According to conventional investing wisdom the greater the risk associated with an asset the greater the potential reward.
This is especially true for Wall Street offerings. Extremely volatile, high-risk stocks offer the potential for high returns while assets that are low risk like U.S. treasuries offer the lowest returns.
Mainstream investors are fixated on this traditional risk-reward paradigm that even has mathematical concepts applied to it. Risk-return in public markets is measured using two variables, alpha, and beta.
Beta measures an asset’s sensitivity to the movement of the overall market. The market beta (i.e., the baseline beta) is always 1.0, so an asset with a beta of 1.0 means that it moves in lockstep with the market.
An S&P Index stock is a good example of an asset with a beta of 1.0. When the market rises, the asset will rise on average to the same degree, and when the market drops, the asset will drop similarly.
A beta of more than 1.0 indicates a higher risk than the market, while a beta of less than 1.0 indicates a lower risk than the market. Penny stocks fit the former category while treasuries fall within the latter.
Beta is one measure of risk-return. Alpha is another. You have probably heard on more than one occasion one or more of the many Wall Street pundits talking about chasing alpha.
What is alpha? When someone talks about chasing alpha, they’re talking about beating the market.
Alpha measures a portfolio manager’s ability to outperform the market. Alpha is typically used to measure hedge fund and mutual fund performance. An alpha number assigned to an investment indicates the percentage by which an investment beats the market – reflecting the skill of the portfolio manager.
An alpha score of 10.0 means an investment outperformed the market (typically the S&P 500) by 10%, while conversely, an alpha of -10.0 means an investment underperformed its benchmark index by 10.0%.
Although many pundits speak about achieving alpha, very very few achieve it.
In the real world, achieving alpha is elusive and spoken almost in hushed tones. The data backs this up. According to a recent article on cnbc.com, over a period of 15 years, a study found that over 92% of active managers (i.e., hedge fund and mutual fund managers) underperformed the S&P 500.
In other words, you were better off putting your money in an Index Fund than investing in one of the 92% of funds that underperformed the market.
Choosing that 8% of funds out of the crowd that beat the market is a fool’s errand. Investors are just as unlikely to choose the winning funds as funds, in general, are likely to choose winning stocks. In other words, “Good luck.”
This whole discussion of alpha and beta brings me to the discussion of investing in debt and why most investors who are seeking to build wealth avoid it because according to conventional wisdom, debt only offers low-risk low-reward options.
Achieving high returns can only be achieved by taking on high risk. And you can’t rely on professionals who are lousy at beating the market.
What’s an investor to do to achieve high returns at reduced risk?
Many would love to keep the low-risk benefits of investing in debt but achieve the high returns of more risky stocks.
Is a high-return, low-risk debt investment just a unicorn? No.
Here’s why:
Beating the market through high yield debt investments at reduced risk can be achieved but it’s not going to come from where many investors think. Beating the market through high-yield, low-risk investments can be achieved only in private markets that are uncorrelated to Wall Street and where skilled management – unrestrained by Wall Street – can indeed achieve alpha.
The appeal of low-risk high-return private debt investments is not lost on the ultra-rich who have been flocking to private debt investments in droves in the wake of the COVID-19 pandemic.
According to a recent Bloomberg article, armed with cash and long investment windows, the ultra-rich, who aim to grow fortunes across generations have been turning to private debt investments insulated from Wall Street. The number of ultra-rich represented by family offices active in private debt has more than doubled since 2015, according to research firm Preqin.
The appeal of private debt to the ultra-wealthy are numerous:
-
- High Yields
- Low Risk
- Typically Asset-Backed
- Consistent Income
- Uncorrelated to Wall Street
Private debt funds offer what most public hedge funds and mutual funds can’t offer: The promise of high alpha through skilled managers able to exploit market inefficiencies.
Private debt locked in for an established term is illiquid and shielded from market volatility. Expert management can unearth value from market inefficiencies by for example tapping untouched industries and market segments. Unlike hedge funds, skilled private debt fund managers have consistently shown the ability to achieve high alpha.
While many ambitious investors have shied away from debt investments for building fortunes, maybe it’s because they’re looking in the wrong places.
Bound by market forces, public debt investments are unable to offer the low-risk high-return investment option available in the private markets where skilled management can truly achieve above-market returns on private debt at reduced risk.