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Making Sense with Ed Butowsky
Hosted by 35-year investment manager, Ed Butowsky, "Making Sense" is designed for delving deep into understanding investing in episodes less than 30 minutes.
To learn more about Chapwood Investments, you can visit us at our website (www.chapwoodinvestments.com).
Making Sense with Ed Butowsky
Navigating the Misunderstood World of Alternative Investments
Have you been told that alternative investments are risky or only for the ultra-high-net worth? Think again.
What if we showed you alternative investing creates a more efficient investment portfolio and goes beyond even hedge funds to collectibles like whiskey barrels, sports cards, or even sneakers? Join me and our Managing Partner, Ed Butowsky, as we take you behind the scenes of the alternative investment landscape.
We'll talk high level about everything from gold, silver, and diamonds, to hedge funds; and explore why top-notch firms might be hesitant to enter this space. You'll get practical advice on allocating funds and understand the crucial role these investments play in achieving portfolio efficiency.
If you'd like to learn more about any one specific investment in particular, give us a call today to dive deeper.
As always, these episodes can also be viewed on our YouTube page, "Making Sense with Ed Butowsky."
The Making Sense podcast is recorded by Chopwood Investments managing partner, ed Butowski and Jordan McFarland. If you have any questions, please email them to info at chopwoodinvestmentscom.
Speaker 2:Hi everyone, welcome back to the Making Sense podcast. This is Jordan, your co-host here. Join alongside Ed Butowski, as normal on this Wednesday. Ed, how are we doing today? Doing great. It's a great day, jordan, awesome. Well, it is a great day and a great day. I always start with a tough trivia question, ed. So we are talking about alternative investments today, so I went with art, ed. I'm not sure if you're a big paintings guy Maybe not but the question of the day is what is the most expensive painting ever sold? And you can either guess the amount it was sold for, the artist or the name of the painting, and I'll give it to you.
Speaker 3:Renoir.
Speaker 2:Honestly, I'm not even sure who Renoir is, but no, that's not correct. It was the Salvatore Mundi by Da Vinci at $450 million. Wow, how long ago was that? I think this? I thought it was just in the last few years. I would hope so and I'd hope that the investment has paid off for them. But anyway, let's continue on that. I finally got you and the first answered trivia question wrong, but talk to us, ed. So alternative investments obviously, the reason we're doing this for our listeners is we want to give them better insight into how they can invest and what they should be looking for. And we've found, given research, given all the years that experts have put into this, that it's mathematically impossible to have an efficient portfolio without alternatives in it. So just want to turn it over to you why is that? And give us a high-level definition of alternative investments.
Speaker 3:Sure, and I'm really happy we're doing this subject because it's really near and dear to my heart, because most investment portfolios. The way to look at an investment portfolio is you look at a rate of return and a standard deviation and you want your standard deviation to be 80% or less than your historical rate of return. That's what makes a portfolio efficient. However, it is mathematically impossible to just have long only investments and have a standard deviation that's 80% or less than your historical rate of return. So therefore, you must have alternatives in a portfolio to make them efficient, and most investment professionals sadly don't know this, and most retail investment portfolios are grossly inefficient or inefficient, and so, as a result of that, that's why this is such an important subject and most investment firms limit the amount of alternatives that people can have in their portfolios and, at the same time, jordan people look to alternatives for different reasons. The number one reason you invest in alternatives is for the reduction of risk in a portfolio, and I'm sure we're going to dive deeper into that as we get into the subject.
Speaker 2:And no, that's a great point. In fact, I'm going to break script here for a second, because we did have a question when we had our webinar on alternative investments. So let me kind of throw this at you right away, because a listener did ask why are these investments referring to alternative investments not as popular at large-scale firms?
Speaker 3:Well, one of the reasons that a lot of big firms don't allow their advisors to recommend them is that a lot of times, alternative investments are limited in their size. So if they offered at Morgan Stanley, they have 20,000 or 25,000 financial advisors. If they let all their 25,000, actually it's more than that, it's a lot more than that. But if they allowed all their financial advisors to recommend things to their hundreds of clients, there would be too much of a move towards that alternative investment. So there's a limit to the size on a lot of these alternative investments.
Speaker 3:But at the same time, they are viewed as risky on their own. So, for instance, a typical alternative investment might be gold. Well, gold is not something that advisors are shy away from, but buying actual gold coins is shyed away from. They implore their people to buy publicly traded ETFs in gold and silver and copper, but they don't allow them to go out and just buy the gold or the silver coins on their own. But the whole concept of alternative investments at these big firms is viewed in a negative light, and they shouldn't be. It's just the complete opposite. They actually, by including these in an overall portfolio, you reduce the risk in a portfolio.
