Phil-in the Gaps: Why Alternative Investments Belong in Your Retirement Portfolio

Taylor Schulte: Welcome to the Stay Wealthy podcast, I’m your host Taylor Schulte and today I’m revisiting the world of alternative investments.

You might recall the episode I published a couple of months ago discussing alternatives and if retirement savers should invest in them.

In short, I concluded that, while alternatives tell a compelling story, the large majority of products and solutions don’t meet their stated expectations. That most retirement savers likely wouldn’t benefit from adding alternatives to their diversified portfolio.

Well, today, I’m joined by Phil Huber, author of The Allocator’s Edge and Chief Investment Officer at Savant Wealth. Through Phil’s research and writing, he’s come to a different, more optimistic conclusion about alternative investments, and that’s exactly why I invited him to come on the show.

I wanted to better understand how he thinks about alternatives, how he defines them, and why he thinks they are a valuable addition to a diversified portfolio.

I also wanted to give him the space to share what I might have previously gotten wrong about this complex asset class.

To support Phil’s work on this topic and further help our listeners come to their own conclusion about alternatives, I’m giving away 10 copies of his book, The Allocator’s Edge: A modern guide to alternative investments and the future of diversification. Phil is a wonderful writer and does an incredible job breaking down this asset class and breaking it down in a way that everyone can understand.

Unlike prior giveaways, to give all time zones an equal opportunity at getting a free book, ten listeners’ names will be drawn at random. To throw your name in the hat, just head over to this episode’s show notes page which can be found by going to youstaywealthy.com/187.

You’ll see a short giveaway form where you can quickly add your name. The deadline to submit is Monday, May 8th at 11:59pm and winners will be announced shortly after.

Once again, the show notes for this episode, including the book giveaway form, can be found by going to youstaywealthy.com/187.

Without further ado, here is my conversation with Phil Huber.

Phil Huber: Any investor has a broad menu of sorts that they can choose from when it comes to building a portfolio. And so when you think of how the vast majority of investors allocate their dollars, it's typically through some combination of stocks and bonds and what we often refer to in the industry as the 60-40 portfolio, 60% stocks, 40% bonds, and the reasons for this are multiple.

Well, number one is that portfolio mix absent 2022 has done quite well over a multi-decade period, and so it's delivered good results to investors over time, both in an absolute and a risk-adjusted sense. It's gotten increasingly easy to implement that type of portfolio as time has gone on, as technology's improved and costs has come down, you can get pretty much entire global stock and bond market exposure through one, two, or three mutual funds or ETF.

So very, very easy. Just a few clicks of a button, a couple of ticker symbols, and you're kind of on your way. It's very intuitive, I think even the most novice investor I think understands the role of stocks in a portfolio is there for long-term growth and appreciation, the role of bonds more for stability, defense income, etc.

So you don't have to be a CFA charter holder to understand why you would wanna blend those two assets together. And then there's everything else that we broadly and loosely refer to as alternative investments, which in my opinion really tells you not so much about what something is, but more about what it isn't. And for a long time, it wasn't something that the average investor had to pay a lot of attention to because most of what we would deem to be alternative tended to be things that were more institutionally focused.

So investment and asset classes that were more the domain of your large pensions, endowments, foundations, et cetera, or perhaps just the ultra-high net worth type investor. As time has gone on, like anything in life, technology gets better, access improves, and so you're starting to see more and more of these different types of alternatives become more readily accessible to your average China net worth investor in the marketplace.

And so what that has brought to the forefront is this idea of should investors expand their pallet a bit to include other things beyond stocks and bonds in a portfolio as a form of additional diversification or potentially to play some sort of either return enhancement or risk management role in a portfolio to perhaps maybe pick up the slack a bit where either stocks and or bonds might fall short.

That's the decision facing a lot of investors today is how to exactly tackle that space.

Taylor Schulte: Like you alluded to, the term alternative investments is broad and people have all sorts of different definitions for what's an alternative and what's not an alternative. How do you define alternative investments? What do you consider, what don't you consider an alt? And maybe even share some examples of specific asset classes that you personally own or some of your clients own, and talk us through some of those different asset classes inside the alternative category.

Phil Huber: I always like to say when the topic gets brought up, someone says, should I be invested in alternative investments? I'll often say, well, alternative to what? An alternative to whom.

We've talked a little bit about alternative to what, and that's kind of your stocks, bonds, cash, everything else fits in there, but there's also a little bit of it that the definition is in the eye of the beholder, and so something like private equity, for example, might be alternative to your, but if you're the CIO of CalPERS or something like that, you've been investing in private equity for decades and so it's not quite that alternative to you.

Something like Bitcoin, we'll use it as an example, probably alternative to my grandmother, maybe not so much to my 25-year-old cousin. So everyone has their own perception of what constitutes alternative, and it's also this constantly evolving definition.

If you look at things that are fairly commonplace today in diversified portfolios of traditional asset classes, you'll typically see things like emerging market stocks or publicly traded REITs for real estate exposure or things like high-yield bonds. Very few people would really consider those to be alternatives today, but those were asset classes that were essentially in their infancy in the eighties and nineties and at that point in time in history, very much were kind of on the frontier are considered more alternative.

