Before You Add Alternatives: How to Tell if Private Markets Fit Within Your Plan (EP.231)

0:28We all need to make smart decisions with our money. Swimming with Allocators, which is a VC-focused podcast from the LP perspective. And I was invited to talk and share some of my views on the world of not just venture capital, but private investments in general. So if you want to get deep in on my investment philosophy, this is going to be the episode for you. And if you want to always stay in tune with my latest insights, you can sign up for my newsletter using the link at the top of the episode description. And now, here is my conversation on Swimming with Allocators.

1:03Welcome to Swimming with Allocators. Today, we have Peter Lazaroff as our guest. He's the Chief Investment Officer at PlanCore and the host of Cheddar's The Long-Term Investor Podcast, of which I am a avid listener. And after hearing from him, I think you will be too. Today, we've invited him on because most of our guests are bullish on venture as an asset class. And here we have an RIA who is not recommending venture to his clients. And we thought that would be helpful for both the allocators and the GPs listening to hear from the other side. He's also going to share with us some of the popular tools he's developed for clients and the thesis of his upcoming book.

1:42Thanks, Peter. Alexa, Ernest, thanks for having me. Our resident hater. Thank you for coming on the show. We've had a few. The more the merrier. Peter is in Missouri. He's overseeing$8 billion in assets across over, what, 1 ,500 clients. Yeah. So can you just give us a quick overview of your investment philosophy so people can understand where you're coming from? Sure. I think the most important thing I could say about my philosophy is that I'm more worried about implementing a bad idea than missing out on a good one. And let me give a little context. The example I always give is the FDA. When they seek to approve a drug, they're trying to approve a drug without it having crazy side effects.

2:28And every drug has some side effects. It's why they have the people who can do fast reads. I cannot do the fast read. The other side of that is that sometimes the FDA is a little too stringent and they fail to approve a drug because there's bad side effects, but it would have been a net positive to society. And so what we're talking about for statistics lovers is type one error and type two error. You have false positives, you have false negatives. And I think that ultimately investment success comes down to minimizing mistakes and making sure that you don't interrupt compound interest. And I think in general, I don't think you can only index and that's all you should do.

3:06I think index funds are great, but I don't use index funds myself. I do only use one fund, though. It's 100 % globally diversified. It is what would be considered a factor fund. So rules-based, like an index, but not index investing itself. And for our clients, we have a couple different strategies that are just focused on a rules-based, repeatable, process-driven, not going to predict the future. and really leaning on that, I'm more concerned about minimizing type one error. If you want to totally minimize type one error, that means owning the market portfolio and nothing else. If you want to minimize type two error, you have to add everything with a good back test to your portfolio.

3:43And so let me go full circle there. I'm more concerned with implementing a bad idea than missing out on a good one. And when you go through that lens, the bar is higher for inclusion. And so I think what's exciting, I've listened to the show, I've known Alexa for a while, and when she told me she had a podcast, I went back to episode one and started plowing through. I'm like, yeah, everyone loves venture. Let's get it clear. I don't hate venture. I just don't think it's for everybody. And I think privates in general, I don't think are for everybody. So that's a quick global view of how I see investing.

4:13Wow. What a way to start. When you talk about your lens, Peter, it's definitely very different than talking to two GPs here like us, where it's like, yeah, what's wrong with betting in the house? You have to turn over every rock to find that golden nugget. I'm always curious, what shaped your investment philosophy throughout your career? Well, I started my career as an individual stock analyst, and I had a lot of success. And I have loved stocks, broadly speaking, since I was a kid. My grandmother gave me a share of Nike stock for my 12th birthday, and it split right away. Actually, by the time she had gifted it to me on my birthday, I have a December 20th birthday.

4:54My family celebrates Hanukkah and Christmas. So we got a lot of stuff going on in December. But she had bought the shares of Nike for me, I think, in November through her broker. And they'd already split. And by February, they split again. Later in the fall of that first year of me owning it, it split again. So somebody had eight shares of Nike. I'm getting this$1 dividend check in the mail. And I'm thinking, this is great. So I was all in. Anything that had to do with making money as a kid, I'm like, this is cool. I want to learn more about this. So when I was a stock analyst, I didn't know a lot about the world like much of us when we graduate from school.

