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Alternative Wealth is a podcast focused on advanced tax planning & wealth preservation for business owners, entrepreneurs, and high income earners hosted by Ryan Kolden. Weekly guest interviews, plus shorter deep-dive episodes about business planning, tax mitigation strategies, alternative investments, personal finance, and retirement strategies. Covering everything from private equity, venture capital, hedge funds, private credit, & real estate to tax-efficient exits & captive insurance corporations, privatized banking, and different retirement strategies.
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[Ryan Kolden ]: In the case of the world's largest financial institutions, they do have something that they're doing that the average retail investor is not. What these institutions are doing is investing in alternative assets. So this would mean that a major university endowment, somebody like Harvard or Yale, or a large family office might have 40% or more of its portfolio diversified across alternative assets, things like private equity, real estate, and private credit. Alternative assets, that's just simply a broad term for anything that doesn't fall within traditional forms of investing, things like the stock market, bonds, mutual funds, ETFs. Hey, welcome to the Alternative Wealth Podcast, where we discuss all things alternative investing, personal finance, and retirement strategies. I'm your host, Ryan Golden, and in today's episode, I'm going to be giving you a high-level overview of alternative investments, what they are, how they work, and why someone may want to consider them or add them to their portfolio. And I'm also going to discuss what this podcast is about, what you can expect from it. If you want to go ahead and access any of today's show notes, transcript, or video, you can get that at ryancolden.com and I'll include that link in the description. All right, let's go ahead and get started with today's episode. So the first thing that I want to briefly cover is what this podcast is all about. This podcast is going to be covering alternative wealth building strategies, everything from nontraditional investments little known personal and business finance strategies, as well as retirement. And my goal is to educate you on different tools that are available to you that you may have never heard about before. And that way you can make an informed decision with regards to your finances and your retirement. And here's what you can expect from podcasts. So every week we'll produce one podcast about alternative wealth strategies or do an update on the economy. And sometimes I'll be running these topics solo, and other times I'll bring in a topic-specific expert, somebody like an estate planning attorney, CPA, or asset manager, and interview them about a specific subject. And now that we've kind of got that out of the way, let's dive into today's topic, alternative investment. So the first question that we have to consider is why do we care about this at all? Why do we care about investments or investment strategy? So at the end of the day, most people. And dare I say, everybody is interested in preserving their wealth, multiplying it or using their wealth to generate income. And we're all searching for the highest returns with the lowest amount of risk. And as human beings, we're always looking at the most successful people and companies in the world and asking ourselves, what are they doing that I'm not. We believe that these successful people and companies have some kind of edge over us, or they have some kind of secret that they're not sharing with everybody else. And in the case of the world's largest financial institutions, they don't necessarily have a secret per se, but they do have something that they're doing that the average retail investor is not. And what these institutions are doing is investing in alternative assets, things that you and me, we simply just don't have access to with the normal Fidelity, Vanguard, E-Trade account. And so the next question we have to ask ourselves is, okay, these institutions, they're investing in things that we don't, but does it make a difference? And I do have some research here that actually says, yes, that these things do matter. And so the first thing that we need to talk about is the number one driver of a portfolio's return. And I'll include the link to these studies in the show notes, but these couple of studies confirmed that about 90 to 100% of the difference in return among investors is due to asset allocation. Now, asset allocation is the name for the process by which an individual investor figures out how much his or her assets should be put into things like stocks, bonds, cash, or other alternative assets. If we ask ourselves just to define what is an institutional investor, well, the broad term institution normally includes anything such as a pension fund, endowment, large corporations, foundations, and family office. And so alternative assets are generally the biggest differentiator between the asset allocation mixes of institutions and average investors. So this would mean that a major university endowment, somebody like Harvard or Yale, or a large family office might have 40% or more of its portfolio diversified across alternative assets, things like private equity, real estate, and private credit. Now I asked before, does it matter? Does investing in alternative assets matter? And so let's take a look at an example. So two studies looked at the investment returns of a defined benefit plan, which is a pension fund versus a 401k, which would be representative of a retail investor. And what these studies indicate is that pension funds on average have experienced annual returns that are about one to 2% higher than