Speaker 2:Great, and I do want to talk more about risk here in a moment, but could you just list off for our listeners? You just mentioned gold. You mentioned hedge funds. What other alternative investments do you mean when you're talking about alternatives?
Speaker 3:Yeah. So again, you're looking at collecting wine, whiskey barrels, sneakers, professional sport cards, collectible cars, lamps, purses, believe it or not. These are all different types of alternative investments and there's a long, long list of them that we have and there's definitely. The idea behind them is that they don't go up and down with the overall stock market, and that's how you reduce risk in a portfolio. The most popular alternative investments are hedge funds and gold and silver, but diamonds are a fabulous alternative investment that people might want to take a look at at some point, because they trade up and down with gold and silver, but you can buy them at a discount to what they're worth. So that's also a very attractive type of investment.
Speaker 3:But again, the whole concept when you're doing a top-down approach is you're looking at the world from a spaceship, for instance, and you're saying to yourself where do I want to have money? Which part of the globe do I want to have money in? Then, once you decide what part of the globe, then you decide what asset category you want to have it in, then you have the bottom up, which is the actual selection. So once you decide from the top down that you need a certain amount of alternatives. Then you go ahead and do some modeling based on those alternatives and what kind of liquidity there is, what kind of correlation there is to the stock market and to the bond market as well. So, again, that's why you invest in alternative investments.
Speaker 2:Great, and I think that's actually at a great time to jump into our upside down pyramid of allocation for what someone should be investing in. So for our listeners, I'll have Ed describe to you and for our people watching on YouTube, we can throw it up on screen here. But, ed, let's start with the top in public securities and then let's move down towards the liquidity line, if you don't mind.
Speaker 3:Yeah, and what you have is a reverse triangle. So on the top of the triangle, which is the base, 75 to 80% of your money should be in public securities and then you should expect to get, or hope to get, a 10% rate of return. Therefore, your money will double every 7.2 years. That's the hope with public securities. Then you get to alternatives and alternatives. You're looking to put 10 to 20% of your money there, but you're doing it to be non-correlated. Then you get to this liquidity line and once you get below the liquidity line, that's where things start to get a lot rougher and you should demand a lot more from your money.
Speaker 3:So with that below the liquidity line, you're looking at real estate and you're looking at 7% to 12% of your money should be in real estate and you should expect to get a 15% rate of return that's income off of real estate. Then you're looking at 0 to 10% in private equity and with private equity, again this is below the liquidity line. So you're demanding a lot more for your money. You should expect to get three times your money in five years and venture capital represents 0 to 5% of your money and you're looking to make 10 times your money in whatever period of time you can, because most of the time venture capital is a crapshoot and most of the time they don't work out. So you're looking to allocate your money in that reverse triangle. But remember, below the liquidity line is where you demand a lot more for your money because it's much riskier there. But above it which alternatives are? There is not as much risk in alternative investments and public securities as there is below the liquidity line.
Speaker 2:And then Ed. What is the amount when we reference the liquidity line? What is the amount needed before you drop below the liquidity line?
Speaker 3:Right. I recommend that until you have $3 million put away after taxes, you do not go below the liquidity line. Now that might sound like a really high number to some people, but if you can make 5% off of $3 million, you're making 5%. You should be able to live off of $150,000 and not worry about anything in the private equity, real estate or venture capital world Because, again, some of those places you lose not just some of your money but all of your money.
Speaker 2:And I think it all comes down to liquidity. When you think about the number one reason that people go broke, it's typically liquidity. So maybe we'd love to hear your thoughts on the importance of liquidity and how if I'm a listener right now and I'm taking away a principle from this pyramid how can I apply this thought of liquidity into all of my investments?
Speaker 3:Well, you always want to have at least six months to nine months worth of money set aside in money market for your living expenses and then when you get down to about four months worth, then you replenish it. So liquidity how you get out of something dictates a lot of what you should expect from those returns. So in the public securities you can get in and out of things on a daily basis, so liquidity is not a concern on the public securities. On the alternative side, liquidity is still there. You have liquidity. You can sell these items. You can sell playing cards. You can sell or player cards. You can sell sneakers. You can sell wine there's a readily available market for it. But in private equity and venture capital and real estate there's not always a readily available market to buy. So that's why the liquidity line is so important. And when you go below that, as you stated perfectly, that's where a lot of the risk comes into investing.
