Podcast cover photo on investing in alternative asset classes

Expected Returns for Alternative Asset Classes, Plus Reading Habits with David Senra | Rational Reminder Podcast with Ben Felix and Cameron Passmore Ep. 219

Check out Rational Reminder’s Episode Page & Show Notes 

Takeaways

  • Here is a summary breakdown of expected returns for alternative asset classes:
  • Private equity investments might look less volatile than public equities, but that’s because their valuations aren’t reported daily 
  • Bad private equity funds tend to be consistent in being bad, but there is not the same persistence in top quartile PE funds
  • If you want to find the best private market managers, find the ones that won’t take your money  
  • It’s difficult to get access to the best venture capital firms; more often than not, you must be committing billions of dollars to consistently getting in with the best managers 
  • Top quartile VC firms beat public equities by 21% per year, on average, while bottom quartile VC firms trail by 16% per year 
  • More than 50% of angel investing deals result in negative returns 
  • Hedge funds have a “big fee” problem, and are extremely varied in their objectives and expected return profile 
  • Hedge fund investors tend to be their own worst enemy relative to public market investors 
  • As an asset class, real estate delivers returns on par or slightly above inflation 
  • Crypto investors are attracted to stocks with lottery like characteristics, penny stocks, and stocks with high media sentiment

Intro

  • In this conversation, Ben Felix and Cameron Passmore share their findings for expected returns for alternative asset classes, including private equity, venture capital, angel investing, angel investing, private credit, real estate, hedge funds, and cryptocurrencies. They also bring David Senra on the show to talk about his reading habits, the books that everyone should read, and his advice for people who want to read more. 
  • Check out these Podcast Notes from the Rational Reminder Podcast on Tech vs. Value, and Private Equity vs. Public Equity Investing 
  • Ben Felix (@benjaminwfelix) is a portfolio manager with PWL Capital Inc. and co-host of the Rational Reminder podcast 
  • Cameron Passmore (@CameronPassmore) is the Executive Chairman and a portfolio manager at PWL Capital, and also a co-host of the Rational Reminder podcast
  • David Senra (@DavidSenra1) is the co-host of Founders, a podcast that explores the lives and traits of history’s greatest entrepreneurs

Private Equity 

  • Unlike public market investing, there are no private index funds that capture the aggregate return of private equity 
  • Theoretically, you would expect private equity to outperform public equities because they tend to be smaller investments and more illiquid, so you might expect a return premium given the additional risk
  • Private equities are at least as volatile as public equities, probably more 
  • Private equity investments might look less volatile than public equities, but that’s because their valuations aren’t reported daily 
  • There’s a 2018 paper that found that after European private equity funds switched to fair value accounting, the reported correlations between private equity and public equity returns increased, which caused those PE firms’ access to capital to decrease because they looked less attractive as an asset class   
    • The asset class becomes less interesting when the illusion of smoothing is taken away
  • Metrics like public market equivalent (PME) are used to try and benchmark private equity returns to public equity returns 
  • A 2020 paper by Ludovic Phalippou reveals an inconvenient fact: private equity funds have returned about the same as public equity indices since at least 2006 
  • Historically, private equity valuations were smaller than public equity valuations
    • This gap has closed and has actually begun to reverse 
  • Generally speaking, investors can expect to pay upwards of 6% to gain ownership in a PE fund 
  • BlackRock suggests private equity investors can expect nominal returns of 14.4% gross fees with a standard deviation of 26.6%
  • There is a massive dispersion of PE performance based on manager selection  
  • Bad private equity funds tend to be consistent in being bad, but there is not the same persistence in top quartile PE funds
    • It’s rare to see consistent outperformance from PE funds 
  • PE buyout investors can expect a mean return of 7.59% annualized with a 28.88% standard deviation, according to Benjamin Felxi and Rational Reminder 

