I don't really hear much about hedge funds as much anymore. It's kind of more of private equity has taken over sort of that that FOMO type of uh >> Yeah, it it it is, you know, and and and of course it it um really the results of hedge funds have been um disappointing. And because of that, they're no longer the shiny object that everybody wants access to. And so they've kind of um diminished in their interest. Private equity is the new shiny object. And private equity has merit, but again, you have to think about what's my net outcome going to be after all fees and expenses. And and that's not necessarily um a positive um expected outcome. So, you know, it's very possible that private equity could be the next version of the last hedge fund um process. >> Welcome to the Informed Investor, the podcast that brings you research and insights to help separate the news from the noise. >> Welcome everybody to the Informed Investor. Today we are talking alternative investments and if they belong in my portfolio. The show is brought to you by Dimensional Fund Advisors, a trillion-dollar global asset manager bringing financial science to investing. I'm Mark Gochner, and today we have a very special guest on the show, Jeff Coil, a long-time advisor who's going to walk us through a framework he uses to think through alternative investments. Jeff Coil, welcome to the show. >> Well, thank you, Mark. It's nice to be here. >> It is great to have you here, and I must say for our audience, we are clearly not uh doing this in Austin. >> >> No. >> We are out in our Santa Monica, California office by the palm trees and the ocean, and you live in Southern California. >> I do. >> So, you get these glorious days >> Yeah, these are normal days for me. >> Yeah. Yeah. >> But it's good to be here. >> Beautiful day out here. It's always great to come back to Santa Monica, and I lived here for 8 years. Uh with Dimensional as well before moving to Austin, so fun to be back out and get this weather again. It's actually summertime in Austin. >> Yeah. >> I see you got >> Oh, that's yes, absolutely. >> All right, um I mentioned you your career. You have been in the wealth management space over 30 years. >> Mhm. >> A big part of that, the majority of that, you worked with ultra high net worth investors. Maybe walk us a little bit through your career and your background. >> Oh, sure. Sure. I would say that um for most of my career I um most of my career was spent working with um the most affluent families and managing multi-generational wealth. Um and I founded a few firms that focus on those types of clients. But I also built um systems for managing that complexity. And um and and the reason for that, of course, is those systems didn't exist. And so I wanted to build systems that enabled us to enable us to do better work. And um so ultimately today um I retired from working with clients a couple of years ago. Today I focus on the company that really is dedicated to building those types of systems. We have professional development programs and communication materials that support it. So that's a little bit about me. >> Well, then that company now is Abrexo. >> Yes. >> And you developed that platform when you had your own advisory business, right? To help you manage all the various complexities for the families you served. And now you take that out to other financial professionals. >> That's exactly right. >> Yep. >> Yeah. >> Let's define ultra high net worth just so you have a sense. Um is that a family $50 million and higher? Where do you kind of put a breakpoint on that? >> First of all, it's every anybody's definition. I would think of mass affluent being less than 5 million, um affluent being 5 million to 20 million, high net worth um maybe up to 75 million, and ultra high net worth maybe north of 100 million. And then you get into enterprise families that would be north of a billion. And so it's really a function of, you know, high what wealth is can be significant. But the way that you approach each of those different segments would be different. >> All right, and we'll get into some of that, but uh certainly a big part of what you are always reviewing and working with these different families on is this idea of alternative investments. >> Sure. >> And where does that come into play? So, let's define that. When we're going to use the term here today, alternatives, what what should the audience be thinking about? >> I think uh simplistically, things that really aren't available in the public markets. And I think people normally think of alternatives as um uh venture capital, non-venture private equity, um private real estate, natural resources, hedge funds, those types of assets. And so, I would say that people generally think of alternatives in those terms, and that's kind of traditionally what it's thought of. >> So, any anything that's really not a stock or bond trading on an exchange. >> Yeah, totally. >> Exactly, yeah. >> All right. So, before we get into it, uh one of the things we do on the show here is we like to read a few headlines. >> Sure. >> So, I've got a couple of headlines for you, >> Okay. >> get your reaction, and then we'll we'll dive into it here. So, I got to get my glasses on. All right, two of them. Uh the first one, access to alternative investments is opening up. Do clients care? The second one, alternatives face mounting scrutiny and skepticism. Do you have a reaction to either one of those? >> I think those two comments are problematic. You know, they're they're opening up, and they're um facing broader scrutiny. Um if facing broader scrutiny, you would hope that it would go the other direction, and maybe think uh more critically about the assets. So, yeah, I I would I would uh highlight a bit of concern with those two two conflicting headlines. >> Yeah, and I'm going to come back to the accessibility of some of these alternatives as you move down, you know, from it used to be institutions and to the ultra high net worth, and it keeps going down now to possibly 401k plans. So, I'll come back to that, cuz I definitely want to get your thoughts on that one. Um but let's get into it here. As you think think alternatives, kind of what was the approach you took historically working with clients when that came up as an option? >> You know, really when when building solutions, really what you're doing is I guess I'll step back from this and say when you're building a solution for a client, you want to think of their total wealth. So, when you when you're actually building a portfolio, you actually want to think about their human capital, their homes, their mortgages, their social security, the operating businesses that they own, their properties, other private assets, estate inflows, insurance payoffs. So, when you think about a portfolio, the portfolio really behaves like a completion fund. It recognizes those other resources and fills in a void to create a comprehensive solution. So, now you're thinking about a portfolio and ask addressing your question, now you're thinking about alternatives, well how do alternatives contribute to that portfolio? And part of the answer to that question is a recognition of those other assets. So, if you have somebody that has significant illiquidity, an alternative is probably not an ideal asset. And that's just forgetting the underlying merit of the alternatives themselves. So, I would think about it in context of the total wealth first and then think about it as an asset class that may contribute to the investable portfolio. >> And you mentioned human capital. Just for the audience, you're talking