expensive reno of a retail space in a major metropolis, and sales just dried up. That new space was so expensive and the renovation was so expensive, they went out of business. All of the investment dollars disappeared as angel investments often do, but then the advisor, my boss at the time, got stuck in litigation with one of the other investors about something he had said about the investment in like a public sort of front-of-the-room type of presentation. And it cost him, my boss, almost a million dollars of his personal money to finally complete that litigation. So, obviously, I’m being vague about the details, but the point is that getting sued was not on my boss’s list of risks he thought he needed to worry about. The whole experience was devastating for my boss. It cost him a million dollars of his retirement.

[00:15:54] Next, there was a managed futures fund – and these are futures, just like in the movie Trading Places with Eddie Murphy back in the 80s. If you saw that movie, you definitely remember Mortimer and Randolph talking about how they were trading orange juice and pork belly futures. These are the same kind of futures. Okay? And in this case, a particular investment fund or firm had bundled 12 different futures fund managers. Sometimes the word futures is used interchangeably with options, but it doesn’t matter. Basically, there’s 12 managers managing this thing where you’re essentially gambling. You’re doing everything on margin.

[00:16:30] So, unfortunately, and it could be rare, it could be frequent, but entire accounts can evaporate in one trade. I’m being a little exagg. It takes it like a day, right? But it happens fast. So, the idea behind bundling 12 of them was that the 12 provided diversification and lowered risk. Unfortunately, though, trading futures, like I said, is really risky and it’s really unforgiving, and a full half of those managers just made stupid mistakes after years of mediocre returns, and our clients lost HALF their money. So, they invested $100, they only got back $50. And that was painful.

[00:17:08] Even more painful, there was an angel investment into a medical device firm that actually did go big, and venture capital got involved. So, these VCs, they know what they’re doing and they have a lot of power when they negotiate the contracts and they’re not really interested in paying out their profits to angel investors who provided seed funding to the company, so their contracts do this thing to the initial investors that we call “cramming them down”. So, our investments, our angel investments got pretty darn crammed down and what would’ve been a 100x payout, and that is close to what it was for the VCs, turned into our clients just simply receiving a return of their capital. So, zero returns. And that’s negative real returns, though, because they gave up their money for a couple of years when they could have done a million other things with it, right, to grow it.

[00:18:00] Next, there was the time the custodian’s CEO stole client monies out of their accounts, like the Sam Bankman-Fried example I used earlier. So, in this case, the angel investment didn’t have negative returns, but it didn’t matter because our clients got robbed! The big, reputable custodians, like Vanguard, Schwab, and Fidelity often won’t custody alternatives so you have to use lesser known ones, and unfortunately, this particular manager selected, had a criminal for a CEO. I’m laughing. I shouldn’t laugh. I was literally in tears at the time. It was one of the more painful and growing experiences of my life. I believe this one was the end of the road for me in terms of alternatives. I said, I’m never having this experience again.

[00:18:44] After I’ve shared all this, you can understand why I would make a decision like that.

[00:18:48] And most financial advisors know this about alternatives, but they also want to keep their clients. And those clients got interested in alternatives for all the reasons I mentioned at the beginning of this episode. So, they offer them anyway.

[00:22:17] Last fall, I was at a conference of financial advisors and we were just standing around the room watching a presentation about alternative investments that are now being offered for advisors like myself to select from for our clients. The firm that I use for that purpose used to not offer alternatives, but now, more and more they do. So, I said to a fellow financial advisor, something like, “It’s really disappointing that they’re bending to the masses here. I get that as a company grows, they lose their niche, and they have more people to please, but I have zero interest in alternatives, and I’m pretty sure these folks who are giving the presentations don’t trust them or use them in their own accounts.” And the other financial advisor said, “Yeah, I’m just like scratching my head here. It’s like, I’ve seen how this story plays out and no, thank you.”

[00:19:49] So, it really is kind of well known in the industry for advisors who have been around for a few years.

[00:19:56] So, these experiences led me to develop a professional philosophy that I hold strong to today, and that is this: I will never ever, not ever, participate in or recommend to a client–really, I just won’t go anywhere near–an investment strategy that could potentially end up with the investment going to zero. I do not accept default risk. I do not accept the possibility that my client will get stolen from by their custodian. I will never ever again in my life sit down with a client and tell them that their money is gone.

[00:20:30] So, does that mean I’m cautious? Absolutely. Does it mean I’m not an early adopter when it comes to investments? It does. Does it mean I’m not interested in crypto and therefore, there are a few people out there who will make more money in some time periods than I will? It does. It definitely does, and I’ve said that publicly before. But it also means that no one on my watch will lose 100% of their hard-earned savings. No accounts on my watch will end up empty. Of course, nobody is publishing returns for the universe of crypto investors, but plenty of those folks lose all of their money when their cryptocurrency busts, when they lose their encryption keys, when the North Koreans hack their crypto wallets. This actually happened to a friend of mine. I’m willing to give up some potential upside to completely avoid, in my opinion, the worst potential downside. When I go to the casino and I put my money on the table, I expect that some of the time, it will go to zero. But when I put my money in an investment account, I expect it will absolutely not.