Venture Capital

  • Private equity mostly involves the buying of an entire, mature company, whereas venture capital is early-stage investing to acquire a smaller percentage of a company 
  • Unlike private equity, there is persistence in the top-performing venture capital funds 
  • Paraphrasing Gus Sauter: if you want to find the best private market managers, find the ones that won’t take your money   
  • It’s difficult to get access to the best venture capital firms; more often than not, you must be committing billions of dollars to consistently getting in with the best managers 
  • It’s great if you can access the top-tier funds, but VC becomes an unattractive asset class if you cannot access the leading cohort 
  • Top quartile VC firms beat public equities by 21% per year, on average, while bottom quartile VC firms trail by 16% per year 
  • Investors can expect a mean nominal return of 9.87% in venture capital, according to Rational Reminder 

Angel Investing

  • Papers published by Robert Wiltbank in 2007 and 2009 find the average angel multiples of around 2.5x with an average holding period of 3.5 years, which equates to an average annual return of 29% on average
  • It is harder to diversify in angel investing compared to private equity and venture capital  
  • More than 50% of angel investing deals result in negative returns 
  • Returns in angel investing are more dependent on the angel than returns in venture capital are dependent on the VC, according to the Wiltbank sample 
    • Angel investors who spend more time on due diligence have higher returns empirically 
    • Angel investors with more experience in the industry have higher returns, on average 
    • Angels who coach and mentor the companies they invest in have higher returns, on average
  • Investors can expect 20% annual returns in angel investing, or as low as 2% if there is little due diligence occurring, according to Rational Reminder 

Private Credit 

  • Private credit is an asset class that provides returns through interest payments on loans for various types of businesses or individuals looking to fund something specific 
  • “When everyone talks about it, it’s probably not a good time to be in it.” 
  • There is much less research done on private credit investing relative to PE, VE, and angel investing
  • A 2018 paper by Shawn Munday on private credit suggests: in general, while there may be diversification benefits to private credit strategies based on low correlation with public benchmarks, the PMEs tend to be close to one 
    • This means you’re not necessarily gaining a return edge when investing in private credit relative to public equity investing 
  • BlackRock expects an 8.8% gross fee return for direct lending strategies, which is one of the strategies within the broader private credit market 
  • Investors can expect to mean net returns of 5.09% with an expected standard deviation of 13.44%, according to the Rational Reminder

Hedge Funds  

  • Hedge funds are actively managed alternative investments that tend to use risky investment strategies in the hopes of obtaining large capital gains 
  • Hedge funds are highly varied in their objectives and their expected return profiles
  • Hedge funds have a “big fee” problem
  • A 2 and 20 fee is the most common fee structure for hedge funds:
    • 2% of invested capital 
    • 20% of any outperformance over a given hurdle rate 
  • When a hedge fund is liquidated following losses, investors automatically lose the opportunity to earn back their losses without paying additional incentive fees 
  • Hedge fund investors tend to be their own worst enemy relative to public market investors 
  • BlackRock has an expected return assumption for hedge funds of 7.8% gross fees with a standard deviation of 7.7%, broadly speaking 
  • Investors can expect to mean net returns of 3.36% with an expected standard deviation of 7.70%, according to Rational Reminder 

Direct and Unlisted Real Estate 

  • Private real estate delivers returns below or on par with publicly-traded real estate investment
  • As an asset class, real estate delivers returns on par or slightly above inflation 
  • BlackRock has an expected mean return of 4.1% nominal gross of fees for real estate 
  • Investors can expect to mean net returns of 3.10% and 4.10% for direct real estate in Canada and the United States, respectively, with an expected standard deviation of 11.10%, according to Rational Reminder 

Cryptocurrencies 

  • Cryptocurrencies are still so new that it is difficult to extract long-term investing expectations from them 
  • Instead of determining the expected returns of the various cryptocurrencies, Ben decided to analyze the types of investments that the average crypto investor is attracted to, and derived their numbers from those investments 
  • Crypto investors are attracted to stocks with lottery-like characteristics, penny stocks, and stocks with high media sentiment, according to a study done by Tobin Hansspal  
  • Crypto investors tend to be overconfident and have less financial literacy  
  • Investors that share these traits tend to invest in high-priced stocks with low profitability
  • “Network hype” plays a critical role in increasing cryptocurrency prices 
  • Despite bitcoin’s performance over the last decade, owners of it might be underperforming the S&P 500 since 2017 depending on when they acquired it
  • Investors can expect to mean net returns of 1.00% annualized in nominal returns with a 60% standard deviation, according to Rational Reminder 

