Why rich people don’t have access to better investments, continued…
In most of life, the more money you have, the better things you can buy. For example, if I spend $200 on sushi, the fish is going to be fresher and better than $5 sushi from a gas station.
Pay more, get better food, better housing, better travel experiences. We all intuitively understand this.
But in personal finance—with rare exceptions—this is not true. Let me show you why.
There’s a whole industry set up to exploit rich investors who want better returns.
The rich find it impossible to believe their money can’t beat what ordinary investors get. So a massive industry has sprung up to deliver this fantasy via private equity, venture capital, and alternative investments.
There are 1{1652eb1ffa4184925f6a63a9c04ea6b421acb7a78117241e7d4325cdca8339fa} wealth management fees (remember, 1{1652eb1ffa4184925f6a63a9c04ea6b421acb7a78117241e7d4325cdca8339fa} means you’ll pay 28{1652eb1ffa4184925f6a63a9c04ea6b421acb7a78117241e7d4325cdca8339fa} of your returns to fees), 2-&-20 (meaning you pay 2{1652eb1ffa4184925f6a63a9c04ea6b421acb7a78117241e7d4325cdca8339fa} AND 20{1652eb1ffa4184925f6a63a9c04ea6b421acb7a78117241e7d4325cdca8339fa} of returns — lol), 10-year lockups where your money is illiquid, obfuscated fees (IRR is not your return), etc.
These investments look glamorous—and frequently underperform.
Here’s one example, where “Pershing Square kept approximately 72 percent of the fund’s gains for itself, leaving investors with the measly remains.”
The alternative investment game is fantastic for the people running it. Not so great for the actual investors, who can often get better returns in a Vanguard index fund. I wouldn’t expect the average Ma and Pa investor to understand these complexities—and indeed, there are some minor rules such as “accredited investor” rules—but what’s remarkable is that even highly sophisticated investors like pension funds often also underperform against a basic index fund.
What about hedge funds?
You’ve probably heard how the ultra-wealthy have access to these secret hedge funds, which outperform the market when it’s going up, but then they also outperform when the market is down. They’re magic!
Yeah, I watch Billions too.
The truth: most hedge funds underperform a simple S&P 500 fund. And despite underperforming for over a decade, extremely wealthy people keep pouring money in. How do they get away with it? My favorite is the hedge fund that went bust in 31 minutes.
In general, hedge funds are for suckers.
You may remember that in 2008, Warren Buffett bet that “an S&P 500 index fund would outperform a hand-picked portfolio of hedge funds over 10 years.” Predictably, the hedge fund lost. Not just lost a little, but lost in an absolute bloodbath. This was like the Superbowl for me.
What about venture capital?
Yes, the venture capital asset class also underperforms the market.
Hedge funds underperform. VC underperforms. PE underperforms.
Keep in mind, there are different reasons to own these funds, so it’s a little bit like me saying that a “Ferrari underperformed a minivan”—well, they both have different purposes. But we all know that you buy a Ferrari for fun and luxury. Most of the people who buy into sophisticated investments like VC/PE actually believe they’re going to get outsized returns. They don’t. So while different and theoretically uncorrelated, the vast majority of alternative investments….still lose compared to a simple index fund.
Now, if you really want to get into these funds and you’re wealthy, they’ll happily take your money and happily charge you insane fees. They’ll bamboozle you with fancy offices and beautiful reports filled with arcane terms and hockey-stick charts.
In the end, many people—and I’m talking about highly sophisticated investors—don’t even realize their returns are below what a guy working at Best Buy can get by investing 7{1652eb1ffa4184925f6a63a9c04ea6b421acb7a78117241e7d4325cdca8339fa} of his paycheck in an index fund.
Same with private equity.
Private equity frequently misleads even sophisticated investors with their IRR numbers (not clarifying that IRR isn’t what investors make). Preston McSwain has been outspoken about this.