Peter and Jonathan discuss what defines an “alternative investment” and what investors can potentially get from these assets that they can’t get elsewhere. Plus, a reminder to keep politics out of your portfolio and why it might be worth taking a second look at your tax return.
Hosted by Creative Planning’s Director of Financial Education, Jonathan Clements, and President, Peter Mallouk, this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
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Transcript:
Jonathan Clements: This is Jonathan Clements, Director of Financial Education for Creative Planning. With me is Peter Mallouk, President of the firm. And we are Down the Middle. It’s said there are four main investment asset classes: stocks, bonds, cash and alternative investments. The term “alternatives” covers a grab bag of investments — everything from gold to Bitcoin to timber to hedge funds. Peter, in your book, what counts as an alternative investment? And what can folks potentially get from these investments they can’t get from the three other asset classes?
Peter Mallouk: Well, alternative assets are a very, very broad category. So, basically, I consider an alternative asset anything that is not publicly traded. For example, if I want to buy a bond, a Microsoft bond or a municipal bond, I can click a button and own a bond in my Schwab or Fidelity account, or wherever my money is. If I want to buy a stock, I can click a button and buy a stock of a publicly traded company, like Amazon or Nike. And I can buy and sell publicly traded real estate that way. So, those are traditional asset classes: stocks, bonds, cash, real estate, things like that. An alternative is anything that is not that. Anything that is an alternative to that. And so, if we’ve got listeners that own duplexes that they rent out, well, they’re in the alternative investment business.
If you’re a business owner, your business is an asset. You’re in the alternative investment business. If you own gold or cryptocurrency, or any of those things, those are alternative investments. And so, anything that doesn’t fit that main publicly traded category fits into alternatives. Now, an easier way to think about it, I like to focus on things that are actual investments. Things that aren’t speculative, where you’re hoping somebody else will pay more for something than you did, like an NFT or all cryptocurrencies, right? You’re buying them, they’re not producing income. You’re hoping someone else will pay you more for them.
I like to look at the part of the alternative investment world that are real investments. And those are the private version of the public investments. So, just like there’s publicly traded stocks, there’s private equity. Just like there’s publicly traded bonds, there’s private credit or private lending. And just like there’s publicly traded real estate, there’s private real estate. Those to me are the major asset classes I like to focus on.
Jonathan: And this is quite a change from maybe 20 years ago, right? I mean, it used to be that private equity was not a big deal, private lending pools weren’t a big deal. This has been a big change in your career and mine, right, Peter?
Peter: Yeah. It’s been a very big change. And I think what we’ve seen happen is the economy has changed. It used to be that when companies got bigger, they went public. The people that started the company, the only way they could continue to raise money or that they could sell was they would take their company public. So, they go to the New York Stock Exchange or the NASDAQ, or wherever, and then anyone in the world could buy in. So, Jeff Bezos takes his company public. Bill Gates takes Microsoft public. Steve Jobs takes Apple public. But today we see more and more owners keep their companies private for longer. Part of it is they don’t want to have to do quarterly reporting and they don’t want to have burdensome regulatory issues. Because it used to be you went public to raise money, but today you can raise money privately for longer.
Because of this, the economy has basically gone private. So, if we look at 10, 15 years ago, there were about 8,000 or 9,000 publicly traded companies. Today, there’s 4,000 to 4,500. So, we have 30 million more investors in the U.S., hundreds of millions more investors around the world, but the number of publicly traded companies has been cut in half. And that economy has largely gone private. So, there’s this enormous amount, 80% of businesses in America with revenues over 100 million are private. So, this is big, big part of the economy that didn’t exist before that you can only invest privately. And that’s really changed things. And so, part of what’s fed that is private equity started in the 80s when some people got together at a couple early firms like Bain Capital, KKR, put money together, and went and bought private businesses, and then institutions would invest in that.
So, a place like Yale University might put money with Bain Capital, who was then buying private businesses, and they found they got a better return than owning public businesses. And then, eventually, similar funds got together and said, “We’re going to lend money to these private businesses because there’s no bond market available to them, and they need to borrow more money than they can get from the banks.” So, you had private lending funds, private credit funds get together. So, there’s this whole ecosystem happening now where you have these private lending firms, these private equity firms. Private equity firms are buying part or all of private businesses that have considerable revenues but aren’t public. Private lending firms are lending money to these businesses that aren’t public. And now we’ve got the democratization of this asset class.