Speaker 2:Yeah, I think part of the problem nowadays is there's a lot of access to social media and there's a lot of excellent investors even that are giving advice to everyday investors, who typically just aren't ready for the risk that comes with real estate, that comes with a lot of private equity and venture capital deals, because I was actually just looking up a Harvard article today and it said that 2022 was the worst year ever for venture capital and obviously a lot of reason is more people than ever are getting the nerve to go and start their own business. In fact, ed, I don't know who the chain smokers are, but they're a common or a popular EDM band and they even started their own venture capital, so it's just something that has come with the times. Everyone wants to go and start their business. They saw everyone during COVID go out and try their thing, so they think it's easy. But, like I just said, 3 out of every 4 businesses have failed in the past 2 years or so, and I'm assuming that's been the case all 35 years of your career, even.
Speaker 3:Yeah, only one out of 30 of the very best venture capital investments work out and the chances that you got one of those from your friend's brother or your sister's cousin or some family member or somebody close to the family it's very, very slim. So, venture capital, that's why you should allocate about whatever you're going to put in there. You should allocate into 10 different venture capital investments, because if one works out, then you have maybe 50 to 100 times your money, but most of them are not going to work out. It's very, very difficult to start a business, run a business, have that business grow and have liquidity from it. So, again, you must demand a lot more from your money, from the liquidity below the liquidity line, but again, above it.
Speaker 3:Don't be scared by alternative investments. They are the great way to reduce risk in an overall portfolio and I would throw Bitcoin and cryptocurrency into alternative investments as well, not recommending them, but I'm just saying that those are also alternative investments. I had a guy yesterday talk to me about how much gold and silver he had and he was doing that for inflationary reasons and I proved to him it wasn't tough to prove to him that they're not anti-inflation, they are not a good hedge against inflation and they've proven that over the last couple of years. As inflation has gone up, gold and silver has not gone up tremendously, so they're not great inflation hedges. But again, alternatives are a fabulous place to put money, but again, you must do that in order to reduce risk in an overall portfolio.
Speaker 2:Exactly. Well, let's kind of pin down a few specifics here in terms of alternatives. So let's start with what you just mentioned venture capital, then we'll go into private equity, then we'll talk hedge funds, and then we'll talk nontraditional assets, like horses, like diamonds, and let's just do a quick brief overview for the listeners on each.
Speaker 3:Okay, Well, let's also. And I want to just correct one thing is that alternative investments are not venture capital or private equity or real estate, and it's very easy to get it mixed up.
Speaker 2:Non-alternative investments are hedge funds. Gold, silver wines, pocket books, believe it or not.
Speaker 3:Yeah, and and. So Turo is a private company. So again, these are usually well-established companies and if you're going to invest in a private company, you want to get three times your money in five years, because in the public market you should be able to get two times your money in seven years. So that's what you should demand. So if you're looking at a private equity investment, unless you can get three times your money in five years on the front end, don't even look at it again, just automatically say should I be able to get three times my money in five years? If the answer is no, then you walk away from it.
Speaker 2:So let's say I'm a listener. Right now, past the liquidity line, I've got $4 million in investable assets and I want to invest in venture capital. I want to invest in private equity. Obviously, I don't just want to throw this in on Google or ask ChatGPT where the best place I can do this at. If I want to do this, what are the next steps for that? And that sounds like I just set them up for something, but, frankly, wondering.
Speaker 3:Yeah, well, you have to be in the flow.
Speaker 3:There are search funds out there that are out of Harvard and Stanford and Cal Berkeley and University of Texas that search for offerings for private equity offerings and venture capital offerings, and these are very difficult to find. But you have to kind of get into that fold and there's a small community of search funds but then there's also private equity funds and venture capital funds and fortunately here at Chapwood we have access to the top hedge fund excuse me, top private equity and venture capital managers. So you're looking at Vista, tpg third point, those are some of the better names for private equity and venture capital and you put your money into a fund and these have historically returned, you know, north of 25% internal rate of returns. Not all of them and I can't guarantee that's gonna happen in the future. I have to say that for compliance purposes. But the point is is that you can put your money into a fund and let them manage it for you, versus you trying to select the next great private equity and venture capital company. Excellent.
Speaker 2:Well then, let's transition kind of up the ladder into hedge funds, and I know if we're looking to help maximize our returns when we go to private equity, when we do venture capital, hedge funds, while most people think, take on the same position right, like I want to get a hedge fund because I want to maximize my return, isn't always the case. Talk to us about why someone would invest in a hedge fund and the benefits that it could offer someone.