mostly about somebody's career and their earnings potential over their working career. >> Certainly. Certainly. So, you know, human capital is really it's the the value of your future earnings is really what human capital is. And so, if you work for a a large technology company and the value of your human capital dominates your wealth, which it probably would for most mass affluent families, you don't necessarily want to load up on large growth securities. You already have more than you need in the form of your human capital. So, those are the types of things you want to be thinking about. >> Okay. And then, I guess the opposite stream, you might have a professor. Let's say they have tenure and a very stable, reliable income stream over time, so maybe you could take a little maybe be a little more aggressive on the equity side, perhaps. >> Without question. >> Yeah, okay. >> Without question. Yeah. >> All right, so alternatives. >> Do you mind if I digress a little bit? You know, but the other thing about a professor is a professor is also likely going to have a pretty significant pension. And when you think about that pension, what the pension really is, it's an illiquid bond. And so when you're thinking about their total wealth, that illiquid bond in the form of their pension is going to dominate their protective assets. And when you think about the liquid investable portfolio, its job is really just to fill in a void that the pension isn't covering. So this is um kind of getting back to whether it's an alternative asset or a pension or someone's human capital, each of them folds into the total wealth structure in an important way, and that's coordinating a personalized solution. >> And and that's really the the platform you built, Labrado, to be able to manage and bring all those together from the advanced planning, asset allocation, risk management, all those things come together in the platform. >> Okay. All right, so part of that is evaluating, obviously, publicly traded securities, stocks and bonds, and then you move into non-publicly traded, which gets into the alternatives. >> Yep. >> And that was a prominent part in many of the affluent families, too, right? And not necessarily they owned it or they're always probably getting approached by >> Yes. >> the various entities out there. How how What were those conversations like when you would talk to somebody about these potential alternatives? >> Well, first of all, um first of all, I should say that um Labrado is agnostic to the investments that an advisor would use with a client solution. The reason we're talking about this is I've spent my time my career managing very affluent people, alternatives are critical part of that process. So I've spent an enormous amount of time conducting empirical research, basically evaluating the merits of alternatives. So where I'm coming from today is thinking of from an advisor perspective, how do I think about alternatives within the context of implementing a client? And so that's really where I come from all on alternatives. When when you think about alternatives, you want to step back from it and really say, well, are these something I should incorporate into a portfolio? And the answer's going to be different for different people. However, there's a basic framework that you can use that really kind of enables you to approach the puzzle. And and the first part of that framework would really be to consider, you know, what are the source of returns? You know, what are driving returns? And you can really break that down into three things, at least I have found it helpful. And the first one is enterprise risk. It's the fundamental risk of an operating business. If if you're going to loan them your capital, what are you going to charge that business to access your capital? The second one of which is financial engineering. You can take that same business, you can leverage it. You can buy it in an illiquid form. You can re-engineer it. And then the third which would be skill. Does a manager have an ability to add value to that to the enterprise risk and the financial engineering by, you know, selecting securities, re-engineering a business. We call that activism as an example. Um Um timing markets. And so when you deconstruct it and you think about alternatives, the first thing I would say is, well, where are the returns coming from? How much is coming from enterprise risk? How much is coming from financial engineering? How much is coming from skill? Because you have different confidences in each one of those. >> So Jeff, I love that framework and you're always so good in the way you think about things and articulate with a framework like that. And the way you broke that into those three components, right? The enterprise, you got financial engineering, and then skill. How do we apply that to this idea of alternatives, which is a pretty big umbrella? You think about all the different things that kind of fall under that. So, maybe walk us through how you apply those to the different types of alternatives that are out there. >> Oh, sure. Sure. So, um think about all think about venture capital. You know, what is venture capital? I mean, really you're investing in early-stage companies with a new idea, a new product, um and when you think about venture, it's really two things. It's a very high exposure to enterprise risk cuz these are really risky businesses. So, the a primary driver of venture capital is the enterprise risk associated with those really risky businesses. And then, of course, the skill of the underlying managers um that to bring these um these ideas to market and capitalize on them. So, venture capital, strong enterprise risk and skill, not much engineering. We think about private equity, simplistically what private equity has done historically, they buy small-to-mid-cap value companies, they put leverage on them, they re-engineer the operations um and product lines, rationalize the product lines, um and then they try and sell them to somebody else. And and so, there's a skill attached to that. Not only in selecting underlying security, but the re-engineering in the operations and so on. So, when you think about private equity, again, a heavy dose of enterprise risk, the biggest component of it. And that enterprise risk is then augmented with financial and engineering in the form of leverage um and others, and then also the ability to add skill. Now, you move into um real estate, it's very similar. It just um similar to venture and private equity. When you think about um you can buy a a public REIT in in the market and buy real estate through a a security like a public REIT, um or you can move into the private markets, and there's a category called value enhanced. And what they basically do is they they buy, I'll call it ugly real estate. You know, think of that as a small-to-mid-cap value company in the public markets, but in this case it's an ugly piece of real estate. They put a new coat of paint on it, and they turn around and sell to somebody else. And and that is something that has a heavy dose of enterprise risk attached to it. And then there's the financial engineering about the new paint, and and then the skill of the uh manager to manage that process and bring it to market. And then there's a form called um opportunistic real estate, and and that from a somewhat analogous to venture, it's not, but it's somewhat, but you know, you buy a piece of property in the middle of nowhere, and you hope that over time civilization encroaches upon it, and now you can put a um a Home Depot and a bunch of homes around it