And so the definitions of evolving and it's very much in the eye of the beholder as well. When I think about the bigger categories of alternatives in terms of media attention or dollars allocated to you typically tend to think of private equity, venture capital, hedge funds, real estate and maybe gold or commodities or things like that.

In addition to those categories, there's also an emergent, I would say, group of alternatives that are maybe less mainstream but becoming more broadly accessible today. One being what I broadly call alternative risk premium, which is similar to hedge funds in some ways, but if you think of it as taking certain types of hedge funds strategies and applying them in a more rules-based low-cost, more transparent type of wrapper, and that would include things like managed futures or global macro strategies or things like event-driven strategies.

Then you've got things like insurance link securities, which is getting exposure to catastrophe event risk, which is a wholly uncorrelated source of returns relative to financial markets. And then you've got private debt, which is sort of a cousin of private equity but more focused on income. And then we talked about real estate a little bit.

There are other types of real asset classes out there, things that are based on tangible assets with some element of cash flow and inflation sensitivity. And so that could include things like infrastructure farmland or Timberland. And so there's plenty of others that we could go into, but in the interest of time, we'll maybe pause there.

Taylor Schulte: You mentioned that alts can be defined a number of different ways and it is in the eye of the beholder there. Do you believe that an alternative has to have certain characteristics?

For example, does it need to be uncorrelated to traditional stocks and bonds? Are you looking for something and evaluating it a certain way to say this is an alternative and this is not. Second, to that, would you consider a low-cost publicly traded refund to you? Is that an alternative? Is a low-cost Vanguard tips fund? Is that an alternative in your eye?

Phil Huber: I personally don't think of those two as alternatives. I would think of tips as you mentioned as just a component of a broad fixed-income allocation. Rates are a sector of the global stock market, and so that might be akin to calling healthcare or utilities and alternative, they're just sectors of the marketplace. And so alternatives don't necessarily have to be totally uncorrelated.

I think it ultimately depends on what are you trying to achieve with your allocation. There are certain, if you think about like a bell curve sort of thing, there are certain types of alternatives that are exposed more to right tail risks. Things like venture capital perhaps or crypto would be a couple of examples there maybe others that are focused more on left-tail risks.

So extreme downside could be certain types of hedging strategies, things like that. And then you've got other alternatives that I think again, if they can solve for some sort of intuitive risk premium that can deliver a meaningful risk-adjusted return over time in isolation. And I think if you can combine that with traditional assets in a way that it is complimentary due to the independent nature of its return driver, that kind of serves as more of your core alternatives.

So when I think of how we utilize alternatives at Savant, we focus more on what, what are the core alternatives that are what we think ways to augment a traditional stock-bond portfolio that improves overall risk-adjusted returns and creates a greater degree of resiliency to a broader spectrum of different macro and economic type of environments.

Taylor Schulte: You referenced a number of different alternative categories or asset classes, one that more recently has made headlines as managed futures, especially last year where managed futures funds had a pretty good year, so it's come up a lot more in recent years.

I don't wanna go through every definition of every alternative category, but given that managed futures has made more headlines recently, would you mind just sharing what managed futures are like when you're buying Managed Futures fund, what are we buying? What is that?

Phil Huber: The reason it's called managed futures is the word futures in the name is in reference to the fact that rather than buying a stock or a bond, the instruments being used in these funds are typically futures contracts or other derivatives. And the managed piece refers to this idea that the exposures are dynamic.

And so there are futures contracts and derivative contracts that are liquid in nature that encompass everything from equity indices to interest rates, currencies, commodities, and so really across the different types of asset classes.

And essentially what most managed futures funds do is try to capture this trend behavior that there's a lot of great research in academia that supports this notion of trend following being a valuable type of investment strategy, kind of rooted in behavioral finance, where prices essentially don't necessarily move in a complete random walk. They tend to exhibit trends more often than not, and these trends can be positive trends.

An asset that has been rising in price may continue to rise in price and one declining in price might see some short-term negative momentum or continues to decline. And so trends aren't always there, but the idea is that if you can invest across dozens, if not hundreds of different futures contracts and have the ability to take long or short positions depending on the direction of that trend, you can get a pretty diversified return profile and one that historically has actually done very well, exactly when you want the most, which tends to be when everything else in your portfolio is doing quite poorly.

And so if you look across the data that we have for managed futures, and you look at the worst quarters for something like the s and p 500 over that several decade time period, you can see fairly reliable outperformance in most cases relative and absolute terms, meaning managed sutures has the ability to deliver positive returns in really stressed environments for equities.

And so it could be a really compelling diversifier, but like any alternative or any other form of diversification, there are no silver bullets, if you will. I think that's a common mistake that folks entering alternatives for the first time have is these sort of unrealistic expectations that just because something's uncorrelated, it's gonna work all the time.

The good news and the bad news is the good news is they can be valuable over time and improve a portfolio. The bad news is they're not always gonna show up. And so you have to have a long time horizon.

You have to have patience and discipline because what you run into, which I think you were maybe alluding to is that often everyone wants to shut the barn door after the horse is already out, meaning they experience a year like 2022 or maybe prior to that 2008, they see that something like managed features did quite well during that period when stocks and bonds maybe didn't do so hot and then they wanna add that diversification more as a reaction as opposed to having that preparation built in from the get-go.

