Chapter Four
More Alternatives We Don’t Love
The Elephant’s Graveyard of Financial Products
As Groucho Marx sings in Horsefeathers, “Whatever it is, I’m against it!” Well, we’re not against everything. Just private equity, buy/write funds, structured products, 130/30 funds, and precious metals. These all have their place, but that place is not in your portfolio. Here’s why . . .
Private equity is often mentioned in the same breath as hedge funds as the preferred investment for the elite. What is private equity, anyway? Is there some way the little guy can scoop his bread into this gravy?
Private equity falls into two broad categories: venture capital and leveraged buyouts. They are alike in that they are both illiquid investments that will tie up your money for years. We will take them on one at a time.
Venture capital is what most people mean by private equity. After a start-up business reaches the point where the hapless founder can no longer run it on his personal credit cards, he needs outside sources of capital to help take his company to the next level. The founder has already tapped out his in-laws, friends, and everybody he knows. He goes to a banker for a loan, but all the banker can see is big dreams, a big stack of debts, and no revenue. What is this entrepreneur to do?
Rich people, pension plans, and endowments are happy to lend him money if they think his fundamental business plan is sound. These folks pool their money into a venture capital fund, where the money is allocated by professional managers. The business founder gets the cash he needs like oxygen to stay alive, while the fund gets a piece of the business and a big say in how it is run. The shareholders of the fund, who coughed up the dough, hit the jackpot when the company is finally taken public. Note that it may take years before there is any return on their investment in the fund, and indeed if the idea doesn’t pan out (an ever-present possibility), it may be a total write-off. In the meantime, for the years while they are waiting for all this to come true, there is no market whatsoever for the business or any piece of the business. The ideal ending is that the company turns into Apple Computer, and in fact most venture capital funding does go to technology or biotechnology companies. Sounds good, right? Who wouldn’t want a bite of the next Apple?
Investors willing to tie up their money for years in ultra-small companies require compensation for bearing these risks. If brilliant portfolio managers like Yale’s David Swensen are willing to sink 17 percent of their money into this asset class, shouldn’t you?
Almost certainly not.
Why not?
Let us count the ways.
In the first place, the big returns accruing to private equity in general are averages. Some stocks will become the next Google while many others go into the landfill. However, the average venture capital investor will not get that average of these returns. He will get some particular return. A lucky one will get Apple and 99 will draw blanks. In other words, the field is strewn with land mines. Do you feel lucky (punk)? Do you?
What the actual returns are from venture capital investing is a mystery wrapped in a taco. Why? The funds are under no obligation to report their returns to anyone except their shareholders. Driessem, Lin, and Phalippou, writing for the National Bureau of Economic Research, tried to figure out what these returns were and concluded that venture capital has negative alpha coupled with a very high beta. Translation: It underperforms the stock market while amplifying the stock market’s risks.
What does this mean to us as investors? This is exactly the opposite profile from what we want. Remember how we argued earlier that most people need to reduce the stock market exposure in their lives? Private equity is like public equity on steroids. It exaggerates market returns. These tiny companies carry market risk that cannot be diversified away.
Parenthetically, this means that if you are a private equity investor, the rest of your portfolio should look as little like the equity market as possible. Venture capitalists fall prey to the psychological fallacy of investing by story. Because they love the story behind the business, they overestimate the potential returns and underestimate the real risks. In other words, they are human beings.
The other type of private equity is a leveraged buyout fund. Here the investors have a public company in their sights that they think they can run better than its present management is doing. Strange to say, there seem to be a large number of corporations whose stock is so wildly underpriced that private equity can step in, buy them at above-market prices, and still make money by spiffing them up.
While this would seem to violate efficient market theory, other explanations are possible.
An alternative reading is that these deals are often done in cahoots with the management of the acquired company, who know exactly how to change the company and make it worth more, but will only put that knowledge to work if they can reap the rewards from the repair job themselves instead of giving it all to the shareholders.
Another explanation is that the buyout fund has acquired a public company, done some accounting tricks with reserves and allowances to make it appear profitable, and plans to resell it to the public for a big profit. Accounting is, after all, more art than science at the highest levels.