and make um make an awful lot of money. And there are other forms of opportunistic >> You you just have to have the funds to get you to that point. You have to have the funds to get you how many years that is down the road. >> Yeah, you know, there there are examples of where people have um purchased farms, and they farm the property for years until take Central Valley in California. We're in California. Um until um the until civilization grows from Sacramento out to this farm, and now of a sudden they're going to put homes in a Home Depot. And so the value of that property dramatically increased. And and these are different um types of investments, and so there's skill attached, a lot of skill. So that opportunistic real estate has an enormous amount of enterprise risk. That's a really risky um uh um opportunity. And so the cost capital is going to be high, but there's an awful lot of skill attached to it as well. And so you can use these tools, and and the final one is really hedge funds, which is really the most difficult of all, because really hedge funds, it's not really an asset class. I mean, you can find a hedge fund that does almost anything you can think about. And so it's it's almost more like a compensation structure than really an asset class. >> Well, sorry. I was I was going to say, maybe describe the hedge fund in the sense of what are they buying? It's mostly publicly traded securities. >> Yeah, I mean, that is that is what you can say that's common about hedge funds. Most of them are buying publicly traded securities. So when you deconstruct a hedge fund, in general, they own publicly traded securities. >> And and that could be stocks and bonds and of course it could be futures >> Stocks and bonds, uh sorry, options. It could be futures, options, stocks, bonds, but they're publicly they're publicly traded securities. And they will often apply financial engineering in the form of leverage, illiquidity. They might buy more illiquid companies in the public markets that may have a liquidity premium attached to it. Um they might buy securities that have optionality. A mortgage has optionality. And so it's in a mortgage, the person who has the mortgage, they have the right to pay it off at any time. So, if interest rates decline, they pay off their mortgage and they refinance. To the owner of that mortgage, that's a negative characteristic. And if they're going to loan you money, they're going to charge you more for it. So, that's what you call optionality. And so, hedge funds engage in all kinds of optionality. But when you think about it, you summarize it, they're investing in the public markets. Um they're applying a lot of financial engineering, and you hope that they have some skill in the work that they're doing. So, hedge funds are heavily loaded towards financial engineering and skill. And so, you want to evaluate, well, you know, what's the outcome um expected to be? And if you step back then think about it intuitively bought a large pool of hedge funds, it basically looks like a balanced fund. You've got You've got equities, you've got fixed income embedded into into a different securities. Looks like a large balanced fund. And what would you expect the return of a large balanced fund to be after fees and expenses that look like two and 20 as an example? Not all that good. And by the way, that's exactly what >> And then that's a typical fee structure in hedge funds similar to private equity. >> Yeah, typical fee structure. Um very high fee structures in hedge funds. And not surprisingly, the results over time have have not measured up to what people had hoped. >> Well, and so I'm glad you brought up hedge funds because that used to be the rage. We hear about them all the time about well, I I got to invest in hedge funds and I don't really hear much about hedge funds as much anymore. It's kind of more of private equity has taken over sort of that that FOMO type of >> Yeah, it it is. You know, and and and of course it it really the results of hedge funds have been disappointing. And because of that, they're no longer the shiny object that everybody wants access to. And so, they've kind of diminished in their interest. Private equity is the new shiny object. And private equity has merit, but again, you have to think about what's my net outcome going to be after all fees and expenses. And and that's not necessarily a positive expected outcome. So, you know, it's very possible that private equity could be the next version of the last hedge fund process. >> That's a great overview. Thanks for that. And with that said then, how would you assess sort of the contribution of each one of those as you were thinking about this any expected return from whatever that investment might have been? >> Well, you know, it's it's interesting when you think about it. There's very little difference There's few differences between a public and a private company. So, when you think about enterprise risk, you know, it's a fundamental risk of an operating business. It doesn't matter if it's a public company or private company. And there are things that actually cause systematic risk to price the cost of capital, which over time becomes the investment return minus some default. And and those characteristics are present in both public and private companies. So, when you think about an alternative, well, you know, I can access enterprise risk far more cheaply and more tax efficiently in the public markets. I then really have to step back from and say, well, why would I access it private markets where my fee structure and my and the tax efficiency is so much reduced? So, what you're really back up into thinking is well, then the reason the primary reason I'm thinking about alternatives, is the potential value of financial engineering, is it valuable to apply leverage or illiquidity, um and the potential for skill. And so it helps you to break it apart and think about the puzzle that identify well how confident am I that I'm going to come out with a positive solution. >> The the public the private would have similar I guess expected returns potentially as an operating company, but then how would you think about like the engineering side of that? Maybe the private has more leverage perhaps in a public company. That's where you're talking about maybe risks are different, expected returns are different. >> Well, it's going to elevate it's going to elevate the expected return when you leverage. Um and um because you're applying leverage to it, but it's also elevating the risk. So it's elevating the the likelihood of failure too in stressful environments. So both of those things are happening with leverage. Um illiquidity most people, if you think about rationally if if somebody if you loaned a dollar to a public company and you could get it back tomorrow, um versus if you loaned a dollar to a private company you had to wait for another 10 years to get it back, you probably charge more for that dollar and that's what what there's a liquidity premium that's associated with that. So I'm using two examples leverage and illiquidity as forms of financial engineering. There's others. Um and um you can evaluate that. The other side of it is then just think about skill. You know, often what happens in private equity is they tend simplistically private equity tends to buy or at least historically small to mid cap value companies and they leverage them and they try and re-engineer the businesses. And when you re-engineer the businesses you might call that skill. Um and um because they're getting in there and they're trying to improve the operations