The flip side of that too is if you had been following the asset class for years prior, it's no surprise that the 2010s were a challenging decade for managed futures. It was a pretty long equity bull market and it was just an environment that didn't lend itself well to managed futures funds. And so for those that were already allocating, a lot of folks did not have the patience to stick with it. And if you just look at flows for the category, you see a lot of outflows in the years leading up to 2022.

So even folks that were in the asset class maybe didn't eventually reap the benefits when it eventually showed up. And so then that's not a challenge that is specific necessarily to alternatives. We see return-chasing behavior all the time in investing. Stocks, bonds, alts, everything.

My view there is any type of alternative you're gonna introduce to a portfolio should really be more from a strategic standpoint, something you feel like you can buy and hold over a long period of time and not just try to time it or make some sort of tactical adjustment based on your view on where stocks or bonds might be going because there can be long winters, if you will, for any type of asset outside of Tebows.

There's no guarantees or no real risk-free type of return. So you're still bearing risk. It's just the idea is that this is an independent and diversifying source of risk relative to the things you already own.

Taylor Schulte: I'm jumping ahead a little bit, but since we're on Managed Futures, I wanna ask this question. I think one of the challenges with allocating to an asset class like Managed Futures, let's imagine one of our listeners here is bought in to manage futures and feels like it would compliment their current portfolio.

One of the challenges that I've come across is that not all managed futures funds are the same. Some did very well last year, some didn't. And so you really have to look under the hood and understand how that fund is positioned and how it's managed and those nuances. Are there any high-level tips that you can provide if someone wants to go shopping for a managed futures fund, add to their portfolio?

Again, we know there's a number of different alternative investment categories, but just zoning in here on Managed Futures while we're on it, what are you looking for when you're evaluating Managed futures funds to know that you're getting the fund, you're getting the exposure that you're actually looking for?

Phil Huber: Yeah, it's interesting in the sense that it managed futures funds relative to say large cap equity index funds are different in the sense that there's probably 10 different S&P 500 ETFs you could pick from. They might have different expense ratios by a few basis points here and there, but by and large, they're quite fungible with one another.

It doesn't really matter which one you pick for the most part, when you look at other categories of investing and you look year by year or over time, you can see a wider degree of dispersion in terms of your better performing funds and worse performing funds.

It may seem at the surface like they're all kind of doing the same thing, which is by and large trying to apply a trend following strategy, but they may differ quite a bit in terms of how they implement that, in terms of what types of markets they're willing and able to trade, what sort of volatility level that they might be targeting at the overall fund level, what sort of trend signals they might be focused on.

Some funds focused more on short-term trend signals, others on longer-term trend signals. And so those different design choices and implementation choices could actually mean a lot different actual realized returns. For someone who doesn't wanna spend a ton of time trying to weed through every fund and decipher what they think might be the most optimal solution, there are approaches out there that offer exposure to multiple managers within one fund.

And that might be a way to get more of a smoother ride in the asset class where you're not betting on one single trend following manager, but maybe a broader set of those where you're trying to get more of the asset class return as opposed to the variability that comes with any single manager.

So that's one consideration to keep in mind and I think that can be applicable perhaps to other types of all categories, especially as you move more on the illiquid side into areas like private equity and venture capital. You see much greater dispersion between your top quartile and bottom quartile performers. And really the difference between success and failure and allocating to those areas is gonna be more contingent on which jockey you're betting on as opposed to the horse itself. Whereas in public equity markets that are more efficient, you're kind of really more betting on the horse, if that makes sense.

Taylor Schulte: In your book, The Allocators Edge, which will be given away to a handful of listeners here today, you referenced this acronym that you came up with, SHARP. Talk to us about what sharp is and the underlying meaning of each of those letters in the acronym.

Phil Huber: What I wanted readers of the book to come away with was not this idea that there's some sort of perfect portfolio out there that's gonna solve all their problems and get them great returns every single year with no risk. That's not the idea. I think obviously the message of the book is positive in general on alternatives. I don't wanna overgeneralize there because like, like anything in investing, there's good, there's bad, there's ugly.

I think there's certainly some alternative categories that can add value in others that I would shy away from. But really the acronym is more about less of a specific portfolio per se, more of a framework and a mindset to approach investing with whether you're building your own portfolio or if you're someone in our seat, if you're an advisor or some sort of allocator of other people's capital, how should you think about building portfolios?

And so the acronym SHARP is sensible, humble, autonomous, resolute, persevering. By sensible, it's really this idea of is this investment grounded in data and common sense? Why should I expect to make money in it over time and is it supported by evidence?

Being humble is just this idea of the future may not look like the past. Rather than try to predict where inflation's going or interest rates are going, why don't we prepare for a very uncertain future and to do so through diversification?

This idea of being autonomous is really just about, it could be really hard at times, but just really trying to be curious and also an independent thinker and not necessarily just always follow the crowd when it comes to best practices, particularly for those that are working on behalf of others being resolute. In other words, always understanding, bringing yourself back to this idea of what is the purpose of this money and making sure that we're focusing on our clients' outcomes more than anything else.

And then lastly, P for persevering investing is a long game. It's a marathon, not a sprint. While an alternatives may have the potential to improve the odds of successful outcomes over time, it's not gonna show up every year. You have to have patience in order for these things to work over time. And so just this idea of being process-oriented and focused on the long game, so really combining those attributes together.