defined contribution plans. So 401k. And again, you can check out these studies in the show notes. And so what is the reason why these returns are different. And the reason for that is asset allocation, specifically alternative assets. That's really the only difference is asset allocation. And these pension funds are investing in things that the participants in the 401k cannot. And although 1% to 2% really doesn't sound like much, let's look at an example over a 30-year period. So take $100,000 as an example. And let's say we invested that for 30 years. Let's say that our average annual return was 7%. That $100,000 would grow to be $760,000. Now let's run the same example, but this time 1.5% higher return. So again, take $100,000, but this time instead of 7%, let's say we get 1.5% higher, so 8.5%. That same $100,000 would grow to be a little bit more than $1.1 million. So as you can see, A 1.5% difference, although it seems small, can make a huge impact on a portfolio's overall value, in this case, on the order of over $400,000. Now, I want to show you an example of one instance of an institution that's allocating their capital towards all-term investments. And again, I'll just make a blatant statement now for the rest of today's podcast that all the facts and figures that I'm talking about, you can find them in the show notes. But this particular figure is from the 2022 2023 BlackRock global family office report, and it's showing how family offices that we surveyed are allocating their capital. So in the United States and Canada. about 60% of family offices portfolio is allocated towards traditional investments. And these things would be like a public listed equity, cash and fixed income. Now the remaining 40% is allocated towards alternative asset classes. And we'll take a look at what the most common types of alternative assets that they're investing to is. So Just to briefly go over what exactly is an alternative asset, if you don't have a clear idea of what it is by now. Alternative assets are simply, that's just simply a broad term for anything that doesn't fall within traditional forms of investing. So things like the stock market, bonds, mutual funds, ETFs. So the different types of alternative assets, just to go over probably the most common, and there's a bunch, but private real estate, private equity, private lending and credit, infrastructure, venture capital, hedge funds. And then finally, some of the other just kind of catch all would be things like cryptocurrencies, precious metals, arts, collectible commodities, timber, and finally farmland. And that's there's there's tons of others just These are probably the most common that you'll run across. Now that we've defined what alternative assets are, how are these institutions allocating their capital across various alternative assets? So again, this figure that I'm looking at, again, comes from the 2022-2023 BlackRock Global Family Office report, and it's showing which alternative assets family offices are allocating their capital to. So the number one current alternative asset class allocation is global private equity with 83% of family offices allocating to this. The next is private equity funds, 75%, 68% would be net real estate and infrastructure. 63% real estate, 60% private debt and credit, 56% private equity and direct deals, basically direct investments, 53% hedge funds, 47% venture capital, 26% infrastructure, and 12% is other real assets such as timber and farmland. And now we also can't talk about alternative asset allocations without mentioning the Yale Endowment Funds. And this is something that I find particularly interesting So David Swenson, if you haven't heard of him, he was Yale's chief investment officer. He developed the Yale model, sometimes known as the endowment model, which consists of reducing Yale's endowment's dependence on traditional assets and reallocating that difference to alternative asset classes. And what I'm looking at right now is Yale's asset allocation from 2021. And he had the Yale endowment, I say he as in David Swenson, but About a quarter of their portfolio was dedicated to absolute return, which is a term that he coined as hedge funds, just to be a hedge fund replacement, and that you can basically get a return in all different types of markets and economies, followed by another quarter dedicated to venture capital. 17% to leverage buyouts, 10% to foreign equity, 10% to real estate. The real interesting thing here is he only had about 2.25% dedicated to domestic publicly listed equities. And so as an individual investor, do we really need to allocate to these types of investments? Why are these institutions doing it? And what are the pros and cons? And we're going to go ahead and answer those questions today to the best of our abilities. So the first thing that I really want to focus on is risk. And this is going to sound really boring, but I would ask, do you even know what risk means? So most people, most investors, they only are ever considered or concerned with how much return they're going to get, but they don't ever look at the risk that's associated with achieving those expected returns. And risk is not a feeling, it's a number. So simply put, it's the probability of loss weighted by the expected degree of that loss. And because risk is a number, it can be calculated. Now, the funny thing about risk is a lot of the times, individual investors, they try to manage that risk, and I'll talk about how they default to trying to manage that risk, but even when just evaluating risk, if an individual investor does do it, they on average default to an intuitive or qualitative feeling. You might describe yourself as conservative or an aggressive investor, but have you ever asked yourself what that actually means? What does it mean to be