Alternative Investments: What They Offer and What They Cost

Private equity, hedge funds, venture capital, private credit, commodities, collectibles, crypto: "alternative investments" covers everything that is not a publicly traded stock, bond or cash. They are sold on two promises, higher returns and protection when stock markets fall, and they are increasingly marketed to ordinary savers rather than only to pension funds and the very wealthy. This chapter explains what each kind is, what it really costs, why the reported returns need careful reading, and which low-cost public versions give some of the same exposure.

The main kinds

• Private equity buys whole companies or large stakes in them, usually with borrowed money, aims to improve them and sells years later. Money is typically committed for ten years or more.
• Venture capital invests in young private companies. Most fail; a few return many times the money, so results depend heavily on access to the best funds.
• Hedge funds are private pooled funds using strategies such as betting on some stocks and against others, trading global interest rates and currencies, or exploiting mergers. Many aim for returns that do not depend on whether markets rise.
• Private real estate and private credit own buildings or make loans outside public markets, often through funds that limit how much investors can withdraw each quarter.
• Commodities such as gold, oil and farm products, held through futures contracts, funds or physical metal.
• Collectibles such as art, wine, cars and watches.
• Cryptocurrencies, digital tokens whose value rests on demand for the network rather than on profits or interest.

Many private funds are open only to accredited investors, defined by SEC rules through income or net worth tests. The idea is that such investors can bear the risk and evaluate the disclosure; it is not a sign that the investment is good. Look up the current definition on the SEC's site if a fund asks you to confirm it. Newer "semi-liquid" or interval funds, and non-traded REITs, offer private assets to smaller investors, often with high costs and limits on withdrawals.

What the fees do

The classic hedge fund and private equity charge is "2 and 20": a management fee of 2% of assets a year plus 20% of profits. Funds of funds, which spread money across several managers, add their own layer on top. The management fee is charged whether or not the fund makes money, and the performance fee is charged on gains the market alone may have delivered.

To see the size of that hurdle, treat the whole charge as a yearly fee. On a gross return of 8%, a 2% management fee leaves 6% of profit, and 20% of that is another 1.2 points, so the total comes to about 3.2 percentage points a year. Compare that with a broad index fund.

With the same 8.0% gross return for 20 years, $100,000 grows to about $457,540 at index-fund cost and about $255,403 after 2 and 20. The manager has to earn $202,137 more over two decades, from skill alone, just to leave you level with a fund that owns the market. Some managers do. On average, studies of hedge fund returns after fees have found them trailing a simple stock and bond mix over long periods.

Why the reported returns need careful reading

Dispersion is enormous. In private equity and venture capital, the gap between the best and worst funds is far wider than between public mutual funds. Steven Kaplan and Antoinette Schoar's 2005 study found that top private equity firms tended to stay on top, which sounds encouraging until you see that those firms' funds are often closed to new investors. The average fund an individual can actually buy is not the top quartile.

Smoothed prices hide risk. Private assets are valued by appraisals and models, not daily trading, so their reported values move slowly. That makes them look less volatile and less tied to the stock market than they are. When public markets fall, private valuations often catch up later.

Returns are often quoted as an internal rate of return. An IRR depends on when money was called and returned, and can look high on a fund that returned some cash early. Ask for the multiple of money returned too, and compare with what the same cash flows would have earned in a public index.

Survivorship. Databases of hedge fund returns rely on funds that choose to report, and funds that close after bad results drop out, which flatters the averages.

The liquidity you give up

Private funds can lock up money for years. Some call for committed capital on their schedule, so you need cash ready when asked. Semi-liquid funds usually allow only a small share of the fund to be withdrawn each quarter, and can limit or suspend withdrawals, called gating, exactly when many investors want out. Money that might be needed for an emergency, a home or a known expense within the lock-up does not belong there.

Public, low-cost versions

Most of what alternatives promise can be approximated, imperfectly, with public funds that trade daily and cost far less.

• Real estate investment trusts (REITs) own property and trade on exchanges. A REIT index fund gives broad property exposure. Their dividends are mostly taxed as ordinary income, which makes them a natural fit for tax-advantaged accounts.
• Commodity funds. Funds holding futures earn the price change plus or minus the cost of rolling contracts forward, which can differ a great deal from the spot price; Gary Gorton and Geert Rouwenhorst's 2006 study describes how commodity futures returns are built. Gold funds that hold physical metal avoid the roll but produce no income.
• Factor funds tilt toward value, momentum, quality or low volatility at a modest cost, the public cousin of many hedge fund strategies.
• Inflation protection from the government: Treasury Inflation-Protected Securities (TIPS) and Series I savings bonds. I bonds can be bought electronically up to $10,000 per person per calendar year, cannot be cashed in during the first 12 months, and lose the last three months of interest if cashed in before five years.
• Crypto. Exchange-traded products holding bitcoin have traded in the US since January 2024, which removes the custody problem but not the price swings. There are no profits or interest behind the price, so its long-run value is a matter of continuing demand. Volume 3 on this shelf covers crypto, commodities and real estate in depth.

A short due-diligence list

Before committing to any alternative, get written answers to these questions:

1. What are all the fees: management, performance, fund-of-funds layers, administration, transaction and exit costs?
2. What did the fund return after all fees, and how does that compare with a public index fund over the same dates and cash flows?
3. How long is the money locked up, when can you withdraw, and can the manager limit or suspend withdrawals?
4. How are holdings valued, how often, and by whom? Are results audited by an independent firm?
5. How much of their own money do the managers have in the fund, and how did they do through at least one bad market?

If the answers are vague, or the main selling point is that someone else did well, that is the answer.