Speaker 3:Sure. Well, the term correlation is what comes to mind. And hedge funds? You invest in them because they're non-correlated not negatively correlated, but non-correlated to the stock market. So, for instance, last year, pershing Square had very, very good returns while the stock market had terrible returns. So these can go up when the stock market goes down. And there's 13 different strategies of hedge funds there's managed futures, there's convertible ARB, there's statistical ARB, or what we call it STATARB, there's global macro, there's long short equity, and so on, and there's different strategies involved with each one of these.
Speaker 3:These people are the smartest people on Wall Street. These people are able to create money just where nobody else would see those opportunities and they're able to trade certain strategies that most people, like myself, are not able to do. So we outsource to the best and, again, through Crystal Capital Partners, we have access to Hudson Bay, millennium, de Shaw Citadel. I think I didn't say Hudson Bay, but those are some of the managers that we have access to for very, very low minimums. If you called up directly to DE Shaw and said I'd like to give you $100,000, they would not take it because they have a certain number of slots. They have 499 slots and almost all of them are taken.
Speaker 3:Crystal Capital Partners has one of those slots, so we're able to add money on to piggyback on to what Crystal does. So it's a wonderful program that Crystal has, but it gives us access to the top hedge fund managers in the world. That doesn't mean we're not interested in smaller hedge fund managers, and we get emails every single day from smaller hedge fund managers asking us to take a look at their strategies, and some of them look really good. But I think you're better off staying with the really good large ones that have 2,000, 3,000 people working at their firm and have $50 billion to $100 billion under management. Those are the better ones to stick with.
Speaker 2:Absolutely. And yeah, I would definitely recommend the webinar that we did about two months ago with Alan Strauss at Crystal Capital. That was a great conversation, pretty brief presentation, if this sounds like something that you'd be interested in learning more in that webinar definitely did a great job in covering more of that. Well, let's transition kind of, lastly, into the investments that we typically never think about. So true, alternatives, right, horses, diamonds, you name it. I mean there's about 100 that we could list off, but just kind of give us the high level of some of these. And if I'm a listener and I'm talking about investing in horses, if I'm talking about investing in hand bags, I would say, well, what's even the point of that? Why don't I just keep it simple? I have $4 million, as I mentioned. Why don't I just keep it simple? So why would someone consider these?
Speaker 3:Well, I'll give you a great example. I had a meeting with a group who were investing in whiskey barrels and I took the meeting because I'm always interested in learning more and over the last three years they've had a 30% internal rate of return by whiskey barrels and I learned a lot about the whiskey business. Then there's a company called VinoVest, which is a wine company, and this has nothing to do with the stock market at all. It has to do with supply and demand in those certain categories. So again, you have to look at each individual category by itself and then look at the correlation to the stock market. And I assure you there's no relationship between player cards for baseball and the stock market. So they're completely separate from each other. And only at an independent RIA firm can you get access to these. You can't do this at a bold bracket firm like UBS or Morgan Stanley or Merrill Lynch or even Goldman. You can only do this at separately run registered investment advisor firms like Chapwood Investments.
Speaker 3:But diamonds again, great investment If you're able to buy them at a discount and if you believe that inflationary pressures are going to be here, they're going to go up with inflation. Gold, silver, copper, titanium, platinum all of these are alternative investments and you should be buying them. If it fits into your portfolio, you should buy them in a small amount and you should diversify. There's also corn, there's soybeans, there's coffee. There's so many different types of alternative investments. As you properly said, there's hundreds of them and there are Not every one of them are right to be invested in, but we have a list of fantastic alternative investments so we can supply to anybody who asks for them.
Speaker 2:Yeah, the reason I always think from a listener's perspective is I listen to so many of these and whenever I think about questions that people should be asking, it's always the well, why should I do this? What does it have for me? And I specifically remember there was a competition that Warren Buffett did with a hedge fund. You may remember this. I think he bet something like $100,000 that over the course of 10 years, that the S&P 500 would outperform. It was like a specific hedge fund on Wall Street or something along those lines, and when I first heard about that I was like, oh, that's kind of cool that they did this.
Speaker 2:But now that you actually gain an understanding of what a hedge fund is intended to do, it was almost like they were playing the entirely wrong game, because the hedge fund doesn't even set out to give you a similar return to the S&P 500. They try to, like you just mentioned, be non-correlated to the S&P 500. So I think that's the one thing that people that are just being introduced to alternative investments need to grasp onto is that's not the goal to have these outrageous returns? Because, frankly speaking, if you're looking for outrageous returns, there's always going to be a correlated risk that goes along with that. Does that make sense what I'm saying?
