In his latest session, valuation expert Aswath Damodaran tackles the growing enthusiasm for alternative investments.
He begins by laying out the facts: “Much of investing as we know it… have been directed at two classes of investments: publicly traded stocks and publicly traded bonds.” But increasingly, attention has shifted to private markets, real estate, crypto, hedge funds, and collectibles. “Alternative investing has been sold to the mainstream… and now it’s coming for individual investors.”
So what’s the pitch? “Adding something that is less correlated with what you hold already… can create better risk return tradeoffs.” Additionally, “You’re more likely to find market mistakes in the alternative investing universe… and the people involved in the space… tend to be smarter than the rest of us.”
Damodaran doesn’t dismiss the logic outright. “Adding alternatives delivers a higher return for any given level of risk.” But he warns, “The alpha argument is a tougher one.”
And the promise hasn’t always held up. “They looked at maximum drawdowns… and what they discovered was that during bad years, adding hedge funds… did not make bad years less worse.” In fact, “You’re not seeing the promise pay off in practice.”
He identifies three reasons why the pitch may be flawed. First, “The correlations… are either understated or misleading.” Why? “Private equity or venture capital… are appraised rather than actual market prices.” During crises, “even lightly correlated alternative investments start to behave like stocks and bonds.”
Second: liquidity. “Alternative investments are not liquid and they’re opaque… you should be okay with that.” But “our need for liquidity goes up during crisis… and illiquidity also shows up as transaction costs.”
Third, those famous excess returns are fading. “As they become bigger they’ve attracted average and below average investors… dragging down those returns.” Plus, “the investment game itself has become more difficult to win.” Even hedge funds aren’t spared: “Hedge fund alpha seems to have gone away.”
Costs matter, too. “Maybe even if alternative investing delivers all the benefits… I would seriously doubt that the benefits are large enough to cover a 2 and 20 fee on a consistent basis.”
Still, Damodaran doesn’t advise avoiding alternatives entirely. “Be picky… forget the alpha pitch… pick low correlation alternatives.” And most importantly: “Be realistic about time horizon and liquidity needs… and how much you should distrust… historical correlation matrices and historical alphas.”
You can watch the entire video here:
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