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What Are Alternative Investments And Should I Own Them In My Portfolio?

True diversification means more than just owning stocks and bonds. Jared Kizer explains common alternative investments, and how incorporating them can impact your overall allocation strategy.

Transcript

Tim Maurer:
Tim Maurer, back with another episode of Ask Buckingham, a new video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today’s question will be answered by Jared Kizer, Chief Investment Officer of Buckingham Wealth Partners. Jared, what type of investments are alternatives, or alts, and should I consider owning them in my portfolio?

Jared Kizer:
Yeah, alternatives, it again can quickly get complicated. But I think of alternatives as, what it’s trying to be is something that behaves differently from the stock and fixed income investments that most people are familiar with, and that are always going to be the bedrocks of the totality of most of the portfolios.

Jared Kizer:
So where it gets complicated, though, is that means it can refer to lots of different things under that umbrella. It could be commodities, it could be private equity, it could be things that are in hedge fund type structures and any number of other areas. So when you think about getting to the answer of can they make sense? Really it’s unavoidable to say, well, let’s talk about what type of alternative strategy are we actually talking about here because it’s such a big umbrella, their potential strategies.

Jared Kizer:
I would say, when we’ve thought about that, the way that I like to explain our history of with alternatives is that historically we’ve been very skeptical broadly because expenses have tended to be extremely high, meaning the investment expenses that the clients were paying. Then when you looked at the academic evidence of all alternatives, it was very mixed to be generous. In terms of in general, have there been benefits there outside of maybe a handful of endowments? The results were very mixed in terms of what the benefits were, particularly because of expense levels.

Jared Kizer:
As we’ve continued to look at it, though, I think there have been a handful of positive developments with some alternative strategies. You’ve seen expenses come down from, if you can even believe this, the 3-5% per year expense range down to 1-2% and can still be a struggle to mentally process even expenses that high. But we’ve come to believe that there are some strategies at those expense levels … that all those expenses are higher than stock and bond fund expenses … can add some value at those expense levels. So there have been some positive developments around the expense front that we would say in some specific alternative strategies could make sense to include in a diversified portfolio.

Tim Maurer:
So am I hearing you correctly, Jared, that if we look at stocks and bonds as the two primary types of securities that most of us are familiar with as investors, alternatives is basically everything else? Is that an oversimplification?

Jared Kizer:
I think that’s the right way to start the conversation in terms of if somebody is trying to understand, well, what does it even mean? Well, the reason there is this third category is it’s really meant to be that umbrella for everything else. Now again, where that’s not terribly helpful is it means that it does cover an extremely expansive set of strategy. So when you get to does this make sense to implement, you’ve got to get much deeper and start talking about specific individual strategies within that bucket because they of course have their own distinct properties and potential benefits or not to a portfolio. But yeah, when I think if you’re starting the conversation at the highest level, I think that’s where you mentally wanted to start in terms of and then dig deeper into specific strategies that you might actually consider implementing.

Tim Maurer:
Okay. Well you mentioned one of the big disadvantages at least historically has been higher than average expense ratios. Are there any other disadvantages that you would point to that seem to be common in the asset class of alternatives?

Jared Kizer:
Yeah, I think this gets yet to your implementation questions. Does it make sense questions. Because there are things like there’s more complexity. So there are absolutely almost certainly going to be strategies that if you implement them, understanding why they’re doing what they did is going to be a lot more complex than knowing, okay, stocks went up or stocks went down or interest rates went up or interest rates went down. So, that definitely sticks out.

Jared Kizer:
Now again, we’re in the camp where we’d say that doesn’t necessarily invalidate it, but it is something to understand. There is that additional level of complexity. And then the other one that I think of that is very consistently true across the alternative space is generally they aren’t terribly tax efficient. So if you’re going to own them, you typically will want to try to shelter them in a tax advantage account because they don’t tend to be certainly nowhere near as tax efficient as a well diversified stock fund portfolio.

Tim Maurer:
Okay. Well, let’s talk a little bit about liquidity. How easy is it to get in and out of alternatives?

Jared Kizer:
Yep. So two different ends of the spectrum. There is a side of the spectrum called liquid alternatives, which are basically daily liquid. In the same way that you could … You would never want to do this, but you could buy and sell a mutual fund or ETF on a very efficient quick basis. There are lots of alternative strategies that are exactly that way as well.

Jared Kizer:
Then you get to the other end of the spectrum which would be less liquid and you get into structures like an interval fund structure, which is probably not a name that a lot of people are familiar with, but it is a way, it is a type of structure, like a mutual fund, but less liquidity, typically quarterly liquidity features. And there’s more detail that we could go into there, but essentially, not nearly as liquid as a daily liquid mutual fund.

