After a year like 2022, when both stocks and bonds went down, it was pretty much a slam dunk that Wall Street would step up the marketing of alternative assets that might act differently — the next time around.
A new report from consulting firm Escalent says 70% of financial advisers now hold alternatives in their client portfolios, with an average allocation of 7%. Advisers expect this allocation to rise to 10% over the next two years.
Escalant defines “alternatives” pretty broadly, including in its description things like hedge funds, private-equity funds, commodities and collectibles, as well as real-estate investment trusts and master limited partnerships.
Everybody should make their own decisions, but before I’d invest a nickel of my retirement funds in any of those, I’d want answers to six basic questions.
Why should I even want this thing?
A pack of chewing gum is an alternative to stocks and bonds, but that doesn’t make it a worthwhile investment. Will these alternatives add any value to my portfolio by zigging when other things zag? And if so, why exactly would they do well when everything else is down?
Some alternatives did well during the 2022 rout: Master limited partnerships (mostly energy pipelines), commodities and resource stocks were up by double digits. Others did OK: The HFRI index of major hedge funds was down only about 3%, while gold was effectively level. On the other hand, real-estate trusts
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crashed along with everything else, falling about 25%.
What am I actually getting into?
When Bernie Madoff’s epic Ponzi scheme blew up 15 years ago, it turned out that most of his investors had absolutely no idea how he was supposedly making money. That was also true of the Wall Street types who were funneling clients into it. This wasn’t an isolated instance, either. Many hedge funds boast that they have a “black box” of investing magic, but how does anybody know the black box isn’t just a black hole?
Also read: Ponzi Schemes Surged in 2022. Many Involved Crypto.
This isn’t only true of complex vehicles like hedge funds, either. It can also be true of collectibles like fine wine or paintings, whether you buy them directly or through a fractional-share scheme.
“Investors in emotional assets need to be especially cautious,” warn finance professors Elroy Dimson of Cambridge University and Christophe Spaenjers of the University of Colorado-Boulder. In an academic survey of the field, they wrote: “The possibility of fakes can be a worry for buyers of art, stamps, wine, and many other collectibles.”
How easily can I get my money out?
Investors were piling into Blackstone’s $70 billion private real-estate investment trust, the BREIT, last year. But the firm has just had to cap withdrawals — again — to stop a stampede to the exit. Too many investors wanted to take out too much of their money at the same time, and the firm couldn’t handle it all at once.
A popular investment trust in the U.K. collapsed in 2019 after it emerged that the manager had overinvested in assets he couldn’t quickly sell. This is a problem with most alternatives, whether they be private funds or collectibles. How soon can I redeem that hedge fund? How easily can I actually sell that bottle of Chateau Latour? At least with stocks and bonds — and the funds that invest in them — I know I can get out immediately.
What are my fees and costs?
Investors have waged a 50-year war against high Wall Street fees on regular stock and bond funds, and today you can pay less than 1 percent of the value each year even for an actively managed fund. If you go for an index fund, in some cases you can pay 0%. So why would I want to pay much more?
Every red cent in fees, after all, comes out of my returns. Collectibles need to be insured and stored, which can be expensive. Niche funds tend to have much higher fees than index funds. And it’s been 12 years since I first attended a hedge-fund conference in Las Vegas, where I sat down and did the math on those high-fee vehicles. The net result? I wouldn’t touch them with a croupier’s rake.
Now read: Why I won’t invest in hedge funds
What are my taxes?
If I own stocks and bonds in a 401(k) or an individual retirement account, my money grows, tax-deferred, year after year. If I pay the taxes up front and own them in a Roth 401(k) or Roth IRA, any future gains will be tax-free. But in the case of private funds and the like, I may not have the option of holding them in a tax shelter — or, even if I can, the costs of doing that will be prohibitive.
So in this case, I may have to pay taxes on any gains year after year, including taxes at the higher rates applied to short-term capital gains. Oh, and if I make bank on collectibles, like rare baseball cards, for instance, the capital-gains tax rate can go as high as 28%, higher than it is on stocks or bonds.
What are the long-term returns?
Dimson and Spaenjers dug up price data for some collectibles going all the way back to 1900. They found that over that time, artworks, fine violins and rare stamps produced long-term returns that averaged out at around 2.5% per year above inflation. And together with economics professor Peter Rousseau of Vanderbilt, they ran the numbers on fine wines and found those had earned 4.1% above inflation.
Meanwhile, the data over the same period for stocks showed an average return for global stocks of 5.1% above inflation, and even if you take out the stunning returns on the U.S. market over that period, the median for the rest of the world’s developed markets was 4.3% — despite the catastrophes of two world wars. If I can get this from stocks, why do I need something else?
Bonus question: What is the rationale for this investment?
A rare Batman comic sold two years ago for $2.2 million. But that’s only useful information if you are the person selling. If you’re the person buying, the question is: What do you think it will sell for in the future, and why?
To earn an average return of 4.3% a year above inflation for 20 years, matching the historic returns on stocks, that comic would have to sell for $5.1 million in 2041. (And that’s in today’s money. Factor in 2.5% inflation for 20 years and it would need to sell for $8.2 million.) But will it sell for that much? If so, what will be the reason for it? And what is the rationale for the return on any other alternative?
Fine wines may have earned 4.1% over inflation during the 20th century for two very good reasons: For most of that time, they only came from France, and twice that country was plunged into catastrophic war, including four years of occupation by the Nazis. So fine wines would have been especially scarce. Will returns be the same in the future, now that fine wines are produced in a variety of countries? If you think so, what’s your reasoning?
Meanwhile, over the very long term, gold has earned 0% above inflation, and industrial commodities have fallen against inflation. Gold used to be the global basis for money. No longer. Will it keep its value? Again, why do you think it might?
I understand why assets that generate profits at a higher rate than inflation will keep gaining value: They will let me buy more stuff tomorrow than today. But what about anything else?
Now: Take MarketWatch’s 2023 Financial Literacy Quiz. Will you get 10/10?
April is National Financial Literacy Month. To mark the occasion, MarketWatch will publish a series of “Financial Fitness” articles to help readers improve their fiscal health, and offer advice on how to save, invest and spend their money wisely. Read more here.
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