Over-hyped and oversold: Three advisors who don't love alts

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Alternative assets are hardly an alternative choice anymore for family offices. This asset class — encompassing private debt and equity, infrastructure, venture capital, farmland, cryptocurrency and hedge fund strategies, among many others — is increasingly forming a sizable portion of Canada’s wealthiest families’ portfolios.

It’s not just Canadians tuning in and turning on to alts, either. A recent survey from KKR shows family offices globally are increasing their allocations as well. In 2023, alternative assets under management owned by institutional and affluent investors accounted for $13 trillion and are expected to grow to $23 trillion by 2027.

Alts are popular, and for good reason. They can provide diversification to public fixed income and equity markets.

Yet they’re not without risks, and some experienced investors in the space note that, while valuable, alts have been over-hyped and oversold, and likely have been under-scrutinized lately.

Here to throw some cold water on this sizzling asset class are three contrarian takes on alts.

‘Extremely overhyped’

Greg Rodger, chief investment officer at HighView Financial Group, a multi-family office in Oakville, Ont., says alts make up a “meaningful component” of most client portfolios, diversifying risk and smoothing out volatility.

But they require more research than other asset classes. “You need your risk management hat on, thinking more deeply about what could go wrong,” he says.

Lots can go wrong with publicly traded securities, too, but specific risks may not be as readily apparent because alts typically have fewer eyes examining them than a publicly traded company.

Rodger also says that “alts have been extremely overhyped,” with even seemingly sophisticated investors enticed by private equity or venture capital deals that promise high returns with limited risk. “That’s just not possible,” he says. “Alts always involve risks, just different from public markets.”

A big one that often emerges only during economic and market stress is illiquidity. “Someone once described [alts] as being in a movie theatre where the fire exit doors only lock when there’s a fire,” Rodger says. “Oftentimes, you can’t get out when you most want out.”

Yet perhaps the biggest risk is that any one deal may be fraudulent. “My biggest fear with alternatives is not that they return 3 per cent when I am expecting 8 per cent; it’s that there is actually nothing there.”

For that reason, HighView’s research is all the more thorough, often going as far as interviewing borrowers in a private credit fund to ensure they’re legitimate, he adds. “It’s still months and months of research after just identifying something interesting.”

Tide hasn’t come out yet

Former alternative asset manager Tom Czitron, now editor of the Investment Survival Newsletter, acknowledges that alternatives diversify portfolios. But this asset class has not been truly tested yet, he says, though that may change in today’s higher-interest-rate environment.

“We have a whole generation of managers who have worked largely in this artificial greenhouse of low rates,” he says, noting that today’s hurdle rate — about 5 per cent — is much higher than it was three years ago. “So you have to find pretty good investments that can go over the hurdle.”

Now, just to outpace the risk-free return and inflation, an alt must provide a return of 8 per cent or higher, says Czitron, who is based in Toronto and is former managing director with Sceptre Investment Counsel (now Fiera Capital).

Simply, “it’s a high-risk area,” he adds. While some alt opportunities are indeed worthwhile, countless others may be “bull— companies, and I don’t think the tide has come out fully yet.”

What’s more, Czitron adds that family offices must do their own deep due diligence because analysts in this space cannot be trusted fully, as history from the 2000s shows. He points to Bernie Madoff’s investment firm, which used a well-known split-strike conversion strategy to derive outsized profits.

“It was a combination of, for argument’s sake, covered call writing and portfolio insurance,” but Czitron says when he was running money for an alt fund in the 2000s, he passed on Madoff’s fund despite glowing analysis from some research firms and its stellar track record. “I tried its strategy on paper, and I couldn’t get anywhere close to the consistency he got,” he says.

In reality, neither could Madoff, who was running a Ponzi scheme.

Blockchain investments — just getting their start

Among the more recent instances of an alternative investment going off the rails — or, more succinctly, being outright fraud — is FTX Trading Ltd., the cryptocurrency exchange platform run by Sam Bankman-Fried, who was convicted of embezzling investor money. The Bankman-Fried case illustrates the Wild West-like growth and careless bullishness regarding cryptocurrency.

“It is a huge opportunity … but it’s also a massive risk,” says Allan Matheson, Vancouver-based founder of Golden Pear Capital, a private investment fund with family office clients specializing in investing in blockchain technology.

Among the biggest risks of crypto — or more importantly the blockchain tech that underpins it — is that the space is nascent. “Crypto, AI and quantum [computing] are the three big technologies,” Matheson says, “and one of the problems with investing in them is that it’s so early that we’re still talking about building out the infrastructure.”

Bitcoin and other digital currencies garner the most attention, but smart contract blockchains present the potential to revolutionize finance and other industries. The catch is that blockchain is so new that it’s poorly understood, and it’s questionable whether family offices have the necessary depth of knowledge to make prudent investments. What’s more, the investment choices are seemingly endless, from VC firms focused on blockchain technology companies to liquid token funds, essentially providing liquidity for smart contracts in a burgeoning lending space

Another risk in blockchain investments is that they “get leapfrogged by a better one, making the one you invested in useless almost overnight.” Investors run the risk of bumping into an FTX, he says, that could be all smoke and mirrors.

Not to mention the blockchain ecosystem — which includes popular liquid tokens such as Ethereum and Solana — consists of more than 2 million different tokens.

“About 99.9 per cent of them are absolute garbage, and it’s a very small percentage that are interesting with the potential to transform society,” Matheson says. “And so you really need to be confident that the managers that you’re investing with really understand the space.”

Words of advice to live by, be it crypto or any other alternative investment.

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