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You are probably seeing the news about private credit, alternatives, and private real estate. Now specially available in 401k plans as well!
But remember, liquidity is thy friend.
Finance firms perceive value when they can get someone's cash and lock it up without that person having the ability to give them a pesky call saying "I need my money back." They can, for example, buy an asset that looks like it has great returns but kind of ignore the leverage attached to it. They can write lots and lots of covenant default terms into the fine print, hoping to protect the investment with a pile of legalese.
There is a lot of interest in this! In New York, all kinds of complex deals are now possible when you restrict liquidity. Let's face it, if you are toiling on the desk of a large investment house, you might be a little jealous when you learn that your classmate from a fancy college, who did worse than you on the Chemistry 202 final, got a job at a Silicon Valley venture capital firm and she has her investors locked in, with plenty of time to make decisions. To make matters worse, she is now ahead of you on the national leaderboard of Brawl Stars, and keeps texting you about it at work while you try to deal with client fund redemptions. This all seems unfair.
And your venture capitalist classmate doesn't have a market reporting on what her investments are worth every fifty milliseconds. So if things go badly, she has time to paper it over, kind of smooth out the returns curve, maybe have lunch with the auditor who determines the value of the private investment. Remind said auditor how much she loves the independence of the audit, oh and also the auditing fees charged are high but remember she hasn't negotiated them down.
So back in New York, this seems like a good idea and you mimic the principles with a private credit fund. You can package all kinds of fees that are hard to see into the investment, you have lots of time to deal with portfolio, you don't have a market reporting on you, and if investors want their money back, you can tell them sorry, they should have read the fine print.
But on the other side of the coin, the investor has given up a lot. It is common that clients need liquidity, and we get it for them, generally within 48 hours. Sometimes the time is not as short, but an asset shift is warranted, and we need to be able to make it.
If you give up the right to liquidity, you should get paid a substantial amount in exchange. This includes CDs from banks, which lock up capital, generally with only minimal extra compensation.
However, Cliff Asness at AQR Capital Management notes that too much liquidity can be a negative to the investor.1 John Bogle, the founder of Vanguard, did not like ETFs because they tempted the investor to trade too much.
This dichotomy is something we think about a lot, and at One Day In July, we take seriously our role as advisors to preserve near-perfect liquidity for you, while creating some barrier to friction-free trading.
~ Dan Cunningham
1. Cliff Asness at AQR notes this:
"I mean, let’s get real, does anyone seriously doubt that at least part of the attraction of private equity, and its wildly growing popularity, is an increasing acceptance among investors that they will have to get very aggressive to reach their goals (e.g., underfunded pension plans and the like), but still possess an absolute aversion to living under the true reported volatility this aggression entails?"
This was from 2019, but still relevant today. Read more here.
I don't love historical business comparisons as they relate to markets. They're used to sell books about market crashes and euphorias, but there are too many significant variables that change over time for the analogies to be worth much predictively.
A lot of people are asking One Day In July advisors if we are worried given the high price-to-earnings ratio of the S&P 500, now exceeding the top of the dot-com bubble. This is only one asset class in which we invest, but let's ignore that detail. Yes, it is expensive, but investors have concluded that business is robust and growing. And there were trillions of dollars printed that have to go somewhere. Eventually some of them reach the bond and stock markets.
Let's rewind to 1997. The movie Titanic was skyrocketing, unlike its eponymous boat which was not so fortunate, and Michael Jordan & Scottie Pippen still liked each other, at least enough to cooperate on court. More quietly, the market's price-to-earnings ratio was rising:
Jan 1, 1995: 14.89
Jan 1, 1996: 18.08
Jan 1, 1997: 19.53
People were getting worried in 1997 about this. The tech bubble was emerging and the sock puppet of pets.com hadn't even made an entrance yet. There was talk that it was time to sell and harbor the ship from the coming storm.
The storm did happen, and no amount of chatter from Sock Puppet could calm it. The S&P 500 declined 47.4% from the top of dot-com to the post-9/11 bottom in 2003, and that included dividends (the price drop was 49.1%).
But if you had reacted in 1997... you probably would not have been happy. For three more years the S&P 500 continued its inexorable rise, with a price-to-earnings ratio that peaked at 29.04. At the top, surgeons were day-trading between procedures, pontificators were declaring the end of work, and Wall St. analysts decided U.S. dollars didn't matter, that eyeballs on web pages were the new currency (I'm not going to draw any analogies to crypto here).