and the financial structure and all of those things so they can turn around and sell it to somebody else at a higher price. And and that's a potential example of skill. Another example of skill is um identifying a good company before other people do or a product line that's different. Um it could be timing the market. Um it can be other things. And so these are the things that you can deconstruct and really kind of get a good handle on. >> How do you know I guess how do you know their liability? Where is you assess the return and the risk relationship in each of those different three? I guess the the enterprise one is a little easier cuz you're saying hey it's similar to a public company, so we got a room's history of data Yeah. around that. How do you think about getting reliable data in the other part around engineering and skill? >> Well, you know, um you think about um it's difficult. You know, alternatives are opaque. You um people are normally more typical way of investing they're investing in a fund managed by a private equity manager. The private equity manager buys a number of companies inside of that fund, and there's some information, but it's not fully transparent. It's not like you're buying a public company. So there's there's a certain amount of a belief you must have in the in the in the private equity managers in order to do that. So you probably don't have a great sense of the underlying leverage of the companies that they're buying and the and the use of leverage of it. Um and you do have good sense of the liquidity cuz you don't have it, but you don't have a good sense of the leverage. And so it's more difficult. So really when you start to analyze this, you can back up and think in kind of a another a a a second set of frameworks is you know, start by thinking where the the sort the source of return. What's driving the return? Enterprise risk, financial engineering, or skill. The second side is then step back and evaluate and say, well, you know, what what are what is the performance look like? Um have they actually delivered value through time? Um um do they add diversification value to a portfolio? Are these unique sources of return that complement a larger portfolio in such way that it adds value. Um and then thirdly is is there purpose? You know, is there a non-investment reason that you might actually want to own um private equity? And then lastly from at least from an advisor's perspective, um is this something that adds value in the business? Is it adding value to the client? Does it add value to the business? And those those four things you can evaluate. So when you ask about, you know, can you evaluate leverage inside of a um the underlying leverage? You can probably get some information, probably not as much as you want. Private equity typically has a lot more leverage than public markets do, so you do know that. What you can do is you can evaluate um the net results of private equity, and that's something you can do. >> >> And by that you're just talking about the returns of this particular pool of assets. And I know you've done a lot of work around that, both on looking at the academic side and probably the as a practitioner, too, looking at live managers. How do you How do you gauge and rank because it's not it's a volunteer database for the most part, isn't it? In the return stream of these particular around private equity? >> Yeah, actually, um it it has been. In fact, um you know, um there's been a lot of empirical work done on alternatives for decades. It's just the quality of the information, I would say it was poor to begin with and it's been improving ever since. Um but there is there is actually a pretty good database out there. It's It's been known as called the Burgiss database. It was originally purchased by a larger company. Um but what they do is they basically look at the underlying returns of the limited partners themselves. And in this way you're you're they're able to avoid um issues like survivorship bias and backfill bias and those types of things. So you can actually get to some pretty good data today. And there've been a lot of studies that have been done recently, um including Hendricks and Medhat um here at Dimensional, actually, that really do a deep dive evaluation of the performance merits of alternative investments, and it's not necessarily all that attractive. >> So, expand on that. Not necessarily attractive, and I you know, you used a term earlier about assessing if it adds value. And and what are you comparing it to? A publicly traded market when you talk about adding value? >> Yeah. So, as an example, you know, the reason I think enterprise risk is important is I can go out and buy a small to mid-cap value company in the public markets, and expensive, tax efficient. And so, the question is if I if I buy something similar in private equity, why am I doing that? And and I guess the argument in this case would be, well, because they're applying financial engineering and potentially skill, and those two things are going to add up to something that has value from a performance perspective. Um the the And so, when you think about this, by the way, um intuitively, you would anticipate, well, you know, the gross return of private equity, it should be higher than public markets. They're leveraged, they're illiquid, there's an illiquidity premium. Um they're generally investing in riskier businesses. So, there's a lot of reasons why the gross return expectation should be higher. But, the key question though is, is there a net return after all fees, expenses, and taxes? And that's where it becomes more problematic. Um you know, typical fee structure in private equity is 2% of a value and 20% of the profits. That's an enormous hurdle to overcome. And so, you know, what the um Hendrix and Medhat paper basically highlighted is, you know, private I always talk about private equity. Private equity um basically perform produced returns slightly above the S&P 500, but when you risk-adjust it and compare it to a risk-adjusted benchmark, they tend to either equal the public markets or slightly underperform in some cases. And by the way, that makes a ton of sense. Because you do have a higher expected return, but all that excess return is really going to managers. It's not really being left over for the investors. >> The cost structure is so high. >> Cost structure is so high. >> Now, what about after tax? You mentioned taxes a couple times. Compare and contrast some of the tax burden you might have in in alternatives. >> Yeah, you know, and this is kind of an interesting puzzle actually or an interesting piece because when you think about alternatives, you know, you're going to part of the alternatives, they're buying companies, they're selling companies. You're going to be realizing these gains through time. So, you're thinking about well, what's the after-tax return of the alternative? What if on the other hand, I'm being simple, I went out and bought that small cap value ETF? Um if I never sell it, it's going to get a step up in basis through my estate. >> Mhm. >> Most people investing in alternatives have more wealth than they'll consume during their lifetime. And so, most of the time, a lot of those assets will get a step in basis. And so, what you realize is you're actually comparing the pre-tax return of a public market investment to the after-tax return of a private market investment. So, if you start the if you start the puzzle thinking that pre-tax is private equity earns a return something very similar to the public markets, after-tax is going to be something