Then there is the old “rip, strip, and flip”: The fund buys the company and has it issue junk bonds. The company gets saddled with debt from these high-interest instruments, while the fund managers pay themselves immense dividends and fees from the proceeds of the bond sale. This lets them cash out with a profit before they even start to reorganize the now-hobbled company, whose subsequent performance is now less transparent and a matter of relative indifference, at least to them. Back in the 1980s Drexel Burnham Lambert facilitated a chain of these transactions until their junk bonds massively defaulted.
Leveraged buyouts claim to align the interests of shareholders and managers, but levering the company to the max simply creates the familiar “heads I win, tails you lose” scenario for the fund managers and creates a far more glaring conflict of interest than would ever have occurred had the company remained public. Other people disagree, however, and feel that this kind of activity contributes economic value to society. You make the call.
How to Make Money in Private Equity
The best way to get into private equity is to run your own fund and invest other people’s money. The compensation befits a Maharaja. First, you get a 2 percent management fee every year just for turning on the lights. Then you get 20 percent of any profits. Finally, you can charge additional deal fees and fees for “monitoring” the fund’s investments.
As for David Swensen and his ilk, are they crazy? Not a bit. They have access to the finest talent pool money can buy. They get in first on all the prime deals, while everyone else gets leftovers. There is too much money chasing the rest of the deals for them to be profitable to anyone except the fund managers.
That said, we do have one private equity idea we like: Berkshire Hathaway (ticker: BRKB). It is run by Warren Buffett, the most successful capital allocator in history, and he manages his $200 billion company for a salary of $100,000 a year. As a private equity play, Berkshire is diluted by large holdings in public companies. Buffett keeps his eye on every nickel, so he will tend to underbid private equity funds in making new acquisitions. Then again, Berkshire has a money bin that enables it to do deals (like their acquisition of the Burlington Northern Santa Fe railroad) of a scope that no one else could touch.
One private equity idea we like: Warren Buffett’s Berkshire Hathaway.
Some people recommend buying Goldman Sachs (ticker: GS) as a private equity play, since Goldman seems to be collecting a toll at the crossroads of every deal. However, we question how much of that benefit actually flows to shareholders. Most of it seems to go to the partners and never is seen again.
You can also buy mutual funds that invest in companies that own private equity funds such as KKR (ticker: KKR) but why would you want to, since they would presumably concentrate your total risk in the rest of your portfolio instead of diversifying it?
Before we explain why we aren’t fans of these alternative funds, we are going to have to explain what they are. They start when a manager buys a stock index (such as the S&P 500) and then sells covered calls against it. What are covered calls, you ask? These are transactions where, in exchange for some cash, a buyer of a covered call option is given the right (or “option”) to “call away” the underlying stock from its present owner, if the stock price rises to a certain level by a certain date. If the stock index falls, stays the same, or doesn’t rise far enough, the money paid for the expired call option amounts to an extra bonus to the stock owner. If the market goes up a lot, then the stock owner gets the gains up to the strike price of the call option, but the gains thereafter go to the buyer of the covered call option, who becomes the new owner of the stock at that strike price and calls it away. The seller of the call option would rather keep the stock in that situation, of course, but that is the gamble he took.
The income from the call options is not a free good. Notice that this strategy delivers nearly all the downside of equities with the upside clipped off. That does not ordinarily strike us as a good deal (depending on the price).
Some funds take this a step further. They take the money from selling the covered calls and use it to buy out-of-the-money puts on the underlying index. This means if the market falls, they can “put” it to somebody else, effectively limiting their downside exposure. They are exposed to the downside to a certain price, but thereafter they have bought the right (or “option”) to stick it to somebody else.
Selling calls and buying puts places a collar around the portfolio and gives you a stock index fund that will move within the channel created by the puts and calls—neither going up nor falling as far as the stock market in the extreme cases.
