An episode from Vanguard’s Investment Commentary podcast series
Lauren Virostek: Hello, and welcome to Vanguard’s Investment Commentary Podcast series. I’m Lauren Virostek. In this month’s episode, which we’re taping on May 25, 2016, we’re going to discuss alternative investments, or nontraditional investments.
Doug Grim, with Vanguard Investment Strategy Group, is here to help us better understand what alternative investments are and how to strategically consider using them in a portfolio.
Hi, Doug, and thanks for joining us.
Doug Grim: Sure. Good to be here.
Lauren Virostek: The recent low-yield environment has prompted investors to consider a broader range of portfolio solutions, including alternative investments. This, coupled with institutional endowments, such as Harvard and Yale, using alternatives successfully, helped spur significant growth in alternative assets in recent years.
So, Doug, can you start off by explaining the different types of alternative investments?
Doug Grim: So when you think about alternative investments, there’s no universal definition of what constitutes an alternative investment. So Vanguard thinks there’s five broad asset classes—equity, fixed income, cash, commodities, and real estate. And then there’s just different ways of accessing those asset classes.
You know, with the equity category, there’s either public equity or private equity. With fixed income, there’s bonds and, of course, cash. And then with real estate, obviously people have their primary residence. They might have rental properties, and also you could buy private real estate funds through general partners.
With commodities, that’s really where you’re buying physical assets. And, certainly, if you’re buying crude-oil barrels, that’s not something that my wife and kids would be happy that I put in the backyard. So a lot of people don’t like to access it that way, because it’s not really that practical. So some would do it through commodity futures or through private entities to get that access.
With hedge funds, they’re broadly dispersed. There’s a lot of different types out there. They’re not really an asset class at all. They’re just a private investment vehicle that uses different investments within the five asset classes in order to generate some sort of return that tends to be independent of whatever is being generated by the broad equity and fixed income markets.
And then private equity is just another form of equity in that it’s investing in companies that are not publicly traded and trying to build those businesses over time and eventually sell them either to the public market or to another private equity buyer.
Alternative investments to us is really anything that is outside of what we would consider the traditional space. So when we think of traditional, that’s basically the low-cost, broadly accessible, highly traded categories—which would be public equity, public fixed income, and then cash. Each of the other categories would be alternative investments.
Lauren Virostek: What kind of considerations should one make when deciding whether to include these investments in a portfolio?
Doug Grim: We all know at Vanguard that active management is a tricky game, and we, certainly, are not opposed to investors doing it; and we know how challenging it can be. It’s even more challenging in the private space. What you notice is that there’s a huge dispersion of what the outcomes are. So, in other words, when you have a certain manager and how that manager performs against another manager, it could be plus or minus a few percentage points or more.
In the private space, that magnitude of the difference between how different managers perform can be much more substantial and we’ve found that through the research that we’ve done in the past. And [it] can be sometimes in the neighborhood of three to four times more dispersion in those results.
And that might feel, as investors, “Well, that’s okay because I think I can pick managers and stay with them.” And there’s been a lot of discussion historically about the persistence in that way. In other words, “persistence” meaning that a manager who’s done well over a certain period of time will then do well over the next period of time.
And what we found with some recent research that we’ve done on that is, if you look at the hedge fund space, and we reviewed over 25 academic papers that have been written on this topic, hedge fund persistence is not really as well-documented as some may perceive it to be. In fact, in all those studies, it was split 50-50 roughly between those that found that there was some persistence and those that found that there wasn’t. So it might not be as simple as trying to access a fund and then holding it over the long term.
In the private equity space, it’s historically been thought of, well, there’s persistence there. In recent research that we found in the academic world, that has proven not [to] be much of the case anymore, at least in the leverage-buyout part of the private equity space. It does have a little bit of validity in the venture capital space, but the venture capital space is much, much smaller.
And then there’s the other question of access. With hedge funds and private equity, unlike the mutual fund world, many of them are closed to new investors or don’t have to be democratic in terms of their access. The managers themselves can actually pick and choose which investors they want to have in those funds. And as a result of that, even if an investor finds one that they might like, there’s a chance that it might not even be available.
