Podcast Summary: Excess Returns – Show Us Your Portfolio II: Larry Swedroe on Alternatives and Interval Funds
Release Date: December 21, 2023
In the second installment of the "Show Us Your Portfolio" series, hosts Justin Carbonell and Jack Forehand delve deeper into the intricacies of building a diversified investment portfolio with guest Larry Swedroe, a prolific author and head of financial and economic research at Buckingham Strategic Wealth. The episode, titled "Show Us Your Portfolio II: Larry Swedroe on Alternatives and Interval Funds," offers listeners an insightful exploration of alternative asset classes and innovative investment vehicles that can enhance long-term portfolio performance.
1. Introduction and Recap
Justin Carbonell kicks off the episode by welcoming Larry Swedroe back for a follow-up discussion. He recalls their previous conversation where Larry introduced his evidence-based approach to investing and hinted at a broader array of asset classes within his portfolio. This episode aims to unpack those additional elements, providing listeners with a comprehensive understanding of how to achieve a highly diversified portfolio.
Quote:
Larry Swedroe (01:05): “I take a disciplined, evidence-based, and first principles approach that all investors can learn from.”
2. Market Valuations and Expected Returns
Larry begins by addressing the fundamental concepts of equity and fixed income performance, especially in the context of current market valuations and interest rates. He emphasizes the importance of distinguishing between public and private equities and fixed income investments, highlighting that private markets offer different dynamics and potential returns.
Key Points:
- CAPE Ratios: Larry discusses the Cyclically Adjusted Price-to-Earnings (CAPE) ratio as a predictor of future equity returns. He notes that with CAPE ratios at historical highs (~30), expected real returns for equities are around 3%, which is significantly lower than the historical average of 10%.
- Bond Yields: Current bond yields are low, with floating rates hovering around 1.5%, compared to historical averages of 4-5%. This shift necessitates adjustments in traditional portfolio allocations to avoid underperformance.
Quote:
Larry Swedroe (02:29): “A good predictor we have of future equity returns is the earnings yield... which gives you 3% or so expected real return, about half of the historical return.”
3. Equity Valuations and Market Segmentation
Larry highlights the bifurcation in equity valuations, where large-cap tech stocks are highly valued, while international and small-cap value stocks remain undervalued. This segmentation presents opportunities for investors to tap into higher expected returns by diversifying across different market segments.
Key Points:
- Large-Cap Concentration: The top 10 companies in the S&P 500 account for 35% of the index, with high PE ratios indicating overvaluation.
- Undervalued Segments: International and emerging markets, along with small and value stocks, trade at lower valuations (P/E ratios in the 7s and 8s), suggesting higher future returns.
Quote:
Larry Swedroe (06:09): “International stocks are trading more at 12 and 11 for emerging markets and developed and small value stocks around the globe... predicting much higher expected returns.”
4. Framework for Evaluating Alternative Investments
Larry outlines a rigorous framework for assessing alternative investments, ensuring they meet specific criteria before inclusion in a portfolio. This framework is rooted in academic research and emphasizes systematic, transparent, and replicated strategies.
Criteria Highlighted:
- Premium: Evidence of a consistent return premium.
- Persistence: Demonstrated performance over long periods and various market conditions.
- Pervasiveness: Applicability across different industries, sectors, countries, and asset classes.
- Robustness: Sensitivity to different definitions and categorizations.
- Explanatory Power: Strong risk-based or behavioral justifications for the premium.
- Survival of Transaction Costs: Net returns remain attractive after accounting for all costs.
Quote:
Larry Swedroe (14:48): “Any investment must meet all those criteria... persistence, pervasiveness, robustness, intuitive explanations, and surviving transaction costs.”
5. Exploration of Alternative Asset Classes
Larry provides an in-depth analysis of several alternative asset classes, explaining their return profiles, investment cases, and how they fit into a diversified portfolio.
a. Private Credit
Private credit involves lending directly to mid-sized companies, often backed by private equity firms, offering higher yields compared to public credit markets.
Key Points:
- Higher Yields: Example of Cliffwater’s private credit fund yielding approximately 11.5%, outperforming Vanguard’s High Yield Fund.
- Superior Credit Quality: Senior secured debt with minimal default rates (~1%) due to backing by private equity.
- Liquidity Considerations: Typically accessed through interval funds, requiring disciplined long-term commitment.
Quote:
Larry Swedroe (26:18): “Cliffwater's fund is much safer than Vanguard's High Yield Fund... with no term risk and superior credit profiles.”
b. Structured Life Settlements
Structured life settlements involve purchasing life insurance policies or structured settlements at a discount, providing liquidity to policyholders in exchange for future returns.
Key Points:
- Uncorrelated Returns: These investments offer high expected returns (10-12%) with low correlation to traditional asset classes.