measurably lower. And you so, from a performance perspective, it's not that compelling. >> You have the hassles of tax reporting, K-1s usually from a lot of these I can get. Just a nuisance trying to track those down. Um a lot of it's income oriented. Um I'll have you expand on that, but then also I want to go back to a question you mentioned on if you get to step up in basis as it flows to the estate. Do a lot of those funds return your capital though after a certain number of years? To where you may not have the luxury of holding it that long so it goes through your estate. >> The the alternatives? Yes. Yeah, oh absolutely. And that's part of it. So, what what in the structure of an alternative investment is he's typical structure is you're investing in a fund. You commit a dollar and they draw that dollar incrementally from you over a couple of years. That means the investment period. Now that dollar is invested, but it took a couple of years to get there. And and then during that time they the companies are maturing, they're preparing them, they're selling them off and that's the distribution period. And so that typically is the full period of your lack of liquidity is somewhere between 10 to 12 years before you get your last dollar back. So, it's a long time. >> Okay. And then how is that taxed when you get your distributions? Is that the long-term long-term gains? >> Long-term capital gains. Usually it could be short, but that would be unusual. In order for it to be short, they'd have to buy a company and flip it and sell it quickly. That would be unusual, but it most of the time it's long-term capital gains. >> Okay. >> Whereas in the case of that ETF, the ETF is managing tax efficiently. There's almost no in this case capital gains distributions. And so if that ETF is held and passed through their estate, they'll never pay the tax on capital gains. So, that's what I mean by there in certain circumstances you can be comparing the pre-tax return of the of the public market with the after-tax return of alternatives and it makes the comparison not so not so positive. >> Got it. All right, you mentioned diversification and that's one of the things you often hear about alternatives in this case quite often about private equity or private credit that is just a smoother investment ride. Now, it's smoother because it's probably not marked to market. Those are my accounting terms I like to use or properly valued. You know, where you probably trade market every minute of the day market exchange is open. It's getting repriced and revalued. So, expand on that a little bit. >> Sure. Well, you know, first of all, intuitively um, uh, the the is there diversification in a private equity investment different from a public market investment? And I'll get to that in a minute. Um, but what the the key thing though is historically um, you go back um, decades as an example. People were thinking alternatives, private equity, I'll use private equity. Private equity was a strong diversifier. And one of the reasons for that is is all um, private equity, you know, over the decades, it usually used an appraisal-based method of valuation. A lot of discretion involved in there. And it's and it's um, and it's valued every quarter. So when you apply an appraisal-based valuation methodology, it's applied on a quarterly basis. It's going to have the appearance of very smooth returns. It's not going to actually demonstrate the actual volatility that's under the economic volatility that's associated with that company like a public market company would. And and because of that, there was this view that oh, these are diversifying. Um, low volatility means you have a low correlation to public markets. Low correlation means you've got this wonderful diversifier. And and a lot of things have have advanced um, in valuation methodology, you know, there is you know, um, uh, I don't 15 years ago, there was a a move to fair value accounting. And with fair value accounting and it's it's a better effort to value private equity so that it's more closely aligned with public markets. It's a better effort, but it's not a perfect effort. And when fair value accounting showed up, all of a sudden the correlations just ramped up dramatically. There's a study out there that basically identified that institutional investors thought that the um, correlation coefficient for private equity, which is a measure of their I'll call it diversification value, um, it was something like, you know, 0.3, 0.35 a couple decades ago, and fair value accounting comes in and now ramps up to 0.8 and starts to look a little awful lot like public markets. So, I would say that, you know, thinking that they have diversification value, you have to have a bit of humility associated with that. Is they they probably do, and if I were to argue why they do, um, is when you take a I'll take a public market equivalent, you add leverage, you change it a little bit. It it's going to have more volatility, not less, by the way. It's going to have more volatility. Um, there might be deal structures that are involved, um, that might be different. You might have a manager that's basically trying to re-engineer the company, uh, rationalize their business operations and their financial structure. These are things that can add value, but not not a massive drivers of diversification value. Um, and, um, so I would walk into this thinking with with a bit of humility about um, their ability to add diversification. The caveat I would say is, you know, right now we're talking about traditional private equity, even venture capital as an example, private real estate. Their public market equivalents are very similar. There are some assets that are very different, though. You can have contractual cash flows. You can have the earning streams of a pool of professional athletes. You can have, um, disaster insurance payoffs, and these don't relate to the public markets. And those I would argue would have diversification value. But you'd still want to do a critical evaluation. Where is that return coming from, and how much am I paying for it to get it, and what taxes are associated with doing so? >> Yeah, so you if let's say you're buying real estate, some of this private real estate or private equity, different companies, in addition to your publicly traded securities. So, you're expanding your holding set, which is a diversification play. So, that that could be a positive from diversification, but I'll I'll back to the comment about the correlation comment you made. So, let's go back to that widget company we were talking about. One on the left side, the public company, one on the right side. They're both exposed to economic variables. Interest rates, tariffs, whatever you want to call it, right? And that's kind of where we it makes sense that that that correlation would rise when you think about more fair value. >> Mhm. Yeah, you know, there's um agreed. You know, really the again, when you solve for enterprise risk and you have two things that look roughly the same, you would not anticipate diversification. Um there is an argument that says, well, you know, there's a recognition since I think you know, the 1990s, um a lot of public market companies have been taken private. So, there is a lot of private companies out in the world. And so, do I need access to those private companies to get diversification? And um and that's that's one argument. And you know, I would step back from and think though, well, you know, how many securities do you need to own to have diversification? So, if you're to go out and buy a total market portfolio