5:29And I was having a lot of success, but I was learning a lot. And I think I accidentally stumbled onto a book. I was reading Barry Ritholtz had a blog called The Big Picture and blogs were just starting to have their day in the sun. And he is pointing to a lot of resources I hadn't ever seen before. And there was one in particular, Michael Bobasson, who is still one of my favorite investment thinkers, had written a very obscure paper on skill versus luck. And I think that that ended up taking me down a very, very big rabbit hole that made me realize my success as a stock picker might be more luck driven than anything.

6:09You're the monkey who just wrote Shakespeare. here. What's weird about it though, is what I've come to learn about stock picking in general. I mean, I used to own a lot of individual stocks. I don't currently own any individual stocks. And the last time I had a seemingly dying urge to buy individual stocks was during the pandemic. Cause that was the first time to me since the financial crisis that I would see valuations where basically the stock is priced, like it might go bankrupt. And then you're out there just picking things that you don't think are going bankrupt. And I remember telling myself, man, Nordstrom's not going to go bankrupt.

6:43Amazon will buy them. Because I'd already thought that Amazon would buy them. It would help their distribution. Amazon wanted to get into clothing. I'd made up this narrative that would have forced to buy. And the thing about individual stock picking is everybody's got a ton of information. You just have to hope that everybody sees your view of the world eventually. And you're making up stories. And individual stock picking, very luck-driven, but very story-driven. probably more so than in the 80s and 90s when stock picking was a little bit more just about fundamentals. You're really trying to predict valuations.

7:14Now, here's the thing where I think the parallel to venture is super interesting. So if you go by the Russell 3000, which there aren't actually 3000 companies in, but let's just say there are roughly 4 % of those individual companies are driving all the returns. Does that sound familiar? I mean, it's not that different than In venture capital, it's just you are betting on bigger companies who are reporting more regularly and have more public information. And so price discovery is different. In venture or in private equity of any kind, really, price discovery is minimal. And there's a lot of easy ways to be critical.

7:52And I'm not saying they're untrue, but I think some people have skin in the game in the sense of they want privates to be bad. I don't care if privates are good or bad. I think there's merit to some of the volatility washing, to some of the way that people mark prices. But at the end of the day, it's just not as efficient of price discovery. So it's kind of the same mechanism. And that's why I wanted to emphasize, hey, I'm not anti-venture. I think it's just when does your balance sheet allow for you to take that kind of risk in general? Ernest, I'm way off the path of how did I get this investment philosophy?

8:24So let me pause and see where we should go. I just realized this has nothing to do with what you asked me. But here we are. I just that parallel between it's hard to pick stocks. I am fascinated with stocks. I'm fascinated with human behavior. I think that private investing and public investing have more in common than most people realize. And it's one of those, it's not quite interdisciplinary, but anytime you start crossing disciplines, you start seeing that a lot of things in our world actually are quite similar as for how they all work. That's absolutely true. It reminds me of a conversation I had earlier this week with someone who was an emerging manager in the hedge fund world.

9:00And he was explaining to me why he felt the need it was the right time to start a new multi-strat hedge fund and bringing up the same thing of some of the biggest players have gotten really big and are just asset allocators and their misalignment of incentives has not generated as much talent and novel ideas as in the past. So there's stifled talent internally and there's a better way. And so I was like, man, that sounds very familiar. But to that point with the blending of all the worlds, how does that change actually what you recommend a lot of your clients to do? So PlanCorp serves high net worth clients, which can mean a lot of things to a lot of different people.

9:41But if you just do simple math of the assets we're managing divided by the number of clients we have, let's say the average client has about$5 million. The average investor in the world, and this is theory, but it's also true. The average investor, if we all put our money into a pot and then we divide it evenly, we all own the market portfolio. And so the average investor owns the market portfolio. So what I always do is I ask people, well, how are you different than average? The market portfolio is amazing. There's not going to be a person who's going to convince me that it's a bad investment.

