Have you ever considered why affluent individuals often gravitate towards investments in hedge funds, venture capital, venture debt, private equity, and specialty funds? Despite their tendency to underperform the S&P 500, these actively managed funds continue to attract billions of dollars annually.
Many of these funds fall into the category of alternative assets, which typically aren’t as efficiently priced as conventional marketable securities. This inefficiency opens up opportunities for active management to capitalize on market gaps. Examples of alternative assets include venture capital, leveraged buyouts, and investments in commodities like oil, gas, and timber, as well as real estate.
Since 1999, I’ve been allocating a portion of my capital to various actively managed funds. Based on my experience, I want to share the evolving reasons behind this choice, segmented by age group. This perspective was prompted by a reader’s query in one of my posts about investing $1 million, making me realize how my motivations have shifted over the years.
Investing in Active Funds: A Journey Through Different Age Phases
Our relationship with money evolves as we age, and it’s important to recognize and adapt to these changes.
1) Investing in your 20s: Driven by curiosity, access, and a degree of naivety
My first foray into hedge funds was with Andor Capital in 1999, available through Goldman Sachs’ 401(k) plan. Despite the higher fees, I was drawn in by the fund’s strong performance in technology. With a modest salary and limited means to invest otherwise, this opportunity was my entry into an exclusive investment club.
My investment in Andor Capital, especially during the tech stock downturn in 2000 and 2001, left a positive impression on me about hedge funds. At this early career stage, access and curiosity were my main drivers, not the fee structure or investment size.
2) Investing in your 30s: Fueled by aspirations and success stories
As wealth grows in your 30s, so do your aspirations. Stories of fund managers achieving extraordinary wealth, like John Paulson’s success in 2008, fuel the desire to replicate such gains. The realization that concentrated bets are the pathways to immense wealth leads to a natural inclination towards active funds.
Your 30s are a phase of active investment learning, marked by successes and setbacks. While most active investments might underperform compared to the S&P 500, those who experience significant gains often wish they had invested more, reinforcing their enthusiasm for active investing.
3) Investing in your 40s and beyond: Focusing on security and capital preservation
With two decades of investment experience, you recognize the likelihood of active investments underperforming passive ones. Your investment choices become more aligned with this reality, focusing on proven funds and managers.
In your 40s, you value the expertise and dedication of fund managers in safeguarding your capital. With sufficient wealth to generate a stable income, your focus shifts to peace of mind rather than chasing high returns. You appreciate the flexibility and protection that actively managed funds can offer, unlike index funds that are bound to their benchmarks.
Investing in active funds later in life offers a balance between protecting your wealth and the ongoing pursuit of growth. For instance, Melvin Capital’s dramatic performance in 2021 and its eventual closure in 2022 highlight the dual nature of active fund investing – pursuing maximum returns while being mindful of potential risks.
Diversification as a Hedge Against Financial Crisis
Wealthier individuals often shift towards capital preservation, adhering to the adage, “once you’ve won the game, there’s no need to keep playing.” Diversifying into active funds is part of a broader strategy to protect wealth from significant losses. A prime example is Yale’s endowment, which allocates a small portion to domestic equity and a larger share to various active funds.
Scenario: Managing a Deca-Millionaire Portfolio
Imagine managing a $10 million portfolio, often considered the starting point for generational wealth. With no active income and annual expenses of $300,000, achieving a 5% return is sufficient to cover living costs, reducing the necessity to invest heavily in higher-risk options like the S&P 500.
A balanced portfolio might include 40% in real estate, 30% in public equities, 20% in active funds, and 10% in risk-free investments. This diversification can potentially offer a steady 5% return with lower volatility. In this scenario, the goal is to avoid the stress and anxiety of significant market dips, as seen in the 19.6% drop of the S&P 500 in 2022.
Investing in active funds becomes a way to hedge against market fluctuations and maintain peace of mind. This approach aligns with a lifestyle focused on tranquility and enjoyment, like spending quality time with family, rather than solely maximizing investment returns.
As you accumulate wealth, the value of peace of mind often surpasses the desire for higher investment returns. Therefore, paying for active management becomes a worthwhile trade-off for many affluent investors. This mindset doesn’t negate the reality that active investments might not always outperform indexes like the S&P 500. However, the potential for lower losses during market downturns can be a comforting thought.
In summary, as your wealth grows, you might also find yourself more inclined to pay for the security and peace of mind that actively managed funds can provide.