Easier said than done. Of course we don't all get up every single morning with complete sensibility and humility and autonomy, etc. To me it's something to I think strive for over time to be a better investor.

Taylor Schulte: While we're talking about your book here, Cliff Asness kindly wrote the forward to your book and I'd love his few pages there. It sounds like both you and Cliff, at least at the time of this writing, were both on the same page with regard to traditional stock and bond portfolios suggesting that these traditional 60-40 stock-bond portfolios are being challenged and will be continue to be challenged going forward.

Talk to us about why those portfolios will be challenged going forward and maybe why you think if you think that the opportunity to add alternatives to a boring 60-40 portfolio might be more compelling today than, I don't know, a few years ago or even 10 years ago.

Phil Huber: The math there has really been more focused on the 40 of the 60-40 meaning the bond piece. In other words, your starting yield on bonds is a fairly good predictor of what you can expect to earn in returns over the subsequent, call it five to 10 years. And that was really where the alarm bells were going off.

It wasn't necessarily something you ever wanna market time, but really the idea, if you think about where we entered 2022 with interest rates, essentially it's zero on the short end and historically low levels further out on the yield curve, it didn't paint a great picture for what to expect over the next five to 10 years.

Now the potential outcomes were one of two paths, either what we did experience, which was fast pain, which was rates going from zero to over 4% in short order less than a year. That was the double-digit declines we saw in bonds last year. That was short pain.

The other potential, if we didn't see inflation potentially go up the degree that it did would've been probably more of a long pain, which is I think probably a worse outcome longer term for investors and savers and retirees, which was, what if the 10-year stayed at 1.5% for the next 10 years? That's a bad outcome too because if someone's got 40% of their portfolio and fixed income, then that's really gonna mute their ability to meet their objectives and take income from their portfolio, all these things.

And so the good news after a yearly last year is that expected returns are now higher, and that's the same for bonds, that's the same for sos and the same for a lot of alternatives as well. If you think about the risk-free rate, that's sort of the center of gravity and almost the sort of rising tide that lifts all boats.

And so I think in general, whether you're allocated in a traditional stock-bond portfolio or one that's more diversified with alternatives, you should feel better about your forward-looking returns than you did 12 to 18 months ago cause of that big shift in interest rates. And so that being said, it's still not an easy environment to get a sizable return with not taking a lot of risk.

There's a great study by Callan who's a big institutional consultant that they update periodically where they said, what type of risk would it require to achieve a 7% expected return? And so if you go back to their study in 1993, you could get a 7% return by being almost a hundred percent allocated to just core fixed income. I think they show it's like a 97% bond allocation and 3% large cap stocks, and you could have an expected return of 7% with a fairly low risk risk profile if you fast-forwarded to 2022 before the start of last year, essentially you almost had to take three times the amount of risk to achieve the same expected return.

And so it's gotten increasingly tougher to get a reasonable rate of return without taking more risk. If we fast forward from 2022 to 2023, the math looks better, but it's still not anywhere like what it was in 1993. So as much as rates have gone up at the end of the day, 10-year treasury around three and a half or so around the time of this recording, but certainly better, but we're still not quite back to an environment where you can get a really high expected return from a conservative portfolio.

And so I think again, the case for diversification is as strong as ever. So as much as I'm happy to see bonds in a better place today going forward for investors, that doesn't lessen the case in my opinion, for alternative investments for a couple of reasons.

One is that the expected returns on some of those alternatives is higher as well. And I think it's just this idea that diversification is the only free lunch in investing, and if you can find things that are truly independent and uncorrelated and have a intuitive risk premium associated with them, those are things that you might wanna consider owning to build a portfolio with. And so that's kinda my thinking on that.

Taylor Schulte: I'm not familiar with the Callan study. I'll have to get a copy of that or get a link to it and we'll put it in the show notes. It's kind of chuckling as you were talking about that. One of the most downloaded episodes on this podcast is an episode I did titled How to Get a 7% Rate of Return. So I talk a lot about those different time periods where it was a lot easier.

Phil Huber: It probably came from them. I'll send you the link afterward.

Taylor Schulte: It might have, maybe I have come across it and I was influenced by it, so we'll make sure to put that in the show notes and I'd love to check it out. Again.

Another question kind of popped up as you were talking there, and maybe this changes and evolves depending on the current environment, but when you look at that boring 60-40 portfolio and you say, okay, I wanna inject alts into this portfolio and let's just say I wanna carve out a 20% allocation to alternatives, you kind of led your answer by saying really the stock portion isn't necessarily the problem the bond portion has historically or in recent years been the problem.

When you inject that 20% in your mind, are you taking that from the bond allocation? Are you cutting your bond allocation in half and now you have a 60 20, 20 portfolio? Are you taking a little bit from stocks and a little bit from bonds? How do you think about where alts fit in and enter into that 60-40 portfolio? Is it always the same or does it change depending on projected forward looking returns or expected returns?

Phil Huber: It's really up to whoever's deciding on that particular decision. There are different ways to approach it. If you're taking it all or almost all from fixed income, it's likely that you are increasing your expected return, but probably adding a little bit more volatility to the portfolio. If you're taking it all from equities, you're likely lowering the portfolio is expected to return, but maybe orienting it more towards capital preservation.

