Show Us of Your Portfolio II: Larry Swedroe on Alternatives and Interval Funds

Episode Summary

Executive Summary: Larry Swedroe explains how he builds a highly diversified portfolio using evidence-based, systematic strategies plus a wide range of illiquid or alternative assets—private credit, life settlements, drug royalties, reinsurance, and managed futures—to capture distinct risk premia, reduce correlation, and improve long-term outcomes. He emphasizes due diligence, liquidity matching, and staying disciplined through inevitable tracking error.

Main Topics: Market outlook and valuation context (Priority: 5/5): Swedroe contrasts today’s elevated bond yields and bifurcated equity valuations with the low-return environment of 2020–2021, arguing that expected returns vary greatly across market segments. Portfolio construction and first principles (Priority: 5/5): He outlines his evidence-based framework: use systematic, transparent, replicable strategies; seek diversified sources of return; and avoid concentrating too much risk in market beta. Interval funds and illiquidity premiums (Priority: 5/5): Swedroe explains how interval funds enable access to private, less liquid assets by limiting redemptions, allowing investors to capture illiquidity premia that institutions have long exploited. Private credit and structured alternatives (Priority: 4/5): He details the investment cases for private credit, structured life settlements, drug royalties, and litigation-like cash flows, highlighting their higher yields, diversification benefits, and long track records. Reinsurance as a distinct return stream (Priority: 5/5): He describes reinsurance and quota-share exposure as a way to isolate catastrophe risk without also owning the balance-sheet risks of reinsurance company stocks. Managed futures and factor investing (Priority: 4/5): Swedroe discusses long-short factor funds and managed futures, noting their role as diversifiers and tail-risk hedges rather than return enhancers. Investor behavior and discipline (Priority: 5/5): He stresses that investors must accept tracking error, avoid judging strategies by short-term outcomes, and stay committed through ugly periods if the underlying logic remains sound.

Key Arguments: Expected returns differ substantially across asset segments; broad statements about equities or bonds are too simplistic because valuation and risk vary by segment. Investors should focus on systematic, transparent, replicable strategies grounded in academic, peer-reviewed evidence. Risk is broader than volatility and includes tail risk, skewness, kurtosis, and liquidity; illiquidity can be rewarded with a meaningful premium. Most 60/40 portfolios are overly concentrated in market beta, while institutions like Yale and Harvard diversify across many uncorrelated risks. Interval funds open access to illiquid asset classes by allowing only limited periodic redemptions, reducing run risk and supporting long-term investing. Private credit often offers superior credit profiles versus public high yield because it is senior secured, floating rate, and backed by private equity sponsors. Life settlements, drug royalties, and similar contractual cash flows can provide high, uncorrelated returns when analyzed properly and diversified. Reinsurance is attractive because it earns premiums from catastrophe risk that is unrelated to stocks and bonds; investors should own the risk premium, not the insurance-company equity. Managed futures/trend following can be useful for tail protection, but investors should not expect them to outperform in normal times. The biggest investor error is resulting—judging a strategy by recent outcomes rather than by the quality of the original decision and its expected long-term edge.

Data Points: Top 10 S&P 500 concentration: 35% - Swedroe noted the top 10 stocks in the S&P 500 account for about 35% of the index, highlighting concentration risk. Expected real equity return in high CAPE environment: About 3% to 3.3% real - He estimated future real returns from equities using CAPE around 30, implying much lower returns than historical norms. Expected nominal equity return: About 5% to 5.5% - Combining ~3% real returns with ~2% inflation led to his estimate for expected equity returns in that period. Bond yields referenced in low-rate environment: About 1% to 1.5% - Swedroe described bond yields in 2020–2021 as implying much lower expected returns than historical averages. Private credit fund yield: About 11.5% net - He cited Cliffwater’s private credit interval fund as offering a materially higher yield than comparable public high yield. Public high yield yield: About 8.5% - He compared Vanguard’s high yield fund to illustrate the return gap versus private credit. Private credit losses: Around 1% historical defaults and 1% losses - Swedroe referenced Cliffwater’s long-running senior secured credit index history. Private credit credit losses with PE backing: About 25 basis points - He said the PE-backed version of the strategy has had even better credit performance. March 2020 private credit drawdown: -3% - He contrasted the fund’s modest drawdown with the severe stress in public high yield during the COVID panic. Life settlement return range: Low/mid-to-high single digits before GFC; high teens after; around 10% to 12% today - He described how the return premium in structured life settlements shifted with liquidity conditions. Reinsurance recent fund return: +43% (approx.) - He said Stone Ridge’s reinsurance fund was up about 43% in the current year discussed. Reinsurance prior year return: -5.5% (approx.) - He noted the fund had reported losses the prior year due partly to conservative catastrophe estimates. Alternative sleeve in his own portfolio: Mid-40%s and rising - Swedroe said his personal portfolio allocation to alternatives had moved into the mid-40% range. Typical client alternative allocation: 10% to 15% - He contrasted his own allocations with those of his clients, who typically hold much less in alternatives. Harvard/Yale alternative allocation: 50% to 60% - He cited endowment-style portfolios as a benchmark for higher allocations to alternatives. Interval fund redemption minimum: At least 5% per quarter - He explained the SEC structure that forces periodic liquidity for interval funds. Potential annual liquidity via interval funds: Up to 20% per year - Based on the 5% quarterly minimum redemption feature. Blackstone private real estate fund fee example: 1% and 10% - He cited newer private fund fee structures as cheaper than traditional 2-and-20 models. Traditional private equity fee structure: 2 and 20 - He referenced the older standard management and incentive fee model as increasingly less common. Sequence risk mitigation: Portfolio flat/up slightly in 2022 - He said his alternatives were up while stocks and bonds were both down double digits, helping his overall portfolio.

Pivotal Quotes: "If you believe that all risk assets have similar risk-adjusted returns, why would you concentrate your portfolio in any one factor or unique source of risk?" — Larry Swedroe: Used to justify broad diversification across multiple uncorrelated return streams rather than a stock/bond-centric portfolio. "You cannot judge things by the outcome, but only by the quality of your decisions, or you will be always chasing returns." — Larry Swedroe: His central behavioral warning against evaluating investments only by short-term performance. "The key is what that means is you want to diversify. You must accept this tracking variance to reduce the volatility of your portfolio, which is the objective." — Larry Swedroe: Explaining why investors should tolerate underperformance versus benchmarks when the goal is lower overall portfolio risk.

Implications: Investors may improve long-term outcomes by matching liquidity needs to assets, embracing diversified illiquidity premia, and avoiding performance-chasing. The future likely brings more democratized access to alternatives through interval and evergreen structures.