All-you-can-eat pizza and ice cream

The HNW sales force will give you a number of reasons why you should be investing in prestige investments, a large subset of which they call “alternative assets.” A recurring theme you’ll hear is that they provide returns that are “uncorrelated” to the stock market.

The individual without a degree in finance might wonder what’s so great about uncorrelated returns. I’ll spare you the math, but basically this is the holy grail of finance. Adding an uncorrelated asset to a portfolio has the potential to simultaneously improve your returns while lowering your risk.

I can’t put into words how excited this makes financial analysts. It would be like someone telling you that you can eat all the pizza and ice cream you want and never gain weight. It’s that amazing.

ChatGPT suggested serving

How does low correlation work in the real world? Let’s say you own a popular water park. In the warm months your business absolutely kills it. But the rest of the year’s business can be pretty slow, and cash flow can be tough to manage. One way to address this is to acquire a nearby ski hill. The business peaks at the ski hill will be negatively correlated with the water park. Adding the ski hill to the water park will improve your overall returns. But what if it’s a rainy summer and business at the water park is down? Well, then, maybe you want to add a movie theater to your portfolio—as people will be more likely to go see a movie on a rainy summer weekend. As you keep adding these low-correlation businesses to your portfolio, it strengthens your overall empire by diversifying your sources of cash. You can see how your total returns would go up, while your risk is reduced at the same time.

The way the math works out, your overall portfolio return improves when you buy an uncorrelated asset, even if it has a lower potential return than a different business that has a higher correlation to your existing portfolio.

We love uncorrelated returns. Higher returns. Lower overall risk. This is the proverbial “free lunch.”

And so, invariably, the sales material produced by the alternative investment industry trumpets uncorrelated returns.

I recall meeting a sales guy for a private equity fund early in my career. “The asset class is uncorrelated to public markets” was one of his pitches.

“How is that possible?” I asked. “Let’s forget what your charts and numbers say and think about this logically. Ultimately, in order to realize a return, the private equity fund needs to either sell the business or take it public. And so proceeds will be higher when public markets are doing well—there’s a clear correlation. Not to mention the asset class’s reliance on debt markets…”

This is now commonly acknowledged, especially after the private equity market buckled following the 2008/09 stock market collapse. But back then I was often told I was just being overly pessimistic and critical. You see, the numbers in the sales documents showed that public and private markets had experienced low correlations in the past.

But numbers lie. Private equity is not an uncorrelated asset. Since 2008, studies have demonstrated a consistent correlation of about 80 percent between public and private markets.

In fact, very few private market assets are truly uncorrelated with public markets. It’s a trick of the data. Cliff Asness calls this volatility laundering and here I’ll explain how it works to the layman.

You see, private market assets are valued infrequently. At best once a month, but often only once a quarter or even every six months to a year. And these valuations require a lot of judgment, potentially ignoring factors that the valuation professional decides are temporary, or transitory. If you’ve been through a business sale process, I don’t have to explain to you how valuation is more of an art than a science.

Meanwhile, your public market investments are granted no such grace. They are valued daily—in fact, multiple times each second—by the individuals trading them. These individuals are probably playing a very different game than you are—so their estimates of “value” may be quite a bit different from yours. (The “value” of a company’s stock to a trader intending to flip the shares in a few hours is vastly different from the value calculation performed by a long-term investor.)

This gives private investments the illusion of low volatility relative to public market investments.

And so it’s possible that two identical assets—one that trades daily on an exchange and one that is privately held and valued every six months by an independent valuator using a lot of judgment—show a low correlation to each other.

Investment consultants and prestige investment salespeople take this idea and run with it, creating portfolio illustrations that show the magical effect of adding alternatives to your portfolio. High returns and low volatility—basically magic.

I recall being in one meeting where a committee member stopped and asked the consultant, “If these numbers are accurate, why wouldn’t we put 100 percent of the portfolio in alternative investments? Why invest in public markets at all?” The return versus volatility numbers were that compelling.

The consultant mumbled something about prudent diversification and limiting risk. What he didn’t say—what the true answer is—is that the numbers are wrong.

They are made up. They are not comparable in any way.

Some alternative assets are uncorrelated. Most are not. Let’s think through a few to demonstrate.

Hedge funds? If they actually hedge, maybe. Most don’t. Research has shown that hedge fund indices are mostly pro-cyclical and correlated to the broader stock market. So most are just betting on the trend and the momentum in the markets. (The Guggenheim investment company estimates that between 2011 and 2020, hedge funds had a 0.81 correlation with the S&P 500—that’s a meaningful statistic that indicates that there’s not much actual “hedging” going on. Hedge funds and the markets actually move together.) And so rather than providing uncorrelated returns, they are just another risk asset in your portfolio, meaning that they move up and down with the stock market. Only this particular risk asset comes with much higher fees.

Collectibles? Wine? Art? Classic cars? Let’s see… who’s buying them? Rich folk. Most of whom have their money in the stock market. If the market goes down, can they still afford the splurge? When the top 1 percent stop making extravagant purchases, look out below. There is a correlation to public markets, and it’s real.

I could go on. But you’d be surprised how many “uncorrelated” assets are truly correlated to your stock portfolio in one way or another. There is a further problem: due to the unlisted and private nature of such investments, any data on these asset classes will always be incomplete and subject to cherry-picking by anyone with an agenda—whether they are trying to sell you something or, like me, trying to warn you away.

All I can say with common sense certainty is that if part of the sales pitch is uncorrelated returns, evaluate it with a good dose of skepticism.