Episode 6 - Are Alts All Right?
This episode focuses primarily on one topic – and since you’ve probably read more than you want about the tax bill already – it’s not the final tax bill, but rather the push to make alternative investments available in people’s 401(K)s.[i] There are some interesting details out there (charitable deduction for non-itemizers!) I did consider a bonus episode to calculate discuss exactly when and how many people will lose Medicaid and the impact on rural hospitals but (i) that was too depressing and (ii) probably by the time I figured that out and wrote something we’d be in the midst of some other financial, economic, or trade catastrophe. I will note, however, that I spent some time trying to read the bill and find the provision eliminating the carried interest loophole, fulfilling a campaign promise Trump has made repeatedly since 2015[ii]! I couldn’t find it, but I am sure it’s down there somewhere. But bringing up the carried interest loophole (or rather, the repeated failure of Trump to actually eliminate it) is not me trying to make a point about the glaring hypocrisy of Trump’s “populist” message (again, we keep it strictly apolitical here!), but rather a good segue into the main topic – “alternatives” – since a lot of alternatives investments are private equity funds or private capital or hedge funds whose managers can benefit from carried interest[iii]. Unfortunately, while I was putting the finishing touches on this newsletter on alternatives, various news orgs came out with basically the same think piece. This was due not to their attempts to beat me to the presses, but because news broke that Trump was about to sign an executive order about this. At least I foreshadowed this last time! And even before this executive order, I wasn’t thrilled with the idea of “alternatives” becoming a significant part of the average[iv] investor’s 401(k)s or their portfolio generally. But before we dive into why, it’s probably useful to be clear about what we are discussing and why we are discussing it – i.e. what are alternatives and why is this relevant to index investors (or even all of you crazy bastards out there who have some individual equities, individual bonds, or gasp crypto or real estate investments)[v]. So I’ll be concise in describing “alternatives”; but it is a broad and purposefully vague term (for reasons which may become obvious). But before that, some self-indulgent reflection.
Updates and Other Short Thoughts:
AI: First to toot my own horn (and unlike this episode!), I was thrilled that just a few days after my newsletter about AI’s impact on fraud the news broke that a fraudster was employing AI to impersonate Marco Rubio to various other government officials. Bold, but unsuccessful (or so the media tells us). Other interesting AI developments that were interesting include cities banning the use of AI to set rental prices (as anti-competitive collusion) and Delta deciding to use AI to price discriminate on an individual basis. I was pretty concerned on flight price discrimination – but then I read to the bottom of the article and saw that, in fact, often the wealthy are getting the best deal out of AI price discrimination! Phew!
Climate Change and Insurance Markets: More and more insurers are taking climate change seriously but the hits are going to keep coming. Note that in reference to the devastating and tragic floods in Texas, despite being in a well-known area for flash flooding, it was estimated that no more than 5% of properties had insurance. So rates are going to keep going up, for sure – and transparency is definitely lacking (maybe because the insurers are using AI to price it - and the computers don’t care about political implications of telling the truth about climate change and cost/need to adapt and prepare?)
Congressional Stock Trading and Performance: No updates on stopping congressional insider trading, of course, with the elites of both parties still firmly opposed (Schumer was too busy focusing on changing the name of the OBBB – democratic leadership once again sparing no efforts to make themselves look more toothless and ineffective). But while Schumer fiddles and rural hospitals burn, congressional representatives are losing even the embarrassment factor – note that a Republican Representative sold out his healthcare stocks before voting to gut Medicare, preventing a 40% loss on his position! To be fair, its not just Congress; the executive branch also enjoys trading on non-public news (here with respect to the Brazil tariffs). Again, just like with AI price discrimination benefiting primarily the wealthy, I am glad there are a few things which remain constant in this ever-changing world.
Alternatives in 401(k)s:
Not the worst idea, but maybe the worst time to jump?