Jared Kizer:
So those are the two ends of the spectrum that we think about and strategies can fit in one of those two areas from a liquidity perspective. So yeah, liquidity is absolutely something to understand and think about with some alternative strategies.

Tim Maurer:
Okay. Well having considered the disadvantages. Let’s talk a little bit about more of advantages to owning alternatives. What are compelling reasons for you to consider recommending them?

Jared Kizer:
Yep. So when I think about this, I think that the first thing you want to think about is are there alternative strategies that we expect that behave a lot differently from the stock market? Meaning can they diversify the stock market side of the portfolio or can they have a forward looking return expectations above of what we expect from fixed income. And I think there are strategies that can check either one or both of those boxes.

Jared Kizer:
Again, we don’t think there are 50 of them, but we think there are probably three to five that can fit there. And I think the easiest one I found for investors to get their heads around is when you look at where interest rates generally have been in 2020 and for a long time in the rear view window, the forward-looking return expectations for fixed income are relatively muted. So we would say there are certainly some alternative strategies that certainly are likely to generate returns better than what fixed income is likely to do. So that’s something to think about there in terms of if that’s true then certainly they can be beneficial in some cases relative to what fixed income is likely to provide.

Tim Maurer:
Okay. And when you look at it from that perspective of risk, what are we talking about? Do you put these more in the category of stock-like risk or bond-like risk? When you’re trying to consider what you might be replacing in your portfolio to have an allocation to advantages.

Jared Kizer:
Right. Good question. Again, there’s basically two ways to go here. I think you can say if I’m considering implementing alternatives, am I doing it to try to reduce portfolio risk or am I doing it to try to improve the forward looking return expectation for the portfolio? If it’s the former, the first thing, then you say, well I may want to take the allocation to alternatives from the stock fund outside of the portfolio and vice versa would be more from fixed income if the second goal is what you’re trying to do.

Jared Kizer:
And then the other part of your question that I think is important to understand is that each individual alternative strategy can be fairly stable in terms of volatility, but some of them can be very volatile as well. So that’s important to understand that you want like everything to kind of think of them as a group of strategies and not pay as much attention to what each individual strategy is doing or how risky it is. It’s really more about the combination of strategies and how they relate to the other parts of the portfolio.

Jared Kizer:
That last point is important because I think that’s one thing we found folks struggle with because some of the strategies certainly are in isolation, fairly volatile, even though they’re still providing diversification to the portfolio and potentially other benefits as well. So, that’s something that’s an important topic within the alternatives realm.

Tim Maurer:
Okay, and lastly, at the beginning of our conversation, you mentioned quickly something about endowments, and I think that this has been one of the perceptions out there about alternatives. It’s almost maybe more that they’ve looked more attractive because they were somewhat untouchable. I want to invest like Yale or Harvard. Can anyone own alternative investments, Jared?

Jared Kizer:
At this point in time, they can. Now I’d say, can anyone achieve the results that say Yale and Harvard have achieved? Almost certainly not. A likely over time. So if you look at the endowments that have had longterm success with alternatives, generally they’ve had very high account allocations to private equity and specific managers within the private equity space, which is a whole other type of alternative we’ve not talked a lot about today.

Jared Kizer:
I would say the evidence that lots of other investors have been successful with private equity is almost nonexistent. It literally looks like it’s been restricted in terms of meaningful success in terms of returns above what public stock markets have provided to some of the largest investors that have manager access that no individual investor is likely to ever be able to replicate. Not to mention the scale that some of those endowments bring to the table in terms of being able to negotiate fees at very, very low levels that an individual investor is likely not going to be able to replicate.

Jared Kizer:
So I would advise extreme caution with seeing the results of the endowments and thinking that that’s broadly able to be replicated by individual investors. I think alternatives can still make sense, but you’ve got to have more probably realistic goals from what they’re able to do relative to what some of the headlines would be from some of those endowment entities that we’re talking about there.

Tim Maurer:
So in summary, Jared, the disadvantages of owning alternatives seem to have diminished over the course of recent history, but it’s still vitally important for investors to understand the role that these investments would play inside of their portfolio.

Jared Kizer:
Absolutely. I think that’s a great summary and a good summary of kind of where we’re at in terms of thinking about alternatives at this point.

Tim Maurer:
Jared Kizer, thank you so much and thank you for tuning into this episode of Ask Buckingham. If you have a question that you’d like to see us address, you can do so by navigating to the website, askbuckingham.com. Or by emailing your question to: question@askbuckingham.com. Or just take it easy and click on the corner of your screen. It’ll take you directly to the website.

Tim Maurer:
Remember, there are no dumb questions, but unfortunately there are plenty of poor answers out there. Our hope is that in giving you straight answers to your questions, it will bring a sense of calm and allow you to apply what you’ve learned in pursuit of good decision making. So please follow us. And by all means, Ask Buckingham.

 

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