I am a long-time stan of Meb Faber. I managed to invest in one of his ETF ($GAA) before my broker blocked me for MiFiD reasons; my not so secret hope of that rule being repelled here in London after Brexit is still not fulfilled: despite all the mess English politicians managed to create, they were quite surgical in making sure nothing good will emerge out of it (on the other side, I recently discovered that my 2yo daughter, who was born here, is now illegal and the only way to register her is to provide a utility bill or bank account in her name, ok…….).
Since I am an idiot, once I wrote him on Twitter out of the blue the Carlo Verdone’s joke “[Ametrano] change the profile pic that you got old“. As much as this is a known joke for Italians, out of that context is just a quite rude comment. Yes, Meb is 100% American and I honestly do not know what was going on in my mind. He is such a gentleman that instead of sending me back a big FU he….actually changed his profile pic.
[An aspect that I should have covered in my post about being a migrant: once you are outside your country, you basically lose 80% of your ‘cultural references’. Making jokes is way harder because people around you most likely do not have the same references as you do. Even when it is about classic American movies, the dubbed lines you know by hearth are not the same ones used in the original movie.]
Four years ago me and wife went to Australia to do our last trip as a family of two. Since I am an idiot, I planned a 2.6k km road trip in 10 days; in my (partial) defense, as an Italian when it comes to road trips I start from two assumptions:
- all big cities are connected by highways
- you can drive at 140km/hour (or more)
Needless to say, these assumptions are basically valid only in Germany. In the endless time that we spent in the car (driving on the wrong side, nonetheless), I ‘forced’ my wife to listen to a few of Meb podcast episodes…and she immediately hated him. Back in the days, the initial jingle was recorded 10x louder than the rest of the podcast: imagine being bored and half asleep in the car and suddenly…BAM! This post is about one of his recent podcast episodes, so if you do not know what I am talking about, a reason more to go and check it.
Despite my love for Meb, I have to admit I recently betrayed him more than once with other FinTwit personalities; but as any real high school crush, his episode with Phil Huber about alternative investments brought back all those sentiments that I thought were gone. Phil just published a book and is doing the now-standard podcast tour to promote it. I listened to his interview with the Ritholtz gang on the Compound and Friends but Meb edition was 10x better, probably because Meb is the OG god of alternatives (at least for me).
It did not hurt that I listened to them just after I wrote my latest portfolio update.
TILS and alternatives
I dedicate a lot of this blog to ‘alternative investments for the poor guys born on the not-best side of the world’. Meb pod made me realize, as chronicled in my portfolio update, that while I focused on avoiding risks I fooled myself by allocating too little to alternatives, up to the point that they are not really mattering for me. To be 100% honest, my wife tried to highlight to me the same for at least a couple of years, like:
So let’s go back to basics.
What are alternative investments?
In his book, Phil lists four examples as the standard alternatives:
- private equity
- hedge funds
- natural resources / commodities
- real estate
After those classics, Phil adds a list of new alternatives:
- alternative risk premia (quant strategies like trend following)
- catastrophe bonds
- alternative credit
- real assets
Unfortunately, a big chunk of Phil universe is un-investable for retail folks.
What are the risks of alternative investments?
I will not delve too much into why you should dedicate part of your portfolio to alternatives, I think there is a blog out there (mine, cough cough) about this.
This opportunity comes with risks:
- opaqueness. Alternatives are harder to understand compared to stocks and bonds. Sometimes managers make them more complicated on purpose so that they can elevate their stand (and charge higher fees). They require more research and there is less available information about them. Failing to understand them might lead investors to over-react and sell at the worst possible moment. (I know a good number of people that invest in this stuff and do not understand shit, do not feel bad if you are confused at first)
- high fees. Justified or not by the increased effort to research and manage them, be prepared to pay more than the few bps required by a Vanguard ETF. Fees are a drag to compounding, more than you would superficially think.
- behavioural risk. Your alternatives-full portfolio will sing at its own tune: it will be great when it overperforms but will inevitably generate multiple questions when it does not. You will read headlines about investors making double-digit gains while you are far behind (hopefully still in the green); it is easier to lose money when everyone else around you is in the same situation than to gain 10% when social networks are bombarding you with post about 20%+ profits. As for the first point in this list, you will sell at the worst possible moment.
Additional risks:
- taxes. Alternatives are (typically) income products utilised to make up for bond low yields. Unfortunately, while the country you live in might offer ad-hoc tax discounts for traditional bonds, alternatives might suffer for ‘unfair’ tax treatments. P2p lending in Italy has been in this situation for years: only recently their taxation have been harmonised with other income investments. In UK, when there is no ISA wrapper available, you are fucked.