Lauren Virostek: So how do alternative investments compare with mutual funds? Are there some key differences?
Doug Grim: Some of the key differences that investors tend to bring up a lot is, certainly, number one, transparency. So private investments, many of them are in a limited-partnership arrangement. As a result of that, the disclosure requirements are far less than what would be required from a mutual fund structure.
Another big one for things like private equity or private real estate is oftentimes they’re “blind pools,” which, in simple terms, means that when the investor starts to deploy capital to it, there aren’t even actually any holdings in the fund yet. So they deploy that capital [or] part of that capital, or commit to it, before there’s even any holdings.
There’s performance of calculation rules [that] are certainly different. How the holdings are valued, and how often they’re valued, is certainly different. And then, since they’re a limited-partnership arrangement, the legal structure is different. So the documentation tends to be very substantial [with] a lot of contract language that has to be reviewed, and you don’t have the same legal backing that you would normally have with a mutual fund–type structure.
Liquidity is another huge key difference. With hedge funds, oftentimes there’s “liquidity periods” where you can take money out. Sometimes it’s quarterly; sometimes it’s annually. Oftentimes you have to give advance notice, 30 to 45 days beforehand. They might not deliver the capital on the day of the actual redemption, and then liquidity windows might change.
So, in the global financial crisis, a number of hedge funds did what’s called “gating,” which means that they actually shut down liquidity for an unknown period of time until the markets sort of settled down and they [the hedge funds] felt more comfortable with it. Depending on what an investor’s comfortable with, they might not be happy with that type of arrangement.
And then with, like, private equity and private real estate, you don’t really have any control over the cash flows. There’s what’s called “capital calls,” which is when the general partner actually asks you for money, and there’s a required period of time where you need to give that money to the manager. And then you don’t start getting the money back until they start to unwind their holdings from their portfolio, which is going to be really unknown over time. Could be anywhere from five to ten years out where you would get that capital. And it’s not going to be all at once. It’s going to be dispersed as they start to sell portfolio companies one at a time.
Lauren Virostek: Okay, so can you talk a little bit about performance? So how have these alternative investments performed relative to, say, public investments over the past several years?
Doug Grim: Yeah, the performance has definitely been mixed. I mean, I’ll focus on the two most popular categories, which is hedge funds and private equity.
In the hedge fund space, since they are so diverse in how they invest and how they try to generate return and the strategies that they offer, there could be a lot of different benchmarks that people use. But if you had to narrow it down to just one, like a 60/40-type portfolio, and compared it to that, on average they tended to not do as well. And as a result of that, you’ve seen a little bit more concern about the performance of those investment vehicles, especially as there’s been more money there and there’s concerns in terms of returns going forward.
With private equity, those returns relative to the public markets have also come down some. Based on some research that we did and comparing that to the public markets, since they’re both equity—public equity and private equity, it’s just a different form, as I talked about earlier—the performance has been fairly mixed and very dispersed.
So, because they’re private and they tend to buy smaller holdings, a lot of people tend to require a higher return because of the liquidity that they’re giving up and also because of the volatility of those underlying holdings. Now, they might not see that volatility, because the funds aren’t really marked to market. In other words, they’re not really valued every day, but you know that the economic value of those companies is changing quite a bit.
So, as a result of that, if you adjust for what you would expect to earn, to be compensated for accepting those risks, what we’ve seen is that on average they have really underperformed public markets.
That’s not to say that there haven’t been managers that have had very good performance, but there’s also been a number of managers with substantial underperformance as well.
Lauren Virostek: Can you tell us a little bit more about the fees?
Doug Grim: Yeah. There’s been a lot more interest with fees in public mutual funds and private markets, particularly over the last few years.
So the fee structures are different. They tend to cost at least twice as much as mutual funds do.