In the last couple of years, we’ve started to see where these are becoming available to what are known as retail investors, so like the typical family. You don’t have to be a university. You don’t have to be a sovereign wealth fund. You don’t have to be a big pension fund. If you’ve got a family office, you may be able to do this on your own. If you’ve got an advisor that has access to these, you can do them through that advisor. And we’re seeing more and more individuals investing in these asset classes.
Jonathan: What do you think of the quality of these investment vehicles that are available to mom and pop investors? Are they well-constructed? Are the fees reasonable, or do you have to be really picky?
Peter: I think you have to be really picky. So, when you look at the public markets, you really want to control your taxes. You want to control your fees. You want to get the exposure to asset classes correctly. When you’re looking at private markets, you really are looking for people that have an enormous amount of experience in the asset class that you’re investing in. So, most people find real estate the easiest to understand. If you invest, let’s say, in your backyard, there’s 20 different people running around with private real estate funds and you meet those 20 people. Well, if one of them has done 20 funds before, and they’ve all done really well, and he knows your backyard really well, is he probably going to do better than somebody who’s doing their first fund and just moved to your area? They probably will.
It’s very different than the public markets. And so, in the private markets, you’ve got to look at how long has this firm been doing it, how many years? Usually, a private equity firm will release funds every year. Those are called vintages, like wines. So, sometimes someone will say, “Well, this private equity family does great, this fund did great.” And the question will be, well, which vintage? Was it 2008? Was it 2017? You want a private equity or private lending company, or private real estate company that’s been doing it year over year over year over year with good results, that they have a big network to access deals. They’ve got a capability to exit deals in a lot of ways. Most private equity firms are so small the only thing they can do is sell it to another private equity fund when it gets bigger. You really want one that has a lot of different options, a very big network to sell.
These firms really do have an edge. And some of these bigger private equity firms, they’ll go negotiate third-party contracts. So, let’s say a PE family owns hundreds of private companies. They might have one big negotiated deal with UPS. One big negotiated deal with Federal Express. One big negotiated deal with Salesforce, where they’re implementing these reduced costs across their portfolio. So, there really is benefit to scale and experience. And accessing those can sometimes be a little bit more difficult. If you’re fortunate to have an advisor that can then negotiate the access, negotiate fees, negotiate lower minimums so you don’t have to have $5 million to put in the fund, these things make a very big difference. And if you can get access to the right ones, you can improve the expected return.
There’s no guarantees, right, but you can improve the expected return of the portfolio and theoretically reduce the volatility. Although, there’s a big question about how we’re really reducing volatility here. You can potentially reduce the volatility. So, I like private investments. They’ve come a long way. And I think that for people who have stocks and bonds, they should at least look at private equity and private credit. But here, make sure you’ve really got the right type of selection, that you have only exposure to those asset classes where you don’t need immediate access to the money because most of these things have illiquidity tied to them, meaning you can’t get out whenever you feel like it. That’s part of why they should do better. They can control when they buy, control when they sell pretty well. And if you do it right, the expected return of the portfolio should go up and the volatility should stay the same or go down.
Jonathan: Peter, in the wake of the 2007-2009 market crash, there was this whole move in the fund industry to bring out so-called liquid alts or liquid alternatives, which were meant to be publicly traded versions of these private investments. There were long-short funds, there were global macro funds, there are commodity futures funds and so on. A lot of these have disappeared in the years since. I mean, is there some sort of fundamental problem with trying to do one of these alternative investments as a publicly traded mutual fund?
Peter: It’s fascinating, because most liquid alts, to your point, have been disaster. Very high fees, very high taxes, not done very well. I think part of this is the really premier players were not really engaging in that, right? They’re getting plenty of institutional money or high-net-worth money, so they were fine with that. And really, the entrance into that space, that was more their niche. Like, “Hey, we’re going to access this market,” and you didn’t have the top performers. What’s interesting, and it’s happening right now, like this year and last year, we’re starting to see the top 1%, 2%, 3% of players in the space. The ones that have been doing it the longest, that have the biggest teams, that have had a lot of success over a very long period of time. They are now starting to adjust some of their offerings so they become a little more liquid.