today, probably has 2,500 companies in it. That's a lot of companies. That's a lot of diversification. If you expand that globally, you probably have north of 12,000 companies in that portfolio. So, does adding private equity add meaningful meaningfully to the diversification of a portfolio with 12,000 companies in it? Probably not. I guess we get back to how much you allocate to the private equity sleeve of a portfolio. You know what I mean? >> Yeah. >> You know, like is it 5% of the overall portfolio? Is it 20%? How do you think about that? >> I think it's fully discretionary. If if if private markets earn similar returns to public markets pre-tax and less return after tax, there's not a large a strong argument from a performance perspective to add them to a portfolio. If they probably if they have limited diversification value, probably not a strong argument to add them to a portfolio. So, how much? Um, I don't think they're I think they're fully discretionary. Um, and I think that you know, it's um, I've worked with very affluent families for a long time and I spent a long time doing this work and as you share an empirical evaluation with people, it's very a common for to get a response back, you know, I've always thought that to be true. Nobody's ever told me that though. And um, and so investors are actually looking for a counsel. They're looking for judgment and from from advisors and when you share judgment with them, it creates an enormous amount of value. So, I would say alternatives are discretionary. Now, having said that, there are reasons to invest in alternatives that may have nothing to do with performance or diversification. You know, some families just want to invest in venture capital, be exposed to innovation. Um, others >> to purpose. >> It gets back to purpose. Yeah, you know, so you know, there are other reasons. Um, so what is the purpose of it? You know, maybe they want access to innovation through venture and by investing in venture early venture companies. Um, or they like to um, affect society or the environment positive ways and invest in companies that are dedicated to solving um, social or environmental types of problems. That's called impact investing. Um, another example of purpose really has to do with estate planning. Because when you take an illiquid asset like an alternative asset where the investor can put it into a structure where that investor has limited control, um, the IRS generally will allow you to discount the value of that security and that discount can be utilized in a wealth transfer. And the logic of that discount by the way is if if you had an investment that was illiquid and you lacked control and you went out and tried to sell that to somebody on the street, what would they pay you for it? Well, they wouldn't pay you for the full dollar of that. They'd pay you for a subset to discount its value by liquidity and lack of control. So, that discount can be used effectively in wealth transfer strategies. Now, on the other hand, when you're thinking about that, they that may be a be a value, but in a lot of wealth in a lot of wealthy families they're paying taxes. So, you still need to back up and say, "Well, okay, I'm getting this discount discount value opportunity, but now I need to compare it to a public market equivalent where I might get a step up in basis through the estate and never pay the tax." So, it's it's more nuanced. >> It gets complex very quickly. That's an area. >> yeah, but it's not it's not complicated. It's just it's just you it's a step-by-step process of thinking through it. >> Or it's fun. So, people just say, "You know what? I just want to have some fun with it. I got a buddy starting a company and why not give him a little something something to help out?" >> I By the way, and I think that's completely legitimate. You know, I I one of my favorite clients of all time, he invested in private equity cuz he loved it. He he he he liked to talk to the managers and dig through the companies intellectually and it was part of his hobby. He loved it. And I and he he understood the results. You know, we analyzed his results. He was basically getting public market outcomes, but that was fine with him. Um and um that's completely other reason to think about it, but an unusual one, but a good one. Yeah. >> All right, I love the framework you have there of okay, think about the sources of of return for any one of these potential alternative investments, right? From the enterprise, the financial engineering, and then the skill potentially from the manager, and then getting into more of the nitty-gritty, right? The the the the the performance, the cost, the taxes, purpose, diversification benefits. All right, now I'm going to ask you I got some just specific questions. I'm going to put you on the hot seat and we're just going to go from there with that that groundwork laid for it. All right, who's this appropriate for? Meaning is there a size of estates $2 million person, $1 million investor, $10 million like where does it make sense to get into some of these potential investments that may have liquidity issues, longer tie-up, stuff like that? >> You know, um traditionally it would be for people with significant affluence. And and and the reason for that is these are illiquid assets and you want to be cognizant um of liquidity in your financial plan. Um because a lot of people fail not because they lack sufficient assets. Um a lot of people can fail because they lack liquidity. So, you want to think about liquidity. So, generally I would say typically it would relate to ultra affluent families that have excess resources that they can lock up for long periods of time. In a traditional private equity exposure, it takes you you want to have at least a 20-year time horizon in order to make these investments. Why is that the case? Well, because when you start it's you kind of um ladder into a private equity program. You invest in fund A um and by the way in fund when you're investing fund A it has a certain characteristic that it's looking at. Let's say you're in venture. Um maybe you're investing in biotech because that's what's hot today. Or then AI is in the next cycle or information technology is in the next cycle. So, it takes time to get diversification both by securities, by industry, and by time. And so, it takes 20 20-plus years to do that. Now, there's the advent of a lot of evergreen funds today which are basically trying to create vehicles that enable people to have liquidity. And that would argue that it could available for people of lesser levels of wealth. But also think about, you know, when I started this we started the conversation talking about performance, you know, um under traditional structures, um alternatives don't really produce returns that are very similar to the markets. If you have another layer of fees on top of that in the form of an evergreen fund, the performance um of course is going to be diminished fairly measurably by those additional fees. So, while it makes it accessible, it makes it a lot less desirable. >> Mhm. >> And so, I I'm I wouldn't say for most people that our alternatives are probably are great solution, unless there's a purpose reason and they're intellectually interested and they want to dedicate capital to it. And if you do dedicate capital, dedicate enough that it's not going to hurt you. >> Yeah. Okay. >> Yeah. >> What do you do if you've got a friend that comes up and knows you have some assets and wants you to invest in a company. Is there a polite way to assuming you're not interested >> Yeah. >> in investing, is