- Behavioral Aspects: Investors must understand the risk of uncertain lifespans and require strong due diligence.
Quote:
Larry Swedroe (30:30): “It's like the perfect asset because it's totally uncorrelated to stocks and bonds and has a relatively high expected return.”
c. Litigation Finance
Litigation finance involves funding legal cases in exchange for a portion of the settlement or judgment, providing capital to litigants while generating returns for investors.
Key Points:
- High Returns: Potential for substantial returns based on case outcomes.
- Illiquidity: Requires a long-term commitment as payouts depend on the resolution of legal cases.
Quote:
Larry Swedroe (36:36): “Firms will fund your litigation in return for a percentage of the proceeds, offering high returns but with significant illiquidity.”
d. Long-Short Factor Investing
This strategy involves taking long positions in undervalued assets and short positions in overvalued ones, aiming for market-neutral returns.
Key Points:
- Pure Factor Exposure: Example of AQR’s Style Premium Fund, which is completely uncorrelated with market beta.
- Risk Management: Provides diversification and tail risk protection, enhancing overall portfolio resilience.
Quote:
Larry Swedroe (37:25): “It's long value, short growth... totally uncorrelated with what's going on with market beta.”
e. Reinsurance
Reinsurance involves taking on insurance risks from primary insurers, offering returns based on underwriting profits and premium income.
Key Points:
- Stable Returns: Historically low correlation with traditional assets, providing diversification.
- Discipline in Investment: Requires trust in the fund manager’s ability to handle long-term risks.
Quote:
Larry Swedroe (39:34): “Reinsurance has been around for 170 years... a great asset with no correlation to either stocks or bonds.”
f. Managed Futures
Managed futures employ trend-following strategies in various markets, aiming to capitalize on market momentum.
Key Points:
- Behavioral Basis: Driven by time-series momentum rather than risk-based explanations.
- Tail Risk Protection: Effective during market downturns but may underperform during prolonged uptrends.
Quote:
Larry Swedroe (50:07): “These funds do well when needed most in long periods of underperformance... they should be bought to protect tail risk.”
6. Investor Behavior and Discipline
Larry emphasizes the importance of maintaining discipline when investing in alternative assets. He warns against behavioral pitfalls such as panic selling during periods of underperformance and highlights the necessity of understanding the underlying rationale for each investment.
Key Points:
- Staying the Course: Investors must adhere to their investment thesis, even during challenging periods.
- Resulting Bias: Avoid judging strategies solely based on short-term outcomes; focus on the quality of investment decisions.
Quote:
Larry Swedroe (58:05): “The worst mistake people make is engaging in what’s called 'resulting'—judging the performance by the outcome and not by the quality of the decision.”
7. Future Innovations in Investment Structures
Looking ahead, Larry discusses expected innovations in the investment landscape, particularly the evolution of interval funds and fee structures.
Key Points:
- Interval Funds Evolution: Anticipation of more evergreen funds similar to interval funds, allowing continuous investment and periodic liquidity.
- Lower Fees: Shift from traditional 2 and 20 fee structures to more competitive models (e.g., 1% management fees and 10% carry).
- Increased Accessibility: Innovations will democratize access to alternative asset classes, previously limited to institutional investors.
Quote:
Larry Swedroe (63:53): “Curve fund structures have changed the game... more illiquid assets being liquidized through interval fund structures to allow individual investors to participate.”
8. Concluding Insights and Recommendations
Larry concludes by reiterating the advantages of incorporating alternative investments into a diversified portfolio. He underscores the significance of low correlation with traditional asset classes, the ability to enhance returns, and the provision of downside protection.
Key Takeaways:
- Diversification Benefits: Alternative assets reduce portfolio volatility and improve the odds of long-term success.
- Evidence-Based Approach: Relying on academic research and robust investment criteria ensures the longevity and effectiveness of investment strategies.
- Discipline and Understanding: Successful investment in alternatives requires thorough understanding and the discipline to remain committed despite short-term fluctuations.
Final Quote:
Larry Swedroe (65:57): “These funds are always doing what they’re supposed to do. It’s just that sometimes you like the results, sometimes you don’t. You have to understand why you did it in the first place and stick with it.”
Conclusion
This episode of "Excess Returns" provides a comprehensive guide to integrating alternative investments and interval funds into a long-term investment portfolio. Larry Swedroe offers practical advice grounded in empirical research, emphasizing the importance of diversification, disciplined investing, and understanding the unique risk-return profiles of various alternative asset classes. For investors seeking to enhance their portfolios beyond traditional stocks and bonds, this discussion serves as an invaluable resource, outlining both the opportunities and the requisite diligence needed to navigate the complex landscape of alternative investments.