10:10I think it can be improved upon, but if you choose the market portfolio, you do it. There is nothing wrong with that. You're going to do great. Could to do better? Maybe. Does that matter? Maybe not. So I'm always asking, how are you different than average? Are your liquidity needs relative to the size of your portfolio different than the average investor? Some people that we work with, I say the average is$5 million, but we have a couple billionaires where maybe we're not managing all their money, but we might have a couple hundred million dollars of it. They are overweight liquidity relative to the average investor.

10:45I think that's actually a key point when privates come into play is once you're overweight liquidity, then you should take some more illiquid risks. It's pretty straightforward. And so when we communicate to clients, we talk about how are you different than average? We think a lot about the financial plan before the investing. So in many ways, I'm the sideshow here. Our firm was started over 40 years ago as a fee-only financial planning firm, something that wasn't really even a thing and is borderline an insane business plan to have had back then. And now it's pretty normal. On one hand, the RIA space has maybe not overly commoditized the active asset management, but there has been, thanks to technology, a lot of scaling and systematizing where when you go to an RIA, you're going to get a diversified portfolio.

11:32They're going to try to keep costs low. How they implement around the edges probably makes a difference, but it's not wildly different outcomes if you're globally diversified and not trying to predict the future and keeping costs low. I think where things are different is how can you customize? So the toolbox is where things suddenly become less commoditized. So do you have a lot of concentration in a particular sector of the economy, either through your job or your actual portfolio? Do you have a pain point with capital gains? Do you have very specific legacy goals? Do you have a special needs child?

12:12Once you start bringing in how am I different than average is when your portfolio starts to not just deviate from the market portfolio, but deviate in the vehicle that you're going to use to achieve those goals. And so I think in general, one of the things that has probably played a huge role in the way I think through portfolio construction, as well as communication is I started as an analyst, but after an analyst, I probably should have mentioned this. I was an advisor. I had a book of business. I think over 80 % of it was physicians. So I'd said FDA, I haven't had any other. You just wait, there's going to be more medical analogies because it's just deeply ingrained in me at this point.

12:49My parents are physicians. I was working with all physicians. Okay. I don't know. Maybe I was supposed to be a doctor at some point, but I think in general, when you're talking to clients, that's the big thing. If the average person owns the market portfolio. How are you different than average? And why does that matter? And that's the framework where you start to explore some of those deviations. And I think all portfolios are some combination of market portfolio, strategic tilts, active bets. And then I think you get into that illiquid versus illiquid proportions of the portfolio. Now, that piece definitely hits where your guys area of expertise lies, but it also hits a lot of other people's.

13:27And I think every portfolio, that's the framework, no matter who you're looking at. No, people might be zeroed out in some of those categories, but you're still going through that framework. So would you say that it's potentially beneficial, but not necessarily for everyone? Who is the potentially? It's just those billionaires who need to rebalance their liquidity? I think a big piece of what we do with privates that's different than other people who run firms our size is that most times when you're in a role like mine at a big investment advisor, you're trying to make portfolio decisions that are durable and scalable across multiple advisors and locations.

14:03And our private allocation is the one place where we are highly customized. And I think one of the issues that I have with privates as a whole right now, and the way that they're getting adopted is it feels like because the access is changing, and they're becoming easier to implement these more durable, scalable options, what's happening is people are treating exposures more like a line item in an asset allocation pie and less like a specific purpose-driven investment. And when it comes to privates, I'm broad stroke putting privates. We can go more niche if we want to, but what's really important to me when we add privates is that we understand the why the client wants to use privates in some capacity or alternatives of any kind because they're alts that aren't privates per se.

14:54That to me means so much because it isn't always a financial reason. And that can lead to different categories. We have some models. If I won the lottery and had$100 million of after-tax money, I wouldn't use our models. Our models are these durable, scalable things. And do they give you exposure to the narrative of private investment? Yes, they do. You and your audience probably really understand the impact of dispersion in this space. And so while maybe I can feel comfortable that we won't be in the bottom 50%, how comfortable am I that we're in the top 25 %? Because being in the second 25 % is not that great.