So I think again, it always goes back to what are the client goals and objectives that we're trying to achieve and also what types of alternatives are we considering? There are some alts that might be more appropriate to bucket alongside equities, others that might be more appropriate substitutes or compliments to bonds. And so it's hard to come up with a, I think a generalized answer to that.

Taylor Schulte: Question. In the book, you have this great quote, which I appreciated. You said most allocators like the idea of uncorrelated returns but bulk at the actual experience of owning uncorrelated return streams. So they like this idea and concept, but when they actually go to apply it and try to implement it, they don't enjoy that experience. Why have investors really struggled to historically adopt alternatives? Why is it such a challenge to have a good experience owning alternative investments?

Phil Huber: I think especially when you think of things that are uncorrelated, I was actually listening to your episode on alternatives from a few weeks or a couple of months ago as part of my prep for coming out with you, I had to know what I was getting into. And I think you mentioned this idea of the notion of ALT or something that's uncorrelated is that it might zig when something else is zagging.

And I think that's actually a common misperception of actually what uncorrelated means for something to zig when the other thing is zagging, you're assuming it's doing the opposite. That's actually negative correlation.

In other words, if I can tell you something's gonna be up when stocks are down, there's a negative correlation there. That sounds great. In theory, we'd love to have confidence that we had a bucket of our portfolio that anytime stocks were down over a given week or month or a quarter or whatever, that we had a another piece that was guaranteed or at a high likelihood of being up.

The challenge is that most things that are negatively correlated to stocks either have a very low or negative expected return. An easy example here would just be like buying puts put options. That's a great way to ensure that you're gonna get a pop if stocks go down quite a bit. The challenge is you just buying puts systematically over time.

You're pretty guaranteed to lose money because maybe it pays off one time out of 10, but they're nine times you're just paying a premium and losing money. And so the things that have that negative correlation that we all seek or desire don't also come with the benefit of having sizable investment returns.

Things that are uncorrelated are a little bit harder to hold in practice because we lack that intuition on how they should behave or how we want them to behave depending on the movements of other things in our portfolios. And so if something's really uncorrelated, you could tell me that stocks were down 20% last month and I can't tell you if this all was up, down or sideways because they're not linked in any way. And so that can be really frustrating.

It worked well for those that owned something like managed sutures last year, but gets more challenging when you've got a year where stocks are up 20 plus percent and the alternative is up single digits or negative or something along those lines where it becomes this pain point where you want everything to be working and it seems like something is sticking out like a sore thumb.

So one of my favorite quotes from our mutual friend Brian Portnoy on diversification is that

diversification means always having to say you're sorry because if you really have a diversified portfolio, there's always gonna be something that is disappointing you.

Taylor Schulte: I think that's a really important distinction about negative correlation and uncorrelated returns or uncorrelated return streams. I think there is this misconception with investors when allocating to alternatives that these alternative investments are gonna protect me during catastrophic time periods. We go back to ‘08, ‘09 and everything is a mess, but if I have alternatives, alternatives are gonna save me.

I think part of that has to do with the marketing of alternative funds. When traditional asset classes are suffering, you see these alternative fund companies and their marketing departments going to town to market their solutions. So investors are naturally kind of connecting the dots saying, gosh, well I guess when traditional things suffer, I would expect alternatives to kind of save me.

That's not necessarily true. Is that your line of thinking then? I guess just if we look at alternatives in isolation, your expectation is not that they're gonna save you during catastrophic time periods. Is that accurate?

Phil Huber: No, nothing's gonna save you, especially if you're maintaining your core exposure. It might help you have lower drawdowns or manage risk a little bit more than you otherwise would, but it's not gonna flip a negative into a positive in a catastrophic type of year.

And again, it depends on which alternatives you're talking about. Things that are more equity-oriented are probably gonna suffer and go down alongside equities. You might have others that are more reliable in stressful environments but maybe have less sizable returns in other environments. And so certainly the marketing engine is gonna continue to do what they do when it comes to these things.

And I don't think we do ourselves any favors there necessarily, but I think it's also a function of sizing a 2% allocation to alternatives no matter what it is, is not going to do anything. I think for those that are trying to decide what, if anything they wanna do in this world, in my opinion, there's no right answer, but it's gotta be enough to matter, but not so much that it's gonna overwhelm the portfolio and lead to an experience that an investor can't stick with.

And so if you're debating zero or 1% or 2%, just stick with zero would be my opinion there. And just maintain the simplicity and comfort that comes along with that because adding an alternative, it's not as easy as just saying, okay, this works on paper, this works on a spreadsheet. There's a lot of decisions you have to factor in around how to size it, where to source it from, how to think about taxes, how to think about costs, and just the experience of owning them.

Like if you're managing portfolios on behalf of others, you can't just throw these things in there and expect your clients to stick with them over time. You have to put a really concerted effort around education and setting proper expectations. Because I think that's where a lot of folks get into trouble and all is just having unrealistic expectations. And so if you're not prepared for that journey and the commitment that comes with that, you may be better off just keeping things simple as an alternative at the end of the day.

To reference back to Cliff Asness who wrote the forward to the book, I think I probably quoted him like 10 times in the book. He's a very quotable guy, but he's always had the saying that the best portfolio is the one that someone can stick with. And I would certainly agree with that.