a conservative or aggressive investor? I know that I couldn't really put, you know, pinpoint what that, that, that means and how would we actually achieve that given risk profile? So when it comes to investing. Usually individual investors or just investors in general, they desire to reduce that perceived risk by attempting to directly control something or actively manage it despite not having any kind of knowledge when it comes to investing or operating that asset. And that could be things like real estate, stocks, or businesses. So rather than relying on an intuitive feeling or actively managing an asset with limited experience, risk really should be paid attention to. It should be calculated and evaluated. And when used properly, calculating risk can give you an accurate assessment of the quality of an investment or a portfolio. So failure to look at an investment's potential return without taking into account its offsetting measurable risk is almost navigating blind. And by being to proactively manage risk, you ultimately are able to maximize your expected return and limit downside losses when it comes to an investment or a portfolio. So I'm going to kind of just spoil it here and give you the bottom line, and then I'll dive into it a little bit deeper about what alternatives do. But ultimately, they can allow you to generate better risk adjusted performance than what is otherwise available through traditional markets. So let's go ahead and look at four reasons why individual investors may want to consider alternative assets. We just gave away reason number one, which is achieving better risk adjusted returns than what is otherwise available through public market. So to fully understand and appreciate what alternative assets have to offer, we first need to think about the composition of traditional portfolios. And here's a graph of a couple of very basic generic portfolio builds that I grabbed from Fidelity. And this is all based on Fidelity and Morningstar data. But here I am going to examine their conservative portfolio. which is composed of about 50% long-term bonds, 30% short-term bonds, 14% US equities, and 6% foreign stock. So if we look at the conservative portfolio, even though it's conservative, in its worst 12-month loss, it has a 17% reduction in its portfolio value, so almost 20% loss in a single year. And I also have their aggressive growth portfolio here, which its worst 12-month loss is over 50%. And so now that we've kind of looked at just two examples of traditional basic portfolios, I want to answer the question if the inclusion of alternative assets into an individual investor's portfolio allow for better outcomes. And so what kind of outcomes are we looking for? Are we able to construct a portfolio that minimizes downside volatility while achieving competitive returns, as well as a healthy income. So let's briefly discuss modern portfolio theory and how traditional and alternative assets fit into that picture. So hang with me for a minute. I promise you this will be worth your while. It's going to be boring, but it'll be worth your while. So the foundation of modern portfolio theory is to find the optimal portfolio for your given level of risk. There's something called an efficient frontier, which is a curve that graphically represents different combinations of portfolios that offer the maximum expected return for a given level of risk. And specifically, these returns are dependent on asset allocation mixes that make up the portfolio. In this, just to give you a very brief example with traditional investments, I can get the highest level of expected return if I'm in a 100% equity portfolio. However, I'm also going to have the highest level of expected risk compared to if I was in something like a 100% short-term bond or a long-term bond where I can have a lower expected return with a lower level of risk. Now, With all of this in mind, how does alternative assets affect this efficient frontier? So again, I have a figure that I'm looking at here available for you in the show notes. It's figure five. And this shows that the addition of alternative investments in a portfolio moves the efficient frontier up into the left. So I'll go ahead and explain that here. And what that means is for a given level of risk, alternative assets can potentially increase the maximum expected return. A different way to think about it is for the same level of return of an investment or a traditional portfolio, the use of alternative assets can reduce the given level of risk that an investor takes on. Now, there's a ton of different alternative assets, each with its own respective characteristics. As an example, some are geared more towards generating income. Some are better at preserving capital. Some are better at capital appreciation. But I just want to give you one example of better risk-adjusted performance. So take, for example, private equity. And on average, according to this study, which was done by KKR, has generated an average excess return of 430 basis points versus public equity. So 4.3% higher on average than public equities. Now, I also have another graph here, which basically shows the same thing, but instead of being done by KKR and just evaluating KKR investments versus a public benchmark, this is actually showing private equity outperformance compared to public equity in US state pension funds for a 20 year period. And it's 21 different state pension funds. and their private equity investments relative to the S&P 500. And what these pension funds did on average is they outperformed their S&P 500 benchmark by about 480 basis points. So almost right on par with that first study. So again, this is just one specific or two specific instances of showing a specific asset class relative to traditional markets. And why does this