Why aren’t we fans? Because you can get the same risk/return profile more cheaply simply by not investing as much in equities in the first place. We were able to simulate the total returns of a buy/write fund from 1994 to 2010 almost to the penny just by putting half our money in the S&P 500 index fund and keeping the rest in T-bills. In other words, if you want to control risk, you don’t have to pay fund managers extra money to do it for you this way. You can accomplish the same thing just by keeping half your money in the bank and taking your lumps in the stock market with the rest.
Structured products are products that are carefully structured to make money for the people who sell them, at the expense of the unfortunate individuals who buy them. They were created to take advantage of people’s gambling instincts and poor mathematical understanding of the trade-offs associated with investing in the options market. Like a bar bet, these odds often can be presented in attractive terms, such as, “We’re offering you all the upside of the emerging markets index with only a fraction of the downside risk!” One thing you can bank on: The creators of these products have done the math, and they have no intention to lose money on the transaction themselves. If you have a brokerage account serviced by commissioned salespeople, it is very likely that they have tried to sell you some of these, and unless you bravely resisted their arm-twisting, you already own some.
The structured products themselves are issued by investment banks and typically consist of two parts: a note and a derivative. A note is an IOU. The derivative adjusts the terms of the final payoff according to the performance of some other asset from which it derives its value (hence, derivative).
Would an example help? You buy an IOU that, upon coming due, promises to pay you either a portion of the returns of the S&P 500 Index over the loan period on the upside, or, at worst, simply gives you all your money back if the market doesn’t go up. How would this work?
A simplified example: The bank takes your money and buys a bond that matures on the same date your note does. You give the bank $1,000 and they buy a bond for $900. This gives them $100 to play with.
They keep a portion for themselves and, with the remaining money, they buy an option on the S&P 500 Index at today’s price that will come due on the same date the note matures. If the S&P 500 Index falls between now and then, the option expires worthless, and the bank hands you your money back. If the option is in the money, they take the payout and divide it with you.
There are innumerable variations on this theme. These derivatives can be linked to anything: stock indexes, convertible bonds, an individual stock, foreign currencies, or your Uncle Charley’s cholesterol level—anything people might be motivated to gamble upon. Usually, though, it’s dressed up to sound like a risk-free investment, or at least one where the upside is comically greater than the downside.
What’s not to love?
First of all, these investments are illiquid. There is no market for them. With most structured products, you bought it, you own it, and you will have to hold it to maturity.
Then, what exactly do you own? Despite all the talk about the possible fat returns from the index or stock to which it is linked, you basically own an unsecured IOU from the company that sold it to you. What if the company goes bankrupt? In that case, you own a piece of paper. Get in line to try and collect. This is precisely what happened to the people who bought structured products from Lehman Brothers, the distinguished 158-year-old firm that was one of the leading sellers of these notes (with a 10 percent market share) until it went bankrupt in 2008.
Because so many people lost huge amounts of money on structured products during the credit crisis, the indefatigable helpers of Wall Street have created a new version that has FDIC insurance. These are more expensive, because part of your money is going to buy the insurance policy. They are peddled as “CDs,” but the term here is only a sales metaphor. When you buy a real CD, if your uncle lands in jail and you need to bail him out, you can break open the piggy bank if you are willing to take a haircut on the interest. With the structured note “CD,” you can check in but you can’t check out.
Another benefit (to the broker) is that—because there is no market for these securities once sold—they can be carried at a made-up price on your account statement.
These instruments are very difficult to understand and you need a computer to analyze them. This gives the issuer a chance to bury their fees deep within a web of mystery, which means they have the dream combination of being expensive and yet having invisible fees.
Yet, perversely, structured products are most often marketed as a sure thing to safety-minded investors—the very people who should be the most concerned about the liquidity, credit quality, expense, transparency, risk, and value of their holdings.
Somewhere there is an individual for whom a particular structured product is exactly the thing that would perfectly complement his portfolio. This person has a Ph.D. and is a student of options theory. Does that sound like you?
130/30 funds are becoming very popular for some reason. We have nothing against them per se (well, maybe we have a little against them), except that they are proposed as alternative investments. That they assuredly are not.