Taylor Schulte: I agree too, and I just think it's important to emphasize here that I talk a lot about bonds and misconceptions and bonds and just like bonds when it comes to alternatives, there are different levels of risk that you can take with your alternatives and I think it's important to understand exactly what you're buying and the risks that are associated with those.

Phil Huber: Actually that brings up a good point is that you got to go beyond the label by which, I mean this was an aha moment that a lot of people had in 2008 was just because something has bond in the label, not all bonds are created equal. There's different degrees of interest rate risk and credit risk. And so you have to really look under the hood.

It's like more about not just looking at the thing about like going to the grocery store, not just looking at the front of the cereal box, but looking at that nutritional label to really understand what nutrients are you getting, not just what someone calls itself. Because at the end of the day you can create a really pretty pie chart and have a lot of different line items in a portfolio. But if all of those individual funds or holdings have the same overlapping risks, then you're not truly diversified.

Taylor Schulte: Strategic income opportunities fund there you go. You mentioned this a few minutes ago, fees and taxes and that certainly comes up in the alternative investment conversation.

How do you think about fees and taxes when allocating to alternatives knowing that in some of these there is a little bit more of a tax drag so you have to keep that in mind and what types of accounts you might be owning these? And then also, and maybe it's a question to you, is it, is it fair to say that alternatives are more expensive and that is an important consideration?

Phil Huber: Maybe starting with the tax side, painting with a broad brush, I think they tend to be less tax efficient than an equity index fund certainly can vary by category. What you wanna have an understanding of is what is the turnover of the strategy? Things that have a higher degree of turnover might have a greater propensity to distribute capital gains could be long-term, could be short-term, some combination thereof.

And so being mindful of the associated tax rates with those and maybe being cognizant of locating certain asset classes and tax deferred account types to try to shield those and and retain more of the overall return. Other types of alternatives are more income oriented and so if the vast majority of the return is coming from ordinary income distributions again maybe lends itself to trying to hold inside of a tax deferred account.

So at the end of the day, you wanna make sure you're not just assessing the expected return of a particular asset class, but also the net of tax expected return as well. If you're a taxable investor. When it comes to cost and fees, there's no getting around. Alternatives are more expensive. And when we live in a world of essentially free exposure to total stock and bond markets, if you can get those types of exposures for single basis point expense ratios, for all intents and purposes, we'll call that free beta.

Anything that's more expensive does get scrutinized further and and frankly should be scrutinized. You don't wanna just pay up for something not knowing if you're getting the value in exchange. And so I think first it's important to understand what causes a certain type of investment to be low cost versus high cost. In other words, why is the Vanguard total stock market fund able to offer single-digit basis point expense ratios? Well, it's got essentially infinite capacity. And so think about a fund spreading its fixed cost over a larger base.

Having that type of infinite capacity allows you to deliver that type of thing. The other is they're interchangeable. And so when you think about what would cause something to cost more, one is that capacity. So things that have lower capacity tend to be more expensive.

And that's one of four, I call it the four Cs of investment costs, things that lend themselves to higher fees in general. And so capacity is one, two other ones are what I call craftsmanship in complexity, which are essentially how do you design and implement the strategies to deliver real-world results? And those come with additional investments in people and technology and expertise and that just tends to add to costs.

And then the fourth C is contribution, in other words, something that has a strong risk-adjusted return and is complimentary to things you already own. That's a valuable thing to have in a portfolio and she probably would be willing to pay up for it a little bit. It doesn't mean that any expense makes sense. At a certain point it's a quote cliff as us again, there's no investment strategy so good that it can't be made bad by too high of a fee.

It's tricky because when we're comparing fees on traditional assets to alternatives, we're not comparing apples to apples. Fees should always be an important consideration when evaluating any investment, but it shouldn't be the only consideration. And I think especially in the world of alternatives, just buying the lowest-cost option is not as indicative of good outcomes as it might be in stock and bond allocations.

Taylor Schulte: So fees and taxes are certainly important considerations when evaluating different alternatives. Another might be historical data, historical performance. Again, it's not the end to all be all, but one thing people often go and look at is how has this fund performed throughout history? And maybe we should also say too, we're talking about alternatives in isolation here.

And I think both you and I, while we might disagree on some things, we do agree that we should be evaluating the global portfolio, not just evaluating alternatives in isolation, but how those alternatives behave and how they complement other traditional asset classes we might own. Pushing that aside historical data might be an important consideration when evaluating these different alternatives.

As you and I know historical data in the alternative asset class space is kinda lacking. It's a newer asset class as you kind of mentioned at the top of this interview. How do you think about the lack of data compared to traditional asset classes, which we have a lot of, does that make you more hesitant or should it make someone else more hesitant to allocate to alternatives? What do we do with this lack of historical data?

Phil Huber: I think that's a bit of a myth in a way, and that there's certainly maybe not as much data like index data on certain alternative categories, but there's actually more I think than people realize if we're just thinking about indexes to use for the purposes of, hey, like a lot of funds maybe don't have long histories themselves, but we might be using some kind of index as a proxy for what you should expect in that asset class over different market cycles over a long enough period of time.

Maybe we don't get all the way back to 1926 like we do for the S&P 500, but there are indexes for insurance, link securities for private debt, for private real assets that have histories going back 15, 20, maybe 25 years or so. It's not always readily available to everybody, but there is data out there probably more so than people realize.