Historically, alternatives was the broad industry term usually used for private equity investment or private credit[vi] (and sometimes hedge funds and/or venture capital), with a key phrase being “private”, which meant not “publicly traded” (e.g. on the NYSE, NASDAQ, etc.), and which did not have the same disclosure requirements under SEC rules but were available through wealth managers, financial advisors for investors with sufficient assets (i.e. accredited investors/qualified purchasers)[vii]. Before you just skip over the next three or four or five or six or seven paragraphs thinking to yourself: “I am not interested and I won’t have the opportunity anyway if these are private opportunities only for the very wealthy” – STOP! Because (i) you may soon qualify (if you don’t already) as an accredited investor, and (irrespective) of whether you qualify as an accredited investor, (ii) you will soon be peppered with advice and options to invest in “alternatives” within your 401(k), and (iii) your target date fund might soon have them whether you like it or not. For example, you can see that Blackrock is putting private equity into 401(k) plans and the new president of Vanguard (yes! that Vanguard, yup, the one founded by Jack Bogle, which revolutionized low-fee index fund investing and is considered “investor-owned”) has opined that alternatives could be up to 30% of the average investors portfolio.
And, of course, proponents of this potential change prefer to present this as part of the overall “democratization” of finance; i.e. Blackrock and Vanguard are finally going to let the everyday investor into the club that all the rich investors have been in from the beginning (with the subtle suggestion that this access is why they are rich, and you are not!). Ignoring the marketing push of the “democratization” of finance, though, I admit that there are more private opportunities these days than there were back when Jack Bogle started the index fund revolution. And because I love behavioral finance as you know, I am comfortable acknowledging two huge benefits of private equity/alternatives – which are (i) they are not “mark-to-market” assets and (ii) they are tailored to achieving longer term results.
Not being mark-to-market means that they take a significant pool (or commitment) of money, they “lock it up” in various private investments or contractually (for hedge funds), and then don’t tell you how much it is worth on a day to day basis (theoretically because it is impossible to tell); to contrast, your other holdings are mark-to-market, i.e. there is a publicly traded stock ticker that updates every second (or a mutual fund which updates everyday) and then uses balloons and nice bright colors to tell you at a glance whether you are wealthier or poorer at the end of that day!) I think you get balloons only on Robinhood[viii], unless now that Jack Bogle is dead Vanguard going to try to appeal to the youth? But the point (perhaps already obvious) is that alternatives can prevent investors from overreacting to temporary scary news (e.g. the imposition of stupidly high tariff rates that were selected by an AI agent trained solely on Peter Navarro books). So that is good! If you can’t see the stocks go down, then you can’t get scared and insist on pulling your money out of the market right before the President suggests it’s a great time to buy (a few hours before he pauses all of those tariffs). And obviously, alternatives have (in the past, though not so much in the very recent past) helped broadly diversified portfolios outperform the market – leading, for example, to significant impressive runs of performance by Yale’s endowment (as the most famous example). This outperformance is ascribed to various things, but one of them is Yale (a consummate long-term investor) was early to the alts game. And if alternatives are deployed to individual investors’ 401(k)s (which are also supposed to be long-term buy-and-hold investments) then individuals’ portfolios can perform just like Yale’s portfolio. Their kids still can’t get into Yale, but why would they want to go to New Haven anyway, when they can go to the bucolic purple valley of western Massachusetts?
Though I acknowledge these benefits, I don’t think you should be that enticed at this point in time. Some of these reasons are probably somewhat minor (such as the likelihood of higher fees) or would quickly get too dense for this newsletter (the fact that I think some of private equity’s returns are really more reflective of the impact of leverage than anything else, and you can always lever up if you want – not investing advice!!! or is it?), or that you can replicate some of the behavioral finance benefits on your own (by scheduling a quarterly or semi-annual check of your investments). Plus, even the benefit of smoothing the volatility isn't always a good thing - maybe it just hides the inevitable decline to zero (Sears, anyone?) which is more of a problem with narrowly focused funds with few components rather than large index funds. But most importantly, I think that the push to make alternatives available to individuals right now is more of a reflection that asset managers administering 401(k)s and target date funds are being driven by the (i) desire for increased fees and (ii) the appeal of novelty/exclusiveness, while the alternative fund managers (sometimes within the same asset manager) are seeking to off-load alternatives to retail investors because they can’t do a typical exit.