And there’s also some other indirect fees that many investors don’t consider as part of that: indirect costs such as reporting any extra manager due diligence costs that would come in, any custody arrangements that would need to go on, and the list goes on and on. But it’s just important for investors, if they’re considering the fees of these investments, to consider the all-in fees, both the direct ones and the indirect ones.
Lauren Virostek: Are there guidelines around how much to invest and how the investment should be funded?
Doug Grim: Yeah, Lauren, this is a great question. This one comes up a lot. And this is one where we might be a little bit different than a lot of other asset managers out there. We really fundamentally believe that it comes down to a bottom-up decision. And so you might be asking me, “What do you mean by bottom up?”
And, effectively, what we generally tell investors is for their portfolios to be top down, which means that if you start at the top, it’s asset allocation. That drives the vast majority of the variation of a portfolio over time, so they should primarily focus on that. And then underneath that, they should think about the sub-asset allocation across different sectors and styles and then whether you’re using active managers or passive managers.
If an investor is thinking about including private alternative investments, we think it’s bottom up, which means you’re starting at the bottom with a manager-selection component. So if the investor or the advisor doesn’t believe that they can find and access managers that [they] have high conviction [in] and can generate excess returns over time, then they shouldn’t be in that space at all. And from that standpoint, then they should focus on the other asset class categories and other markets in order to try to generate returns to their portfolios.
And then to the extent that they can find managers and access them, then that bottom-up component: where might it fit in the portfolio and where would they fund it from? Because they’d have to fund it from a part that seems reasonable based on what the return expectations are from that. And it’s going to depend [on] the investment.
So private equity, since it’s another form of equity, would tend to be funded from the equity portion [of] the portfolio. Hedge funds, it’s all over the place. If there’s an aggressive hedge fund, that might be funded from equity too. If it’s conservative, maybe you fund it from fixed income. But the investor or the financial advisor who’s talking to their investor has to be able to say, “Hey, the hedge fund might not hold up the same way that an investment-grade fixed income fund might during the worst periods of the equity market,” and make sure the client, the investors, are comfortable with that and make sure that they’re also comfortable, certainly, with the transparency and the overall cost structure and legal structure of those vehicles.
Lauren Virostek: So this sounds like a pretty complex topic. Are there other ways that investors or advisors could gain access, a more transparent way, I guess, to these investments?
Doug Grim: Yes. Certainly, if investors are concerned that they don’t have the ability to find good private equity managers, certainly, public equity is a great place to go with that, whether it’s indexed or active, since it’s just another form of equity.
When it comes to hedge funds, some investors will choose to think about what many call “liquid alternatives,” which are effectively trading strategies that are in a mutual fund-type structure, where they try to generate returns primarily through security selection while at the same time trying to isolate returns so they’re not really dependent on either the equity market or the fixed income market. At Vanguard, that would be something like the Vanguard Market Neutral Fund.
In the real estate space, instead of private real estate—I mentioned this a little bit earlier—you could use equity real estate investment trusts, or equity REITs. Something like the Vanguard REIT Index [Fund] is an effective long-term proxy. It has a lot of performance attributes similar to the equity market over the short term because they really are part of the equity market. So if you own a broad equity market index, you do own a portion of real estate in there, or REITs in there. But some, if they want a large allocation to real estate, could add a separate allocation to a Vanguard REIT Index-type product in order to gain additional real estate exposure, if they so choose.
Commodities, instead of the private structure, some might use commodity ETFs or ETNs; but they have a lot of complications in terms of both their tax structure and some of them might have some credit risk in there that needs to be evaluated. And they don’t necessarily perform in the same way in which commodities do that maybe people read in a newspaper. So people have to be aware of that.
Lauren Virostek: This has been really helpful, Doug. Thanks so much for being here today.
Doug Grim: No problem. Thanks for your time.
Lauren Virostek: And thank you for joining us for this Vanguard Investment Commentary Podcast.
For more information on alternative investments, you can read our research paper The allure of the outlier on vanguard.com. Be sure to check back with us each month for more insights into the markets and investing. And, remember, you can always follow us on Twitter. Thanks for listening.
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