The other is that I think we often overlook the fact that when you think of approaches to equity investing today about tilting towards factors factor investing a popular way to invest something that we mentioned earlier, you and I disagree on some things and agree on others. I think that's probably one area that we do agree on is certain types of factor exposures, whether we're talking about the value premium or other things. If you actually look at all the academic literature that initially brought these ideas to the forefront, what they're showing there is actually long short portfolios.

In other words, all the academic papers that are citing the existence of a value premium, for example, they're not saying here's what buying a bunch of cheap stocks delivered over time. They're saying here is the return from a long short portfolio where your long basket is your really cheap stuff, your short basket is your really expensive stuff when you sort it based on some kind of fundamental metric.

It's interesting to me that a lot of allocators and advisors cite these papers and all this academic evidence as reasons to support how they invest their long only equities, but they're more hesitant to actually implement strategies in that long short way That is actually the way it's shown in the literature. And so when you look at a lot of the papers out, whether it's you know, size or value or other types of factors, that's how it's referenced in there.

And so I think there is, again, maybe not investible index data, but certainly back tests, which again, there's all the usual caveats that come with back tests. You might wanna probably give them some haircuts when you're coming up with your own expected forward returns, just because as things get discovered and become more popular, they might not deliver the same results that they did in the past.

But the same could be said for traditional investing too. And that we can tell you what the s and p 500 did from 1926 to today. The challenge is index funds didn't exist until the 1970s and even then no one really cared about 'em. And so we have the great benefit today of standing on the shoulders of giants and having just reams of data to use to inform how we build portfolios.

The people two, three generations ago, they didn't have that luxury and unless you had a time machine, there's no way to go back into the 1930s and say, I just wanna buy the US stock market broadly. There wasn't an easy way to do that. And so I know it's a long-winded way of answering your question, but I would say there's a lot of asset classes that more recently have become more accessible through different types of fund structures and things like that.

And maybe they don't quite have the lengthy history of index returns or asset class returns, but I like to just point out a few examples of ones that have what's known as the Lindy effect, which is this notion that if you look at non-perishable things, so not people or food or things like that, but ideas, technologies, this notion of the Lindy effect is referenced to the longer something has been around the likelier it is to be around in the future.

And so things like private debt insurance, link securities or reinsurance, real assets, things like farmland, those have been around for centuries or in some cases like millennia. These are not new ideas, they're more what I would call old wine packaged and new bottles. And so even though there might not be a ton of data, the intuition and just the notion of these have been ways that people have invested throughout history, I think should hopefully give comfort as to that they're gonna continue to be around and persist in the future.

Taylor Schulte: I think those are really excellent points. I appreciate you sharing all that. It brought another question to my mind in thinking about historical data. One of the challenges with alternatives is some of these funds that you're buying, they have a lot more opportunity to invest in different things.

Like one hedge fund is not the same as the other hedge fund. You can kind of go wherever you want as the manager. And so that does create this like how do I measure this fund and the history and the performance first? The other one a long way of asking when you think about allocating to alternatives, should we be buying an index like fund in the alternative space or do you believe that it should be actively managed by somebody?

When we buy an S&P 500 fund or a fund that's tied to a traditional index, that fund has to stay true to that index. It can't really go wherever it wants. So it gets a little trickier in the alternative space. And I know there's some index solutions that have come to the surface in recent days, recent years. How do you think about indexing passive investing in the alternative space versus active?

Phil Huber: It's tougher in the sense that there aren't a lot of index products available for certain categories. There's ways to invest in some where they might technically be active, but the vast majority of the return is coming just from that broad exposure to the beta, if you will. And so yeah, I think absent a thoughtfully constructed and well designed index fund, I think there's still ways to achieve what you want is that you're not seeking alpha per se, but you just want that broad asset class exposure.

You still might be taking a little bit of active management risk, but maybe it's a multi-manager vehicle or at least you're spreading out your manager risk across a number of different managers within a single fund is one way to approach it. The other would be like in certain types of hedge fund categories, again, hedge funds are not an asset class, they're a fund structure.

There's dozens of different hedge fund strategies, some valuable, some not. And within those categories there's gonna be good funds and bad funds. I think for investors that are more oriented towards passive approaches and rules-based constructs, there's plenty of, I would say systematic approaches to hedge fund type strategies out there where yes, they're still active in implementation but not because some person's waking up every morning and deciding they want to go along this and short that.

It's a very systematic approach where they're relying more around algorithmic approaches and not trying to outcasts their models.

Taylor Schulte: And I know a lot of our listeners like to go and take action with these things. And if any of our listeners are wondering what funds should I consider buying or even start to research and in your book The Allocator's Edge, which we'll be giving away and I'll link to in the show notes, I know in the back of the book you lay out a number of different alternative funds with the ticker symbols and so people can go and look a little deeper and do their own research.

So I just wanna make sure that we mentioned that before we part ways today. I wanna be conscious of our time here. You referenced earlier that you took a listen to my recent episode I did on alternative investments. You mentioned to me privately that you were screaming obscenities while listening in your car, driving to work. I know we do disagree on a few things here, but I've really enjoyed this conversation. I wanna just give you some space.