Now here's the problem. As the market ripped up, you were on the sidelines. From 1997 to the top three years later, your calm neighbor who was not worrying about the market but was busy composting her coffee into her petunia flower beds doubled her money, while you and your accountant were figuring out how to pay the tax bill on your trade. While the cash had the benefit of being less volatile, this drip drip of underperformance has the tendency to break someone at just the wrong time, so you may have re-entered the market a few years later... at the top.1
By the year 2000, Neighbor Petunia had room to take some losses versus you. So even if the market comes down a lot, which it did, it went up a lot before that. Here's how it worked out over a decade, starting at the beginning of 1997 with $100,000. The dark green line is the S&P 500, the blue area is a diversified blend of 80% S&P 500, 20% small-cap (Russell 2000), and the gray area is how cash performed:
You can see that it's a fool's errand. There is no way to know when to get out, and there is no way to know when to get in. A small group can make a lot of money selling books that scare people or get them excited. For everyone else, don't try to time the peaks and valleys.
~ Dan Cunningham
Notes:
1. Technically: "At the top... and without the tax money you paid."
2. S&P decline source: Morningstar Sources for P/E multiples. Multpl.com and Shiller
3. Graph data source: Yahoo Finance and ODIJ Research. Daily effective funds rate is used for cash. Daily rebalancing assumed in the 80%/20% portfolio. Total return assumed (dividends included). One Day In July LLC does not guarantee actual returns or losses. Past performance does not guarantee future returns. Returns vary based on start and end dates selected. Returns presented do not take into consideration any taxes, investment fees, or inflation.
Financial creativity is on full display this year: alternatives, private credit, private REITs, crypto, stablecoins. But it is hard to understand these products, and part of the reason they are concerning is that many of them are new and have not been tested under duress.
At some point, markets will go down. They'll go down far and long, and it will feel depressing. Companies will stop naming themselves "Bullish Corporation" and going public.1 But a market-capitalization-weighted index fund reflects the economy, and we have a lot of confidence that over time, in the United States, 340 million of us working hard will figure things out.
But in a more esoteric investment that you don't understand? Or perhaps a single stock that you didn't analyze correctly? Confidence dissipates rapidly. In periods of economic decline or uncertainty, if you don't truly understand what is driving the mechanics of the investment, you'll start to question your own decision-making as the investor. Instead of confidence, panic will creep in. Instead of thinking "This is kind of terrible but we'll get through it" you start to think "I have to change something or I'm going into the abyss."
My wife is in medicine and there is an active debate in our household about whether there are more quack medical or financial ideas floating around out there. She made the point the other day that "research exists so that people don't think their own experiences are scientific reality." I thought this was great and secretly wished I had come up with it! You can get into a real epistemological hole on this one when you start questioning your reality, but keep in mind that your experience and insights are just a sampling point in a set, just a dot on a curve. The very democratic index counts them all.
ETFs are proliferating. There are lots and lots of them, and it's important to know that an ETF *is not* necessarily an index fund. Initially most ETFs tracked indexes.
The financial industry realized that the public liked the term ETF, in part because the goodwill from indexing bled into ETFs, and the vehicle itself is good in many ways, like tax efficiency. So of course a lot of meetings got held and I am sure a lot of consultants got hired to mess up a good thing. "Let's package one stock, like Nvidia, in a triple-leveraged ETF" says Connor at the end of the table, sipping a colorful Alani energy drink in part to show his sensitive side while pushing this daring bro trade. And Maria is like "It's been 17 years since the global financial crisis, and I got through that ok when I was in 8th grade, and so I think these derivatives aren't so bad after all, so let's pack them into an ETF and I promise I'll come up with a nice-sounding name for it. I might use the word 'Freedom' in it, just letting you all know ahead of time.'"
4,300 ETFs later, Connor and Maria have their promotions, and everyone else is confused and buying things that are complicated and hard to understand.
Remember: you want to invest in indexes, and you might do so via a low-fee ETF or via a mutual fund.~ Dan Cunningham
Notes
1. Though I do tip my hat to them on this one. Also Bearish Corporation as a name would have been even dumber.
2. Connor and Maria are hypothetical.
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