there a polite way to sort of get out of get out of having to do that? >> >> Well, the the first thing Yeah, there is >> way to say no? >> Yeah, there is a polite There is a There is a polite way to say that and just say, you know, a good way of um first of all, when you invest in somebody asks you to invest in a restaurant, a private business, whatever, these kind of friends and friends types of things, those are really when you think about it, those are speculations. You're buying one company. So, um it's not diversified. It's not diversified. It's highly speculative. It's highly illiquid. There's a lot of risk there. Um is that suitable for most people? Probably not. Um probably not. And um how would you try and avoid that? Well, just to say, you know, hey, you know, uh we have an investment program and we really can't afford the lack of liquidity. That's what I would focus on for a lack we don't afford the lack of liquidity and because of that we'd would stay in the public markets. >> How would you answer some of the themes out there now in the marketplace of hey, you're the average investor, you've never had access to this type of investment before. It's always been for the institutions or the really uber wealthy, but now we figured out how you can have it and uh be get part of the action, too. >> Yeah, you know, that's it's it's really interesting because that's a that's a business question, too, you know, because you know, there's there's substantial demand from investors or consumers for alternatives. And one of the reasons is everybody thinks of it as an exclusive access and exclusivity is inherently appealing to people. So, what you get is this you get this collision of um an empirical review of alternatives is not all that positive, but with a demand that's coming from the population. And the population, it's not what they do. People don't spend their time evaluating alternatives and reading research. And so, you have this issue. And so, the question is, you know, for an advisor or for a client, do you do you buy alternatives or do you do you make alternatives available to your clients because they're asking for it? Or do you spend time demystifying it? Kind of having a conversation like we're having and and think through it. And well, where are the returns coming from? Um is the performance expectation a positive one? Um what does that look like after tax? Is is there diversification value? Is there purpose to it? And when you demystify something like that, what you're doing is you're applying judgment. And ultimately investors appreciate somebody who can actually deconstruct something that they're not that familiar with. And you might be able to save them um save them from hurting themselves over a long period of time. So, I I would say um it's a question, do you give people what they want or do you help them to want what they need? That's another way of saying it. >> Excellent. Well said. Yeah, great answer. How about real estate? You know, oftentimes you'll people say, well, I'm just going to go buy some properties. Maybe they want to flip them. Maybe they just want rental income properties and I'm going to get all the upside of owning the property. I'm going to make a bunch of money, rental income in in between." What's some of your experiences around around that? Cuz I always think the people that do really well with it, they make it look easy, but it's not easy. >> No, no, it's a it's a it's a business. It's an enormous amount of work. I mean, if if you're in real estate, it's um make it your business. Um because you you buy a rental property and now you need to maintain it and now you need to make sure it's constantly occupied and address people's concerns and wishes. And I mean, it's um all the administrative bill payment and managing vendors and all of it's an enormous job. And so, if you're if you're buying real estate, um be sure you want to be in that business because it is a business. For most people that have regular jobs, um to buy real estate and to have another business called real estate in addition to that, it's an awful lot. If But But by the way, that's a choice though. Just go in with your eyes wide open. >> Yeah. So much of this is focused on the individual investor. Um but, you know, a lot of this got started in the institutional space. These huge pension plans, endowments, uh perhaps uh really got into a lot more of the illiquid assets, private equity, timber, some of these different things. And I think that's where some of that exclusivity came from that we were talking about earlier. How has that worked for many of these institutions? Has it been really effective cuz some of them have a pretty big chunk of that endowment into these illiquid assets. >> They do. >> Have you done much research around that area? >> Yeah, we have. You know, in fact, what we've been talking about, we've really been kind of laying out a philosophical framework or uh for thinking about alternatives. And you know, but on the other hand, you know, one of the things we do also is, you know, there's what's known as the Nakubo study and it's a study of the the results of endowments in the United States. And And reason that's kind of an interesting study is is capturing the actual results of these endowments. And endowments have traditionally had the best access to alternatives of anybody. You know, they they they're the first dollar into the private equity funds of choice. Um because they're stable consistent capital. And um and you know, simplistically probably half a little bit more than half of a typical endowment is held in some form of an alternative investment. So if if you were expecting to see positive outcomes coming from alternatives, you would see it in endowments. And but that's not what happens. So if you were to look at the trailing 25-year um performance of these endowments through the Nakuba study and compare it to a public market equivalent, the endowments actually underperformed by a little bit more than 1% a year from that public market equivalent. And that's pre-tax. Let alone after tax. Of course, endowments don't pay tax, but private investors do. >> Right. And that's public data, right? These endowments have to file certain tax forms and things like that. >> all public data. >> Yeah, it's all public, so you can you can track that. And I guess that underperformance probably largely is just the the heavy fees that are part of all those different investments from >> It's exactly what's happening. I mean, there's it's it's um there is I know go start get back to first principles. The expectation for a higher gross return is there. You've got enterprise risk, they're applying leverage, illiquidity premiums, and they're applying uh uh aggressively trying to improve these businesses. >> And they I would say sorry to interrupt, but they're the ones who would have the access to the most skilled managers out there probably, too, right? >> The endowments, you mean? >> The endowments. >> Yeah, absolutely. Absolutely. And so um uh and and the reason they are is when you think about it from a take a venture. Venture is is typically very difficult get into. The venture capital manager, when you think about it from their perspective, what they want is they have a limited pool of capital cuz they can only deploy so much. They want the best high highest quality stable investors to provide capital to their venture fund. And endowments probably meet the bill better than anybody does. And because of that, they've historically gotten the best access. Um uh places like Yale and Stanford were also the very