Beware of optionality loss

April 12, 2024

Optionality has value in finance. Think about it this way. If you are dating someone, there might be, there likely are, a lot of plusses in the relationship. However, there is a slight loss in that your optionality to date someone else diminishes. Or at least there is more friction in the switching process.

Financial firms like to design products that remove optionality, because it makes it harder to move capital. As an example: private real estate investment trusts (REITs), private equity positions, annuities, whole life insurance, and CDs from banks. Even owning a rental house as an investment. All of these remove optionality. Capital gains taxes do so as well, in that they trap capital in areas of lower return and lower productivity when it should be moving to more dynamic, higher return parts of the economy. ^1,

When optionality (and related liquidity) are removed from an investment, the expected return needs to be higher to compensate the investor.

As portfolios arrive here, we are seeing growing use of "alternatives," including private REITs and private equity. These products perpetuate the myth that there is a secret sauce beyond indexing to higher returns. The problem is compounded because the accounting often is manipulated.

The problem is that these private markets are not liquid or transparent, and so there is no force that says "this is what the investment is worth" in a timely manner, the way a publicly traded index fund does. Say a private equity manager had a bad year, which many did with their leveraged funds in 2022. If they report the true drop in the fund, not only will their own fees collapse, but the limited partner that invested the capital is going to be unhappy and turn down the invite to play golf at Pebble Beach. So the private equity manager has an incentive to use accounting gimmicks to "smooth out the loss" so that it doesn't hit in one year. Problem resolved, back to the links everyone!

Almost five years ago, Sebastien Canderle at the CFA Institute dove into this topic, if you are interested. This is a well-done piece, and shows the pitfalls of investing in private markets: read it here.

This is something to watch out for. It's not a good situation: as an investor, you don't know the value of your assets. It likely will take many years to find out. In the meantime, your optionality is shut down, as these funds can be difficult to exit.

When someone mentions a financial product that reduces your optionality, you should think hard about the compensation. You are giving something up, you deserve something extra in return.

Dan Cunningham

1. This is a real effect, and it exists at One Day In July. We probably hold north of $50 million of client investments that we would sell and exchange for better positions if it weren't for capital gains taxes. So weirdly, these taxes help entrenched, wealthy financial firms get even wealthier, to the detriment of more efficient firms, or entrepreneurs that could use the capital. I probably should do a full newsletter on this, as the topic is complex.