Can you just take my word for it (after double checking my conclusion against your pre-existing beliefs and enjoying some light confirmation bias)? Sure - just move on down to the musical interlude and then call it a day! Plus, I did pick a great new song. But for those diligent few who wish to continue, I’d like to start with Cicero’s famous question “cui bono” (for those of you who remember your Latin classes). Or, instead, if you remember this from sophomore year at Yale when the gloom of New Haven had you in a goth phase and you were dating a cute anarchist/communist with lots of tattoos, it would be “cui prodest” from the classic text “Who Stands To Gain?” Or, if you are like me and don’t remember Latin or Lenin, we can start with the quote of the day: “The Dude: It's all a god damn fake, man. It's like Lenin said: you look for the person who will benefit, and, uh, uh, you know… Donny: I am the Walrus”.[ix] Looking at who will benefit here (and more, importantly for my argument, who will benefit right now) there is a compelling case that the (i) alternatives industry is looking for a “bag-holder” and (ii) the asset management industry is looking for additional fees, and (iii) no one really cares about the individual investors’ 401(k) - except maybe as exit liquidity.
Musical Interlude: No, it’s not I am the Walrus by the Beatles, nor Eggman by The Beastie Boys (which I always think about after hearing that Beatles song, and I did love that song in the past, although maybe a little bit less now that I am balding). But those aren’t new songs! Instead, I figured I'd switch topics for the musical interlude and share this new song “Progress of Man” from one of my favorite artists, Hayes Carll, which is also going to serve as my one commentary on stablecoins/bitcoin in this newsletter (which have both been in the news). And late update – Trump is also considering an executive order to allow crypto investments in 401(k)s…hmmm. But if you are wondering about whether this is also the time to get into bitcoin I think the sarcasm of Hayes Carll might be useful: “we all make big money on bitcoin and cattle/and it’s all for the progress of man”.[x] Tons of good lyrics from Hayes in that one, and I would have quoted “the world’s getting turned on by assholes and racists” except, of course, for my commitment to keep the newsletter strictly apolitical.
Even an abbreviated history of the industry is too long for this newsletter,[xi] but I think it is fair to say that “alternatives” is merely the newest iteration (or maybe re-branding) of the leveraged buyouts of the past, which you might remember from Michael Douglas’s Wall Street (e.g. the corporate raiders and junk bonds of the 1980s) and the Private Equity Industry in the 90s and early 2000s (e.g. Blackstone, Bain Capital and Carlyle Group).[xii] Which is why the industry might have been looking for a re-branding (at least before trying to appeal to Main Street investors). Branding aside, the basic mechanisms haven’t really changed – first, a fund raises money from a bunch of deep pocketed investors with long-term investment timelines (the uber-wealthy, the pension funds, the college endowments, etc.) that are called limited partners (LPs)). The fund then finds companies that they believe are “undervalued”, purchases those companies using some equity from the LPs and, crucially, as much debt as they possibly can (which is collateralized by the company they purchase). Theoretically, the new owners reduce costs and improve the business of their new portfolio company through a mix of (i) improved business practices and (ii) being able to focus on the long-term success because they don’t have to report short term results to Wall Street constantly. And, sure, old boring companies have old inefficient business practices often times or are unwilling to take risks because of short-term thinking – but how much those factors drive the industry’s overall returns is debated. I think everyone agrees though that these firms get a boost to their financial performance (at least for their investors and their employees) by using leverage (borrowing lots of money)[xiii] and taking advantage of the corresponding tax benefits. Ultimately the fund “exits” and re-pays their LPs after some amount of time (no more than 10 years, typically)[xiv]. So why might the alternative’s industry be looking for bag-holders right now? Well, the industry has actually been under-performing against historical results for a while. There are likely various reasons for this under-performance – a good one, of course, is that the early bird got the worm[xv]. But also we may be a limit on the upside of companies that Private Equity funds typically target (as opposed to venture capital funds). After all, a lot of the massively successful companies in the last few years (NVIDIA, Apple, Amazon, Netflix) aren’t so poorly run and undervalued that they need boring Wall Street financiers, consultants, and lawyers to update their business practices and “unlock” value. And those big companies which might actually need an adult to take the helm (or stop taking ketamine at least) apparently have an insanely high valuation that no amount of leverage and business synergies could improve.