early investors in venture capital. And and because of that, they also had they still have very excellent access to what you would call the top-tier firms. And um and so, you know, so therefore, if there was going to be a positive result, um then you would see it in those um uh endowments. But you don't. You when you compare to public market equivalent, they still underperform the public market. >> aggregate, they still underperform. >> Yeah. Right. Yeah. >> Now Now, by the way, I I digressed on something there. And that is is that there um these endowments um would be getting access to the most appealing or attractive managers. And that's kind of a critical thing. Because when we're talking about performance a bit ago, um you know, in general, um private equity earns returns looks something similar to the public markets. But the top quartile returns earn things that are substantially higher. And so, if you could have gotten access to the top quartile returns, now that becomes an interesting argument because the returns are so much different. Now, that is something that would be appealing. But on the other hand, you also have to think about, well, are the are the returns of the top-performing managers today the going to be the same in the future as they were in the past? And that's a term called persistence. So, do the prior winners persist into the future? Now, simplistically, and I'll use venture because that's the that has the most notable results, is the answer is yes, they do persist. But it's not practical. And let me explain why. Is if you knew the entire return outcome of a venture capital fund, and then and you were able to use that to buy the next fund, it would give you information about whether they were going to be good or bad. The problem though is a fund has a life of 10 to 12 years. So, fund one comes out and then you invest in fund or there is a fund one and now fund two comes out. It usually comes out a couple years later, but all you know is you all you know is the first couple of years of that fund's investment really the investment period and most of it has been appraisal or fair market valued. There's not a lot of information to give you information about whether they're going to be good in the next one. And so you're making a decision based upon completely um inadequate information and when you make that decision, there's no persistence. And so there is persistence if you looked in the rearview mirror, but there's not persistence at the time you're actually committing capital. So, it's not useful to you. So, the idea of capturing that top quartile manager and getting access to it, I would approach that with an awful lot of humility. >> It's challenging and I guess that's one of the things where I I get concerned about this movement of getting a lot of the alternatives in this case some private equity into like 401k plans and things like that is the managers that let's say the top endowments have access to aren't the managers a person in a 401k plan getting access to. There's just no chance. >> Well, first first of all, I want to dispel. I mean, no. In fact, in um the there is a limited pool of capital that the venture capital market absorbs anyway. So, it's there's a limited pool and and people are going to get most people can't get access to the quote top tier firms. Now, I would argue it doesn't necessarily matter because you can't really identify the the future top tier firms. Um but when you put it in a 401k, you've just basically democratized it and it means that all capital is there. And um, I would argue that that's probably a terrible place for alternatives to be inside of someone's 401K. >> All right, I'm going to wrap up with a couple comments and then you can supplement um, what I missed there. And I'm going to go back to the original question I had when we started the episode which is alternatives, you know, does it fit in your portfolio? And it sounds like maybe. It's just know the sources of return and you identify that really well, I think with your enterprise engineering and then and then the skill aspect of it and then know the components and how you assess that whether it's diversification benefit, the costs, the tax implications, the purpose. Maybe it's fun, maybe there's something else to it. So if you can address all of those and you've got the wherewithal to survive some of the illiquidity requirements, maybe it does fit. Um, but maybe it doesn't as well for other investors out there. >> Yeah, I I I think if you're strictly looking for a performance and and diversification reason, probably not. If you're looking at true alternatives, not necessarily private equity as an example that looks a whole lot like the public market um, and you're buying um, insurance payoffs or um, professional athlete earn future earnings in a diversified pool. These are These are risks that are very, very different than the public markets. That it does add diversification value. So I think those are places where alternative is alternative is an overly big word. Um, but there are places that do add diversification and at can potentially add value. But I would always evaluate every one of those potential investments through a lens of where's the return coming from and how much am I paying for it. When you say how much am I paying for it, not only to the manager but also in the form of taxation. >> And then what would be my expectation on that relative to a publicly traded security? >> Exactly. I mean ultimately that's what it compares to. That's your alternative is you know where your base case is a public market equivalent. If if I can get a better more confident result in the public markets and maintain full liquidity then it's a better solution. >> Okay. So we've known each other 28 years that's when I started at Dimensional. I know you've worked with Dimensional longer than that in in your career and I just always love talking to you. I always learn so much about investments the industry working with individual investors and and so thank you for all of that. You're just wealth and knowledge and so articulate on this stuff. So I appreciate you joining the show. >> Oh thanks Mark. >> And the other thing too is for the financial professionals that are listening in. I want to go back to Libretto and you have a whole source of information there on the website right you do various workshops and different webcasts and things like that as well. >> Yeah absolutely. We you know in in addition to the technology we we provide to help advisors manage wealth. We also have professional development programs. We have sessions on alternatives demystifying alternatives this is an example of one and then we have materials both materials to help communicate also papers. We have a paper on this on topic as well that basically lays out this framework. So all of those things are available. We also do webinars and those are generally continuing education webinars and you can also join those as well. >> All right Jeff thanks so much. >> All right. >> Great seeing you great to be here in sunny Southern California as well. >> Oh it's a pleasure. Thanks Mark. >> Appreciate it. And thanks to all of you for joining the Informed Investor. We appreciate your time here today. Great session with Jeff as it always is when you get to hear him talk about these things. And also be sure to check out the book Stay Calm. It's by David Booth our founder here at Dimensional and chairman as well. It's great guidance as you think about investing great guidance on life in general as well. Thanks everybody take care have a great rest of the day. >>