Speaker 3:Absolutely, and let's also remember that the long short equity, the long short hedge fund manager they're trying to beat the S&P. Not every manager is, and when they put their numbers out, they always compare it to the S&P, which oftentimes isn't the correct thing to do. A managed futures manager shouldn't be comparing themselves to the S&P. They should be comparing themselves to the commodity trading, I guess, cta's manager index. But there's also liquid alternatives. So for people who don't have huge amounts of money, there are liquid alts, which are ETFs that try to replicate how these different managers perform. So that's also something that we have a list of. So if anybody wants to get a list of the liquid alts, feel free to reach out to us as well, and we'll supply that to you.
Speaker 2:Fantastic. Well, I know we're getting close on time here, so let's jump into the Q&A. So I already mentioned the question about why it's not as popular at large scale firms, and the follow up question that this person actually had on the webinar was how much does it cost to invest in alternative investments? So that's a pretty broad question.
Speaker 3:It really depends on the size of your portfolio, but I would say that for a lot of alternatives, you can invest for as low as $100 in some of these. It really just depends on what you're trying to accomplish and how you're going about it, but you can invest in alternative investments for a very, very small amount of money. You don't have to have a tremendous amount. Years ago, you had to have a huge amount of money to invest in alternatives, but now things have become a lot easier for all individuals to invest, and every individual, regardless of the size of your portfolio, should have alternatives in it, because it's again mathematically impossible to have an efficient portfolio without having alternatives.
Speaker 2:And actually on that note you just mentioned. So I think it's worth talking about how hard it is to properly diversify. I know you go to any office in here in Dallas. You go to any office across America. They're going to talk about how you need to properly diversify your investment account and then we might just invest in the S&P 500, maybe an emerging markets fund and then a bond fund. But, as you've noted, actually in wealth mismanagement your book it's hard to even diversify the right way just by going international these days.
Speaker 3:Yeah, the international markets have become highly correlated to the domestic markets, meaning that the second something happens over in Germany or France, in any developed country, it's immediately reflected in the United States market. So the diversify, the correlations are between one and minus one, and the correlation of developed markets is about 0.94 today, and one means they're identical. They used to be 0.78. And even before that, in the 1990s, it was 0.24. And the emerging markets were negative 0.11. And now the emerging markets are about 0.78. So you really don't gain a lot by investing in international markets as you used to. So a lot of times people will invest, as you said, in large cap value, large cap growth, and they might buy a sector fund, but when you look at the correlations, they all go up and down together. So that's the reason why you have to have alternatives and if anyone tells you anything different, they're absolutely incorrect. Yeah.
Speaker 2:No, I feel like this conversation. I feel like we're just barely skimming the surface, but for the sake of time, we have to keep it high a little bit. I know that as a listener look, I know a lot of this stuff might feel like drinking out of a fire hose, just because there's so much information, there's so much new stuff that you've never heard before. So if this does sound like something that may be interesting to you, please just reach out to me. One of the things I just absolutely love doing is walking people through their options.
Speaker 2:I came from a place where we are heavy on products, heavy on sales, but really what we love to do at Chapo does just be educational, be informative, which is entirely the case of this podcast. But if I could just leave you with one last message, just to be able to understand your plan and when I say that, as we were just going through there, a lot of people's plan for diversification is to go 70% into an American fund, 20% into an international fund and 10% in bonds, and really what you're hurting at the end of the day is your future, when you think of what that does to your compounding, obviously, the more your portfolio goes like this. You're really going to hurt compounding in your portfolio and, ed, we like compounding here at Chapwood. But I will pass it over to you for a final message and then we'll log off here All right.
Speaker 3:Well, we do these podcasts to be informative, but we're also obviously very interested in developing new business and we don't care the size of your portfolio. Reach out to us and let us have a conversation over Zoom, and we'll see if there's a chance that we could work together. So thanks for doing this, jordan.
Speaker 2:Absolutely Well. I hope everybody has a great rest of your Wednesday. Be sure to check us out on YouTube as well, and be sure to tune in next Wednesday for the Making Sense podcast. Thanks, guys, bye.
Speaker 1:The Making Sense podcast is recorded by Chapwood Investments managing partner at Butoskey and Jordan McFarland. If you have any questions, please email them to info at chapwoodinvestmentscom. This podcast contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Pass performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this podcast will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.
Speaker 2:Asset allocation does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments are often sold by prospectus that discloses all risks, fees and expenses. They are not tax efficient and an investor should consult with his or her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques which can magnify the potential for investment loss or gain and should not be deemed a complete investment program. The value of their investment may fall as well as rise, and investors may get back less than they invested.