The other reason that the alternatives industry is looking for bag-holders now is because a lot of the LPs need their money back (demographic changes mean pension funds are shrinking, political changes mean grants have dried up and university endowment money is needed to fund operations, etc.). And because there aren’t a lot of options for the funds to come up with redemption money, distributions have been going down (interestingly, that article suggests that family offices see lower PE distributions as a reason to increase exposure to “private credit”…hmm... I guess we will see how that turns out). And distributions are also down because interest rates have gone up (way up) – meaning (i) the next private equity company in line is not clamoring to buy the already highly leveraged non-growth company and (ii) the current portfolio company can’t refinance a dividend cause the business cash flow can't support higher interest payments. The LPs don’t care – and the contract says that they get their investment back out after 10 years (which may have already been extended several times!). Some solutions the PE industry has been trying to popularize are “continuation funds” and “dequity funds” (a weird name, but probably an improvement over something like “sloppy seconds” which I presume was the original name until the HR and Marketing departments got involved). In any event, those both seem less compelling from an investment perspective. And another solution, obviously, is trying to off-load these private equity investments to retail investors (ideally ones who have very limited say in their selection of funds within their 401(k)!!)
Of course my time in corporate America has made me deeply appreciate synergies (or at least tell my manager that I deeply appreciate them), and this offloading has a pretty convenient synergy; the other side of the asset management business has seen margins shrink as all the normal fees have been driven to zero (in large part by Vanguard and Jack Bogle). Brokerage and trading fees – basically zero. Active mutual funds with 80-120 bps of expense ratios – dying. Index funds – expense ratios trending down, significantly, with some at/near zero. ETFs – no trading fees and low expense ratios. Advisory services are under threat too: (i) robo-advisors who only charge 25-35 bps, (ii) “bogleheads” and self-taught investors, and (iii) more competition (me!). Jack Bogle actually foresaw the possibility of fees in the financial industry collapsing – and lauded the possibility – as he believed that it would be an indication that he had succeeded. So, how can the asset managers improve their margins now – beside the leveraged, single stock ETFs? Or, if lower margins are unavoidable, how can they keep gaining customers and differentiate themselves (i.e. keep the volume growing). Well, people like feeling special, and they also like feeling that they have finally got into a game they were locked out of for so long. Asset managers are ready to present them with a special, sexy, and previously exclusive asset class (and, sure, it costs 75 bps instead of an S&P500 ETF which they can get for 3 bps, but it’s new and sexy). And if the raw math on fees threaten to make that a tough sell, no worries, they’ve got sales people on staff already (no longer able to sell actively managed mutual funds) who will pitch these alternatives to everyone (even the younger, more informed investors who know that they should not be paying sky-high expense ratios for actively managed funds which underperform their indexes). More importantly, if the Vanguards and Blackrocks and Fidelitys of the world slip these “alternative funds” into people’s 401(k)s they don’t even need to convince anyone – 401(k)s don’t have that many funds anyway[xvi] and if these asset managers can slip these “alternatives” into their target date funds. Fidelity estimates that almost 95% of investors in 401(k) plans default to using a target date fund; wow!
And the salespeople will definitely point out to retirees (or near-retirees) who worried about market volatility that these “alternative” funds won’t drop with the market tracking index funds. No need to mention that alternatives “don’t move with the market” because they aren’t required to be priced at market value everyday (and Net Asset Value is basically a bunch of self-interested guesses for these funds anyway). As CalPERS (the nation’s largest pension fund) explains it “at the end of each quarter, General Partners have 120 days to report the value of invested capital”[xvii]; i.e. you would find out how your investments were valued in January of 2025 about 120 days after March 30 (the end of that quarter) which is right about July 28th and hopefully at least a few days (maybe even weeks?) after this newsletter has been published).[xviii] Coincidentally, most stock market corrections are over and done within 8 months (courtesy of Bloomberg/Invesco, which I think I quoted back in one of my first newsletters about “corrections” (yeah, those old episodes are still not uploaded!)). In any event, the 70-year-old retiree probably read that disclosure on pg. 13 of the prospectus, sub-clause 3(ii), right before the mandatory arbitration clause. No need for the sales guy to rehash that boring stuff again.