[00:21:36] Also, and I think I’ve said this on the show before, but nobody ever sued anybody for owning a mutual fund or an ETF. Avoiding alternatives keeps things calm, peaceful, elegant, and evidence-based. Your money should be boring, so your life can be exciting, right?

[00:21:53] So, with all that being said, why all the hype around alternative investments?

[00:21:59] In one line: It’s a triumph of hope over experience.

[00:22:02] While alternatives can provide great risk-adjusted returns, there’s no compelling evidence that they consistently do. Access to the best alternative investment opportunities is rare and hard to accomplish, and given how long many alternatives lock up your money, you could be stuck with a mistake for a decade or more.

[00:22:22] At Hendershott Wealth Management, we prioritize investment strategies for our clients that are:

1. Cost effective – No unnecessary fees eating away at your returns
2. Transparent – You should always know what you own and what it’s valued at
3. Globally diversified – For risk mitigation and long-term sustainable growth
4. Evidence-based – That means it has decades of research backing our approach
5. Tax efficient – We proactively stay tax aware so we can plan to keep more of your hard-earned money in your accounts

[00:23:04] The actual experience of holding alternative investments–given illiquidity, lack of transparency, risk of loss of principle, and potential fraud–just is not conducive to the kind of elegance, simplicity, and true peace of mind my team and I always pursue for our clients.

[00:23:22] Instead, we focus on strategies that are backed by decades of academic research, regulatory oversight, and a clear, risk-managed approach to wealth building–ensuring your financial future is built on a solid foundation, not on speculative trends.

[00:23:38] So, final verdict: Are alternative investments worth it?

[00:23:41] I think, if you’ve listened, you already know my answer, but we’re going to go through this. For most investors, alternative investments introduce unnecessary risk, high fees, and liquidity challenges–without providing their well-marketed, but oft-unachieved higher returns. The data–and my entire career of experience–suggest (strongly) that a well-diversified, low-cost portfolio offers a more reliable path to long-term financial security than speculative alternatives.

[00:24:10] The facts and examples I’ve shared with you today about alternatives could lead you to think that I reject all alternative investments out of hand. And I don’t. Alternatives is a big category, right? So, inside that category, there are investment opportunities with a vast array of characteristics, and some of them are good. If you’ve been listening to this podcast for a while, you know that years ago, I interviewed my husband on the show and he talked about the hedge fund he was running. So, my literal HUSBAND ran an alternatives fund! Though probably 95% of alternatives are, in my opinion, a very bad idea, there are still some very smart and savvy investment managers out there. But you should know that when I’m considering alternatives, the list of questions I start with are some of the following:

1. Are the fees justified?
2. Can my investors both stomach and afford to lock up their capital for years if that’s required?
3. Is there real transparency in both valuation and risk?
4. Would a diversified, low-cost portfolio achieve the same or better returns?

[00:25:20] My team and I don’t at all subscribe to the idea that alts are a necessary part of an investor’s growing financial ecosystem, so we’re really selective and you definitely want to be as well.

[00:25:31] If you want an objective opinion on your investment strategy, visit hendershottwealth.com/contact to schedule a complimentary consultation with us today.

[00:25:42] While we don’t generally endorse alts, my team does have the knowledge and expertise to evaluate specific alternative investment opportunities should they become available to our clients.

[00:25:52] Actually, my formerly-a-hedge-fund-manager husband is now my firm’s Chief Investment Officer and he’s bringing more than 25 years of building very profitable alternative investment funds to the table.

[00:26:04] And we do offer a new-to-market service, it’s called Ultra Tax Efficient Wealth Management^SM, which isn’t technically an alternative investment based on the explanation in this episode, but it does offer a different approach to portfolio management that has the potential to save suitable investors 7 or even 8 figures–that’s real–in capital gains taxes without sacrificing growth or liquidity. If you want to learn more about this service, check out episodes   because in those, we do a deep dive into these tax efficient investing strategies.

[00:26:43] The bottom line is: We all want to live in a world where everyone is thriving–and based on the evidence, the most reliable path to financial security and freedom is a well-built, data-driven investment approach and globally diversified portfolios, like the ones my team and I build for ourselves and all of our clients.

[00:27:02] Thank you, as always, for tuning in today. If you have questions, I want to hear them. Email me at hello@hendershottwealth.com. My team and I, it’s true, we love hearing from you. And again, if you want an objective opinion on your investment strategy or to learn more about working with a firm who prioritizes elegance, simplicity, and true peace of mind for your financial future, schedule a complimentary initial call with us at hendershottwealth.com/contact.

[00:27:32] Until the next time, keep on loving your money so it can love you back!