The Taxable Investor's Manifesto

CHAPTER NINEApproach Alternative Investments with Skill and Skepticism, or Not at All

Alternative investments were once the domain of sophisticated family offices and a few early movers in the endowment and foundation world. The know-how was concentrated in few hands, capital was limited, and returns were consistently high. The markets were inefficient, so superior skill was rewarded with much higher returns. Even middling relative results usually outperformed public markets. Today, alternative investments are no longer “alternative.” Those high backward-looking returns have attracted more than $7 trillion of hedge funds, credit, private equity, venture capital, and real estate funds.¹ A whole network of intermediaries has grown up to sell these investments to just about anyone who has a few million dollars to invest.² Alternatives have gone mainstream.

As these pools of capital have grown, the marketplaces in which they invest have become highly competitive and less inefficient. What started as a market for private taxable wealth has been flooded by tax-exempt institutional assets. Knowledge about these markets is now widespread. Managers looking to structure funds and raise capital are driven to maximize IRRs, not net after-tax profits, because they know that's what the big money institutions are looking for and it's how their own incentive compensation is usually calculated.

The opportunity to invest in these funds is everywhere, but should you invest? The headline returns ...