Summary Table of Expected Returns and Standard Deviations 

Future Proof Conference & Recent Reviews 

  • Cameron attended the Future Proof conference hosted by Ritholtz Wealth Management in Huntington Beach, CA
  • He highly recommends people attend it next year
  • Instead of the traditional advisor conference at a sorry hotel conference center, the event was held outside just feet from the beach
  • There were live podcast shows and high-energy presentations on technology, wealth management, and investing 

Bonus Conversation: Reading Habits with David Senra

  • David Senra has always had an insatiable desire to read 
  • In college, he began reading biographies on entrepreneurs and became interested in the various types of founder personalities 
  • David shares a story about Elon Musk saying he learned about business not from reading business books, but from reading biographies and autobiographies 
  • If you something, it is easy to do the something 
  • Runners run a lot and that is normal to them; readers read a lot and that is normal to them 

David’s Morning Routine

  • Works out for an hour first thing in the morning
  • Reads for 3-4 hours after his workout 
    • Your brain tends to work better when you’re well-rested in the morning, a thought from Jeff Bezos that David agrees with 
  • He takes a break after those 3-4 hours
  • The second part of his workday involves reviewing all the past highlights that he’s read
    • He uses an app called Readwise to review highlights from books he’s previously read  
  • David views the first part of his day as work and the second part as practice 

How David Senra Decides Which Founders to Cover

  • Anyone at the top of their profession has deep historical knowledge and is very interested in the people that came before them 
  • David notes the people that Steve Jobs, Elon Musk, etc. mention as being influential to them, and then reads every book ever published on those people 
  • His process is also crowd-sourced: his audience sends him book recommendations every day 

Impactful Founders

  • Founders are imperfect human beings just like everybody else 
  • Most of them over-optimize their professional life to the detriment of their health, happiness, and family life
  • David wants to be like one founder in particular: Edward Thorp, the author of A Man for All Markets 
    • Thorp is 90 years old and just did a podcast with Tim Ferriss 
    • Ed Thorp wants to be healthy, a great father, and someone that has fun 
  • Action express priority: observe your actions because they will reveal to you what you actually want to do 

Re-reading Books

  • The words on the page don’t change when you read a book for the second time, but you have changed as a person, so it’s a different learning experience 
  • David is selective about what he allows in his brain because he knows it will influence him, whether it’s a TV show, a friend, a book, etc. 
  • David likes finding instances of founders that didn’t know each other, lived at different points in history and worked in different industries, and yet they arrived at similar conclusions 

Books That Everyone Should Read 

  • Everyone should read James Dyson’s first autobiography  
  • There are so many times in James Dyson’s career when he should have quit, and simply refused to 
  • Look for books that are around 200 pages if you’re considering doing a deep dive on a person or subject; if you want more after those 200 pages, then go find the longer books
  • He also recommends Estee Lauder’s autobiography, another book that is hard to find 
  • Dan likes to study entrepreneurs who have died because it puts time on his side, serving as a filter 

The Role of Luck in Entrepreneurial Success

  • Time carries the most weight; you have to stay in the game long enough for luck to become an asset to you 
  • If you have a good business, time is an ally
  • Stay in the game as long as possible so you can get lucky
  • “What people call luck, I call randomness.” – David Senra 
  • David is obsessed with founders because “they’re fundamentally crazy people”: they try to take an idea from their head and create something entirely new in the real world instead of just doing a job that already exists  
  • Founders, who are people that start anything, are the most important people in the world 
  • How to describe Nassim Taleb’s Antifragile book to a five-year-old: “Time is smarter than you”

Books Mentioned

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