Now, of course, as mentioned earlier, there is theoretical value to individual investors (including those primarily investing through their 401(k) plans) of both (i) having assets which are not marked to market each day (to preserve the illusion of a higher total portfolio value) and (ii) investing in long term assets which may provide a higher return precisely because of the long term nature (e.g. lack of liquidity premium). But, as I hope I have made abundantly clear, I am very skeptical of the overall push to make private equity and other “alternative” investments available to the average 401(k) investor – particularly at this point in time. Even if alternatives (theoretically) would have improved the average investor’s return as part of an overall diversified portfolio in the past, the factors above suggest to me that the alternative funds that will end up in these 401(k)s (or target date funds) will not actually improve the average investor’s return going forward (and certainly not more than the fees they are charged).[xix]
Additionally, we typically see that expansion of strategies lowers the returns of those strategies. This is a classic result with funds and strategies: the larger funds don’t have the same great returns as their smaller predecessors – RenTech has kept their high performing Medallion Fund small (and limited to only executives at the fund!); Fidelity’s Contrafund had to abandon its original mandate as it swelled in size, and even Berkshire Hathaway has grown so large that it’s out-performance of the S&P500 has been shrinking (and some view it as simply a more tax efficient S&P tracker, due to no dividends). Plus, we know that fees will necessarily be higher for these funds (for various reasons) and fees are a constant and (sometimes) significant drag on returns (speaking generally, because obviously there are exceptions…like, you know…my fees). Hence our cui bono comments above, although we can also tie cui bono back around to tax policy – for example, has the continued attack on carried interest motivated PE industry lobbyists to look for ways to preserve their preferential tax treatment by trying to get closer to the average American’s 401(k) performance. (E.g. My god, you can’t cut compensation and change tax treatment for Private Equity fund managers, it will crater your 401(k) and make you poor!!).
Finally, the risk of being at the tail end another PE boom cycle is higher now, given the potential interest rates path, the overall development/cycles of the PE industry, and (bias check!) the history of individual investors never getting to the good party, or getting to the party late, or when the party is over.[xx] And certainly when the individual investor class is being specifically invited to the party by the people who may be trying to leave the party, I am more skeptical (compare the way industry is trying to welcome “alternatives” to the reluctance of the finance industry to accept index funds, with their lower fees and their explicit and implicit critique of the value of active fund managers). After all, Jack Bogle gets well deserved credit for first making an index fund available to regular investors in 1976 (with an S&P500 tracker), but he didn’t invent it and was skeptical himself at first.[xxi] We will keep tracking these developments – but it might take a few years to see how this plays out! But all this talk of parties has motivated me to stop polishing the newsletter and head up to see some music at the Strawberry Festival. And it did remind me of other great song (which also has a reference to Lenin…no sorry, I meant Lennon – or as described below “Yoko brought her Walrus”). Enjoy a Garden Party - which you might recognize, even if you don't think you will.
[i] Plus, I found myself wanting to include a few thoughts that hearkened back to other points I wrote about in earlier episodes (although I have not gotten around to loading those old episodes onto the new website…I’ll get to that eventually!). But I was able to at least link to the foreshadowing in my last bonus episode 😊!
[ii] Although the NYT, hilariously, was giving him too much populist credit in 2015 (classic example of the media buying the populist story hook, line and sinker back then, similar to that long anticipated “pivot”). And, of course, the 2017 TCJA bill, which was Trump’s first opportunity to kill the carried interest exemption was another bait and switch – although he campaigned on fixing it, the bill only required the assets to have had a holding period of 3 years; perhaps because he realized the impact on real estate investors? And, of course, the changes in 2017’s TCJA likely had a minimal effect on the actual effective tax rate (because PE funds typically hold portfolio companies for 5-7 years (and rarely under 3 years). Now I confess that I haven’t been able to find a good analysis showing the numbers – but the cynical reader might find it interesting that the PE industry groups were claiming in the 2025 tax battles that the 2017 bill “fixed” the problem, thus no further tweaks were necessary. So draw your own conclusions. Oh, and as one of my favorite things is to highlight etymologies of some of these finance terms, I have to note that “carried interest” comes from the ship captains’ compensation as a percentage of the profits of the trade that their ships carried. (That is two fishing references and one maritime reference in this footnote!)