- risk of default of the asset manager/sponsor. Not sure the definition is 100% correct but you get what I mean: crypto platforms that steal your coins. P2p scams. These investments are called ‘alternatives’ for a reason and this is the dark side of the coin. Surprises are not exclusive to services targeting retails investors, think about Greensill or…Madoff.
- illiquidity. This is not 100% a risk because having an investment locked up for years is one of the main reasons why Private Equity overperform stocks. But illiquidity requires at least a deeper plan. I have investments that I started two countries ago: I had to ‘donate’ the last instalments of a couple of Swiss p2p loans to my brother in law because the platform had to be linked to a Swiss account and UBS forced me to close mine when I left the country. This might be a fringe example but describes quite well where issues can hide; if you are reading this blog you probably read already the most classic illiquidity risks.
What is the risk if you do like I do?
I was so focused on the above risks that I forgot a crucial one: having a small allocation to alternatives offers only downsides (the time spent on research and monitoring investments, plus the ‘free rent’ they have inside my head) while it does not matter on the upside.
The correct position sizing mentioned by Phil is between 10% and 30%. That 30% is for big institutions like pension funds and endowments, or investors that have a family office-like portfolio (the real family office, not this one). Those institutions have (or should have 😉 ) the infrastructure to perform proper due diligence and manage risks so that they can enjoy the returns; it is unlikely retail investors would have the same capabilities, or they should, given they can achieve higher returns employing their time elsewhere (like getting a higher salary).
Anything below 10% is as well a waste of time though, you still did the due diligence but your portfolio returns are not changing that much. The good news is that 10% can be split into different alternative assets, so if something bad happens your risk is still limited. Think like 4% crypto, 4% p2p and 4% farmland. I have c4% invested in p2p but that 4% is split into 10 platforms, so in Viventor and DoFinance bankruptcies I lost less than 0.5% of my Net Worth.
I am not a great example because I am stuck in front of a Bloomberg screen at least 5 days a week anyway. The research I do for myself is usually something I can re-use later for my employer; for example, with inflation and ESG on everyone’s radar now, farmland might become an investment for my employer as well. Meb and Phil point about that 10% followed the same line, it is a comment targeted to professional asset allocators.
If you are not involved, or even that interested, in financial markets (I hope you have better things to do in your life) then a too-small allocation is way way better than a too-big one. As I said many times, if anything this blog is financial advice for MYSELF, your circumstances are different and require different solutions.
Is that an alternative in your portfolio or are you just glad to see me?
Alternatives come in different shapes and forms. Some of them are more correlated to stocks than others. Venture Capital and loans to small businesses move quite in sync with stocks, especially when stocks go down and you would like your alternatives to act differently. Crypto as well tends to crash when growth stocks dive.
Commodities are hard to judge because their past performance was linked to a world that did not have ETFs and ways for retail investors to access the sector. Will their future performance be consistent with our models? Will it be completely different?
In his book, Phil includes Real Estate as an alternative asset. But there are valid models that demonstrate how Real Estate is simply a combination of stocks and bonds, part yield, part capital appreciation. Is it still an alternative? Plus under the Real Estate umbrella there are a lot of different nuances: retail and commercial, REITs and direct ownership, up to new solutions like rent from fractional ownership and high yield loans to developers.
From a portfolio construction point of view, the main reason to add alternatives is to have assets that have a positive expected return (ideally, but as we saw in previous posts about tail hedges, even negative return can be fine) and zig when bond and stocks zag. Your main focus should be towards the “diversifiers”, truly uncorrelated assets. But in many cases the characteristics of the investment will depend on a particular manager or will manifest in the long term. We love to quantify and categorise but the exercise to find alternatives and build portfolios might end up more as an art than science.
Conclusion
Few points to wrap it up in case you are still reading:
- do not overthink or try to overoptimize. Having 3% or 4% or 5% of crypto in your portfolio will not change much your final return at the end of the road BUT
- find an allocation you will be able to maintain after a sequence of down performances. This is the strategy killer, to sell your investment(s) because you cannot sustain (in this case) an underperformance relative to the mainstream index du jour
- if at any point in time all your investments are going up, you are not diversified enough. You always need to have an asset that makes you feel like an idiot (and ideally an asset that makes you feel like a genius too).
- Think about the role each investment should have in your portfolio. Go check the map I put in the Cockroach portfolio post. You should be able to allocate each asset to one of the four quadrants. Do not panic, at least in the short term, if anything weird is happening.
- do not be dismissive to new ideas, be curious. Be prepared, 90% of what you will find around will be trash, researching is part of the game. Do not invest just because you spent hours reading about a strategy or a product.
What I am reading now:
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