occur? Well, in general, private markets are less efficient than traditional markets, which provides investors the ability to exploit private market inefficiencies through active management. Now, by no way am I saying that traditional investments don't work. Traditional investments absolutely work. However, they may not be the only path to get you to where you want with regards to your financial future. And so the inclusion of institutional grade private alternative assets can allow individual investors to generate better risk adjusted performance than what is otherwise available through traditional public markets. So the second reason why alternative assets may be something worth looking into is due to their ability to preserve capital, reduce and reduce volatility. I just want to give you one kind of example here, and that's a look at the S&P 500 versus housing or real estate. Back in 2008, after Lehman Brothers collapsed, the S&P 500 fell over 34% in a single year. In comparison, at the same timeframe, it took the real estate market a significantly longer period to draw down to an equivalent level. It took almost six years for home prices to fall to a comparable level of the S&P 500's drawdown of about 30%. And so an important feature to point out with the alternative assets is its ability to preserve capital and reduce volatility. And the reason that private assets or alternative assets do this is really because there's no secondary market that's available for daily price fluctuations to occur. And I'll talk about that in a little bit more detail near the end when I talk about lockup periods and illiquidity. Some people think that this specific feature is a benefit and others think that it's a con. My personal opinion is for most investors, I feel like it's a benefit to have a lockup of liquidity. It just depends on your individual financial situation. But again, basically because there's no secondary market. These private investments are not going to fluctuate on a daily basis. They might only be traded every quarter. Sometimes they might only be traded annually. And because of that, there's no, uh, there's, there's a lot more inefficiencies in price movements. And because of that, you might only see the price change every quarter or annually. I think that has a real psychological benefit for most investors who can't withstand seeing their accounts go up and down on an individual basis. So the next reason why somebody might want to consider alternative assets is the potential for higher income generation. So incorporating things like private credit can increase the income yield potential of a portfolio while allowing for adequate levels of liquidity. Because sometimes you have a trade-off. You might have a higher yield, but what you're giving up is liquidity. There are plenty of alternative assets where you can achieve a decent level of liquidity while still having a competitive yield. And there's many private credit asset classes that offer yields that are well above the 10-year treasury. And these would include things like direct lending, real estate lending, and structured credit. And one of the most attractive features of private credit can be control or the manner in which you invest in downside protection that's provided Take, for example, we look back at our example of the S&P 500 and the housing prices during the collapse of Lehman Brothers. So let's say that you look at that 30% decline in the real estate value and you say, I don't want that to happen or I can't let that occur. So rather than buying real estate, an individual investor can lend against it instead, which offers that investor exposure to collateral-based cash flows, meaning your principal is backed by a real asset. A fourth reason why someone may want to include alternative assets in their portfolio is due to risk management and inflation hedging. Alternative assets have the potential to offer individual investors an inflation hedge by investing in real assets that have a negative correlation to traditional assets, and that can also do well in rising inflationary environments. And another type of measurable risk is the loss of investment returns due to inflation or the loss of purchasing power. So you'll commonly hear in the finance industry, it's accepted that the current nominal yield of the 10-year treasury represents the risk-free rate of return. The problem with this, however, is that the risk-free rate after accounting for inflation is very minimal at best. And in some cases, it's negative just depending on what time period you look at. Another way to think about this is that inflation completely eliminates the real return of U.S. treasuries. And it doesn't account for that there's actually risk in holding U.S. bonds as current fiscal policies threaten the stability of the U.S. dollar. Now, I have here a figure 10 that I'm looking at, which shows the 10-year treasury overtime index for inflation. And by no means am I advocating against U.S. treasuries. I'm just pointing out the risks associated with them. And if used, they should be part of your unique financial plan. As an example of an inflation hedge, real estate has historically outperformed US treasuries in times of elevated inflation. And particularly as interest rates normalize, real estate has the ability to deliver inflation hedging diversification as well as tax benefits while being able to deliver consistent income all along the way. Now, what are some considerations for alternative assets? Because we can't talk about the pros without discussing the cons. Alternative assets are not for everybody and they do come with some significant disadvantages that you do need to be aware of. So the first thing I want to talk about is less liquidity and lockup period. So as I pointed out earlier, one of the