Now usually not daily liquidity, like what we’re talking about. The typical private investment used to be you had to wait seven or 10 years. Some of these we’re seeing, “Hey, after two years, you can get out under certain conditions or maybe every quarter you can take a little bit out.” So, we’re starting to see these semi-liquid products come out. I think this is really a treacherous area. And as an investor, you need to make sure that you have access to money when you need it. The money you need in the short run should be in bonds. The money you need in the next five to 15 years, probably stocks. And then longer term we can start to look at these other things. But it’s a very, very complicated space. And I think regulators are going to have a hard time keeping up with it.
Jonathan: One last question on this, Peter. So, the idea of having greater liquidity sounds appealing, but doesn’t that put you at risk that your investment may be threatened by the behavior of your fellow investors in any particular fund?
Peter: That’s a very good point. Liquidity is seen as a benefit, and I think it’s actually a bug when it comes to alternative investments. I prefer the funds that don’t have daily liquidity for the exact reason you mentioned, Jonathan. I think that the more liquidity the people with you have, the more likely you get downward pressure at particularly the wrong time, during a market collapse or crash.
Jonathan: All right, Peter, so it’s time for the tip of the month. What have you got for me this month?
Peter: I say this all the time, but I feel like I’ve got to say it now just from all of the commentary coming in is keep politics out of your portfolio. Under the Biden administration, the stock market went up, regardless of whether you felt positively or negatively about Biden. Under the previous Trump administration, the market went up regardless of how you feel about him. And under Obama, the market went up. And the reason is these presidents, they do impact policy dramatically. Biden and Trump, very, very different postures on a lot of things. But the reality is that most corporations are going to make more money four years from now than they did today. And stock prices follow earnings. So, we know whether you have Republicans as president or Democrats as president, whether you have a divided House and Senate with the president or they’re all united, in all of these scenarios, the overwhelming majority of the time the market goes up.
Look, if you want to be stressed about social policy, go ahead. That’s outside of our realm. But if you want to be stressed about economics and the stock market, I think that’s misplaced. And I think give yourself some peace. There’s plenty in the world to worry about. You don’t have to worry about whether or not Disney World is going to charge more to get into Disney World four years from now. They are going to charge more. And the stock price will probably — not always, but probably— follow. That doesn’t mean every day, week, month or year the stock market’s going to go up. One in four it goes down. That actually happened under Biden. Went down one of the four years. It happened under Trump. It went down one of the four. That’s normal. But over four years, your odds are really, really in your favor to not cause self-harm. Stay invested through the whole thing, and you’re probably going to be rewarded. What’s your tip of the month, Jonathan?
Jonathan: So, Peter, in the weeks ahead, a lot of people are going to be getting back their tax return or they’re preparing it themselves. And before you stuff it in the filing cabinet drawer, which we’re all tempted to do right away, just take a few moments and look at that return and see what you can learn from it. And just sort of three notions. You might look at whether you’re itemizing your deductions or whether you’re taking the standard deduction. If you’re taking the standard deduction, you’re not getting any tax benefit from your charitable contributions, you’re not getting any tax benefit from the mortgage interest tax deduction. And that may change your strategy.
For instance, you might decide that you’re going to clump your charitable contributions so that every other year you can itemize and get a tax benefit from your charitable giving. Second, if you’re unhappy about the amount of capital gains on your tax return, hey, maybe you should trade less or maybe you should trade in your retirement account. Don’t do so much trading in your taxable account. That’ll reduce the amount of capital gains that you report.
And finally, if you look at your tax return and say, “Hey, I’ve got so much interest. I’m paying ordinary income taxes on this.” Well, maybe you either want to consider municipal bonds or maybe you want to take those interest-generating investments and move them into your retirement account and behave in a more tax efficient manner within your regular taxable account. So, that’s it for me, and that’s it — oh, you’ve got something to say, Peter?
Peter: No, no. I thought that was great advice. I’m going to do it myself this year.
Jonathan: All right. This is Jonathan Clements, Director of Financial Education for Creative Planning. I’ve been talking to Peter Mallouk, the President of the firm. And we are Down the Middle.
Disclosure: This show is designed to be informational in nature and does not constitute investment advice. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy, including those discussed on this show, will be profitable or equal any historical performance levels.