[iii] This Blackrock advisor pitch page breaks down their “20%” alternatives suggestion as about 2/3 private equity and private credit and 1/3 hedge funds.
[iv] Although, really, since I am writing this about and for clients, friends, former colleagues, and family, I guess I have to first admit that (only a few) of us would be considered average investors purely by the numbers. (I know, I know – we all feel middle class still!) But suffice it to say that this is more about investors with over $50M of investable assets.
[v] If you are dabbling in things like FX trading or zero day options then you are probably irredeemable (I’d say just take up poker – except this tax law will be a disaster for professional gamblers!)
[vi] I acknowledge that there are other parts of finance which are now lumped into “alternatives” which are not private equity/private credit; typically, those are hedge funds of some sort or funds of funds or venture capital funds. It’s not super important for my argument, however, so I am generally going to elide over the differences for sake of brevity and focus more on Private Equity.
[vii] Accredited Investor is not terribly hard to qualify for, as the income limits haven’t kept up with inflation. Qualified Purchaser is still a higher bar, though quickly eroding as well.
[viii] I think explosions and confetti are also on Robinhood? Or I think they were I am not sure now – I deleted it several years ago and didn’t really want to reload it just to research this newsletter.
[ix] That is the second Big Lebowski reference – I apologize. I’ll try to restrain myself.
[x] Both quite environmentally damaging/energy intensive by the way!
[xi] The industry certainly has seized substantial media mindshare in the past:
[xii] Or maybe Barbarians at the Gate (story of KKR and RJR Nabisco), Richard Gere in Pretty Woman (a “corporate raider”), Liar’s Poker (Michael Lewis’s first best seller, about selling bonds at Salomon Brothers), the skewering of Carlyle Group in Michael Moore’s Fahrenheit 9/11; the pillorying of Mitt Romney as a private equity titan at Bain Capital, as well as Leon Black and Steve Schwarzman’s much critiqued birthday parties. Which gives me a chance to bring this full circle to tax policy, since Steven Schwarzman was also infamous for describing a proposal in 2010 to eliminate the carried interest loophole as similar to Hitler’s invasion of Poland (which I think was a pejorative at the time, although I wouldn’t ask Grok – Elon Musk’s AI – to opine on that). And even better for topical humor, I get to mention that Leon Black has gotten even worse press because he chose to pay Jeffrey Epstein approximately $170M over 5 years for “tax advice” and estate planning. I should probably see if Mr. Black needs any assistance with his taxes after Epstein’s murder…uh…suicide… uh, his untimely passing. You know, Mr. Black, I also live on an island!
[xiii] Obviously, proponents argue that the leverage drives improved managerial practices (as they must make their cash debt payments). I’d note that our increased national leverage doesn’t seem to result in any improved managerial dividends (cough, cough, DOGE, cough).
[xiv] Either by (i) taking the improved company public again at a higher valuation, (ii) selling it to another strategic purchaser, or (iii) doing a dividend recapitalization to recoup all the equity investment.
[xv] The early entrants got the easy pickings (KKR, Carlyle and Blackston got in early, they got the deals without having to pay top-dollar, and they’ve made a lot of money.) But like every industry, the later entrants are driving down the gains/margins and it’s getting harder to make huge returns (i.e. you have to pay a higher price to win the initial auction, the companies are already more efficient, and the public companies are more likely to take on debt when appropriate).
[xvi] I see estimates of around 25-30 as average (which seems right based on what I recall at Amazon), with fewer at smaller plans, and fewer still if you count all target date funds just as one option.
[xvii] https://www.calpers.ca.gov/investments/about-investment-office/investment-organization/pep-fund-performance
[xviii] A Day Late and A Dollar Short wasn’t even a glimmer in its author’s eye back then! Or as the author’s partner describes them – the good ‘ole days.
[xix] Is this market timing? If so… god, it feels good. I understand why it is so appealing. What a great feeling! I definitely can’t be wrong when I’ve got such a good feeling about this!
[xx] This is definitely market timing, now, but it still feels good – so we are going with it! (Not investing advice!)
[xxi] Lots has been written about this – I think I first saw this at Get Rich Slowly.