benefits of private assets is that they generally are not traded in the secondary market, which causes transactional friction and slows the price movement down. Because alternatives are removed from daily price movements, their value can either increase or decrease very slowly, usually over the span of several months. While some may see this as a benefit, and again, that's the camp that I'm in, and the reason for this is because people prefer not seeing their investments valuate, fluctuate wildly from day to day. It's a psychological benefit. A lot of other people may consider it to be a downside of Alternative just because they may need access to that money. Now, because of this transactional price friction, as well as the time required to earn a return on the strategy, fund managers normally have longer lock-up periods. And normally this can be anywhere between 12 to 24 months. longer lockup periods, what that means is shares or interest of that alternative asset may not be able to be redeemed or sold on a daily basis. If you compare that to publicly traded securities, you can basically buy and redeem securities in the same day. And not all alternative assets have a 12 month lockup period. There are many private REITs and private credit funds that offer their investors the ability to redeem shares on a quarterly basis. And on the other end of that spectrum, sometimes there's funds that have lockup periods with as much as 12, 24, and 36 months. So liquidity and lockup periods is something that should be taken very seriously before you consider an alternative asset. The next thing that you should consider is transparency and manager performance. The illiquid nature of most alternatives makes it more difficult to get a solid valuation. That's as clearly defined as a publicly traded stock or bond. This doesn't mean that these investments are lesser in value or more volatile. However, it's just merely more challenging to get a real-time assessment of their appreciation or depreciation. Additionally, private funds are generally less transparent than public market assets. Alternative assets are still going to be subject to abiding by federal security laws and guidelines. However, fund reporting is not nearly as accessible compared to publicly listed securities. And then the last piece that I want to mention is the better risk adjusted performance that comes from alternative assets is due to active management. Therefore, careful consideration must be made to the fund manager of the alternative asset that you're selecting. And this is really a two-sided coin because above market performance can be achieved through either stellar or proper manager selection. And subpar performance can be experienced if due to poor or inexperienced manager selection, or maybe you have a good manager that just had a bad run. So it's highly dependent on manager performance. And that's ultimately why we're able to get returns above the market is really just through active management, which is exploiting private market inefficiencies. Who should be considering alternative assets or who may want to consider them? Anybody who wants to diversify their portfolio across a broader range of alternative assets in order to achieve better risk-adjusted turns, minimize their downside volatility, and increase income yields. Anybody seeking to control their investment decisions and knows that the traditional market investments are not their only option, and individuals desiring access to assets previously only available to institutional investors or high net worth individuals. And there's a last caveat here, would be individuals who are looking to have a tax efficient investment. Just depending on what kind of investment, alternative investment that you're selecting, as an example, a real estate fund could, I'm not saying it will, could have tax benefits to where as your As you pull income from that fund throughout the year, at the end of the year, when you receive, you'll receive a K-1, and that K-1 will have depreciation passed upon it. So people always talk about real estate being awesome because of its tax benefits. Again, just depending on the funds and how they operate, some of the funds issue 1099, some of the funds may issue you a K-1, and you can basically depreciate that. basically take depreciation against that income, which is really a benefit for high income professionals and accredited investors who are looking for ways to access tax efficient investments but can't necessarily make contributions to 401k or maybe they're maxing out or maybe they don't have the ability to contribute to a Roth based on their income limit. So understanding how family offices, endowments, financial institutions, and ultra high net worth investors allocate their capital can help us get better insights into how individual investors can develop an alternative asset portfolio strategy. All right, I think it's time to wrap up. If you have any questions, please feel free to reach out to me. And if not, take care and I'll talk to you next time. Thank you for listening to the Alternative Wealth Podcast. Today's show notes and resources are available to you at RyanColden.com. If you liked this episode, make sure you subscribe and leave a review. The opinions and views expressed here are for informational purposes only and does not tax legal financial investment or accounting advice. This material is educational in nature and should not be deemed as solicitation of any specific product or service. All investments involve risk and have potential for a loss of principal. Should you need such advice, please consult with a licensed financial, tax, or legal professional. Neither host nor guest can be held responsible for any direct or incidental loss incurred by applying any of the information offered.