What else in that episode do you think I got wrong? What else might retirement investors take into consideration beyond what I shared when considering alternatives in that episode.

Phil Huber: For those listening, I wasn't actually screaming obscenities. Taylor and I are buddies, so I feel like I can bust the shops a little bit. There's nothing I'd necessarily disagreed with. I think we already talked about the kind of zig versus zag thing and just this maybe misperception people have around uncorrelated versus negatively correlated the study that you referenced in that episode.

What was interesting there was like this is notable across all of investing is that results can be really different depending on your choice of start and end dates. I know that study covered like a 20 I think or so period ending end of 2022 and was looking at a number of different hedge fund strategies.

What was interesting is that was like flipping through my book and I had a similar table of like hedge fund category returns except the date I had at my disposal at the time when I was writing. It was like end of 2020 over like a 20-year period. But that included 1999. And that was interesting too, is that the results looked a lot better there because if you think about what was it like a really great period for hedge fund strategies was that 2000 to 2002 bear market when the tech bubble burst, a lot of hedge fund strategies did really, really well.

And so I think the study that you were referencing there started in ‘03 and so it didn't capture that multiyear period. So I think not to say that either is wrong or right, it's just the data is, but the data is, it's called endpoint bias. And that you're starting an ending points of a certain data set can have really extreme impacts on your results that are being displayed.

You always wanna make sure you're trying to measure things over as long of a data set you can and looking even within those at different sub periods to account for different parts of the market cycle. I think there's also, you had a little bit of commentary around, I think it was private REITs or nonlist REITs you were talking about.

I think people think of liquidity as this binary concept of oh, you've got daily liquid things like mutual funds and ETFs and you've got totally illiquid investments like private equity or venture capital or something like that. And what we've seen in recent years is this kind of growth of what are called like semi-liquid funds. That could be anything from interval funds to tender offer funds to private REITs.

And I think what's important with those is that they all offer some version of periodic liquidity, hence the name like semi-liquid, but it's not guaranteed. And so I think that was something that if you're not going in with eyes wide open and really understanding what you're buying, you might get surprised if you're trying to go redeem and get your money out and you can't get all it back at once.

And so there's a trade-offs involved to have that periodic liquidity. What it does, these different structures, it opens up different types of asset classes you can own that you can't necessarily own inside of a mutual fund or an ETF because there's a liquidity mismatch.

But at the same time you have to sort of treat them as long-term investments because at the end of the day, these type of funds, they have restrictions on how much liquidity they're willing to offer in a given period. They're willing to offer some, but there's always this ability for something like a gate to go up that might limit maybe instead of getting fully redeemed out in a quarter, you get partially redeemed.

That mechanism is there. It's more of a feature than a bug. Maybe it's frustrating if you didn't really realize it. If an advisor put someone in that that didn't quite explain to them what they were buying, then shame on them.

But I think that semi liquidity is nice to have, but you don't always wanna depend on it because it's written right there. And the fund prospectus is in terms of what type of liquidity they're willing to offer. And again, having the ability to impose gates or restrict redemptions is for the benefit of remaining shareholders that aren't trying to exit so that the manager is not supposed to fire sale of illiquid assets at rock bottom prices.

And so I think you're gonna continue to see popularity of these semi-liquid structures because it does allow for other types of diversification that liquid funds don't offer, but we need to be mindful that they're not a panacea and that you really gotta understand the liquidity provisions for each strategy.

Taylor Schulte: Yeah, and I think that really pairs well with where I wanted to wrap things up today. A quote that I jotted down from your book said,

great investments and great portfolios are nothing if not paired with great investors.

So it is really important to look under the hood and really understand what you're buying and what all these nuances are. And if you're not prepared to do that, not interested in doing that, maybe find a great advisor to help you or you do just stick with that boring 60-40 portfolio that you know and you understand.

Warren Buffett often comes up in these conversations about being a great investor and gosh, like he's a testament to that quote he has bought and hold these companies that have gone through all sorts of different troubles and difficulties along the way. It's really not easy to be that investor to buy and hold and never sell and stick with things for the long term.

So hopefully, you know that's the takeaway, that it is important that you understand these things and that these great investments are great portfolios are nothing if not paired with great investors.

Also, the other big takeaway for me is that there is no perfect portfolio. I often share the same quote that the best investment philosophy is the one you can stick with. So really, really good stuff, Phil. Where can people find you? You write an amazing blog, BPS and Pieces, you work at a great firm. Tell us just a little bit about you, your firm, your blog, where people can find you, and we'll be sure to link to everything in the show notes.

Phil Huber: I'm the Chief Investment Officer for Savant Wealth Management. I joined the firm a little over three years ago. We're based in Illinois, but we've got a footprint in, I think 10 different states now in about 25 different offices. And we've been around for over 30 years as a firm providing council to individuals, institutions around investment management and financial planning and other forms of wealth management.

So great organization. You can find a lot of my content on our website, which is savantwealth.com. We've got a blog there and I published pretty frequently there. And then as Taylor mentioned, I've got my own separate investing blog called BPS and Pieces. It's BPS and pieces.

Really thankful and appreciated to be here and thanks again for having me on.

Taylor Schulte: Absolutely love the topic at Kick Talk forever. Appreciate your time, Phil. Thanks so much.

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