A 130/30 fund is two funds in one. The manager takes $100 of your money and buys a portfolio of stocks. Then he borrows an additional $60 against it and uses this money to run a market-neutral fund—more on this coming up—which by definition is half long and half short. If you add up the dollars, he has invested $130 long ($100 plus one-half of the $60 he borrowed) and used $30 to short the market, using the other half of the $60 he borrowed to bet that some stocks will go down instead of up.
Add it up and you get 100 percent net market exposure: $130 long minus $30 short equals $100 net long. For this reason, a 130/30 fund doesn’t hedge anything, and consequently, it is not a hedge fund at all. It should have a correlation to the stock market and a beta of close to one. The great hope here is that it will deliver alpha or extra returns.
Have we mentioned that we are not great believers in alpha stock picking among members of the human race whose last name is not Buffett? Therefore, we were heartened to learn that someone has cooked up a 130/30 index fund. Proshares Credit Suisse 130/30 ETF (ticker: CSM, 0.95 percent expense ratio) ranks stocks along 10 dimensions of value and then buys 130 percent of the ones that look most undervalued and shorts the 30 percent that appear most overvalued. If an investor were determined to go the 130/30 route, this would be a vehicle to look at, at least based on the most casual possible survey of a crowded field. We emphasize that this would be classified as part of the equity portion of the portfolio, not as an alternative investment or portfolio diversifier.
If you are a king or a pirate, you should have a chest full of gold. If your name is Auric Goldfinger, you will want a Rolls Royce made of gold, because you love only gold. In other cases, however, the need is less compelling.
If you are a king or a pirate, you should have a chest full of gold. In other cases, the need is less compelling.
Many people are captivated by gold, especially those who subscribe to a survivalist mentality. If you truly believe that the days of western civilization are numbered and mobs will soon be roaming the streets, a gold coin may be your means to a loaf of bread or your passport to a new life in an exotic locale. That is the subject for another, very depressing book.
Your authors have no great fascination with gold (although we both own tiny amounts). As gold is included in all the commodity index funds we will eventually recommend, we don’t see the need for a special allocation.
Like other commodities, gold should provide a hedge against inflation, provide a store of value as paper currencies become increasingly worthless, hedge against political risk, and be generally uncorrelated with the stock and bond markets. It has served some and all of these roles at various points in the past, but there are no guarantees that it will serve any and all of these roles in the future.
Whether or not there is a modern portfolio theory case for gold as a separate asset class depends entirely on the start and stop dates we choose to make the argument. During certain date ranges, picked after the fact, gold adds a Midas touch. During others—and especially over the long haul—it sits there like lead. The fact that it has gone up a lot recently does not mean that it is going to continue going up even more. There are supposedly special reasons to own gold now (as in, the value of fiat currencies tends to depreciate), but then people have always made up special reasons to own gold. We are concerned that most people will buy exactly when the mystical premium is highest. The subsequent history of commodities that have had a spectacular run up is not a happy story.
Warren Buffett recently put it to your authors this way: You have a choice. On the one hand, you can have all the gold in the world. It fits into a cube of metal about the size of a large McMansion. Or, you can have all the farm land in the United States. Plus, you can own 10 Exxon Mobils. Plus, you can have one trillion dollars of walking-around money. Which would you choose? Which is likely to be the more productive long-term investment?
If You Must Obey the Golden Rule
If you must buy gold as a stand-alone investment, the SPDR Gold Trust ETF (ticker: GLD, expense ratio 0.40 percent) is probably the way to go. GLD takes your money and buys gold bars, keeping them in a giant underground vault in London. No doubt suspecting us to be bank robbers, they wouldn’t say exactly where. Some people don’t believe the gold is really in the vault, but gullible fools that we are, we believe the audited accounting posted on the www.spdrgoldshares.com website.
We like a little gold just fine in a basket with a lot of other commodities, but have no great interest in it by itself. We always prefer the broader index, to which we turn in the next chapter.
The Alternative Reality
There are plenty of worthwhile alternative investments out there. Unless your situation is extremely unusual, so unusual in fact that we have difficulty offhand imagining what it might be, it is unlikely that private equity, covered call funds, structured products, 130/30 funds, or gold need to have a big place in your life. When in doubt, include it out.