15:32Not at all. And I'm not saying the models can't do it. If I have$100 million after tax, I'm probably doing privates. But you know what I'm doing is I'm investing in things that I'm personally interested in. I'm investing in friends who I believe in. I'm investing in ventures where I get to have an active role in it. So there's purpose. I think purpose is so important. I would say that one of the things that people do a poor job of when salespeople reach out is they're just pitching product. And I think they've never worked with clients. Maybe it's not a fair criticism, but for me, I think that generally, let me take private credit.

16:08This is a great example. I have a really hard time wrapping my head around the appropriate use case for private credit for a taxable investor. If you talk to a lot of people in my role, they won't put private credit in something that isn't a qualified account like an IRA or a Roth IRA. The thing is, the best use case that I've found for private credit to date is there's a gentleman we work with. He's got, I don't know, 40 or 50 million dollars. And he just wants to make annual exclusion gifts to all his grandkids and kids. but he's not liquid enough to write these checks. And so he needs something to spit out yield.

16:43But the after-tax yield isn't all that good for how much risk you're taking. And so you could have a model that's an income model and it has some private credit and it has some private equity, maybe it has some infrastructure or real estate. And the models, they look cool. And sometimes that is one of the objectives and people are embarrassed to say it. And I was like, don't feel embarrassed. You want something cool to talk about at the country club? That is not something to be embarrassed about. If you can afford to do that, why not do it intentionally and have something cool? I keep going on these long tangents, trying to go all the way back to the beginning.

17:17I think who is it right for and how do you determine what it looks like is really individually driven. I think where I'm seeing the most interest today remains in the private credit space. What I would say what people feel about venture capital is, God, the word that comes to mind is hopeless. How are we supposed to know? I don't think that's really the word I want to use, but I think with private equity, it's more established. It feels safer. Whereas people who have done venture in the past usually have some scars and bruising to show from it. And if they haven't done it, usually they're asking the type of questions that would signal a misalignment of expectations and reality.

18:00And we all know that the distance between expectation and reality is what equals happiness or unhappiness. I feel like I end up talking people out of venture who come and have never done it before and are talking about finding the next big thing. Whereas really, and actually I would love for you guys to point out where you think I'm wrong with this next line. To me, when you're investing in a fund, you're investing in that team's network. Because even if I know who has the next Google, they're not taking my money. They have to want to work with the person who's collecting and seeding in the first place.

18:34And so I think I feel like I do actually have a good network. But to really flex that network, I would have to be writing bigger checks than what I can write on behalf of my clients. Even if we have 8 billion, I would need everybody to adopt it because they want the big consistent money. And that's okay. And so I think it's knowing what are the rules of the game? Can I play this game or not? And then why am I playing the game in the first place? None of this has anything to do yet with risk and return or liquidity or not, if you'll notice. I think it's a lot of just really trying to align allocations with goals.

19:06And then after that, educate, educate, educate, keep expectations and reality as close as possible. Constantly update expectations because when they separate is when people get upset. And when people get upset, they bail. And when they bail, it's usually at the wrong time. Now that's true, not just with privates, it's true with public equities. I mean, the past decade, all I've been telling clients is no, don't sell your international stocks. You need international stocks. So it's kind of the same thing, just different sleeves of the asset allocation buy. This is incredibly helpful because I think 90 % of our audience are GPs fundraising.

19:41They forget all the reasons why. They forget who's the people who are ultimately buying the fund. 100%. They're out there selling, selling, selling. and you're like, remember the universe that you're in. Even if you're just pitching a high net worth, you are top of the pyramid in terms of people who think a lot about this. But still, your average high net worth, this is their universe too, as opposed to which VC fund should I pick? So meanwhile, all the other RIAs are offering faults in mass. So what do you suspect they're doing and why? Well, I think it's easier for an advisor to sell complexity.

20:20That's the baseline of what I think is happening. What's also interesting, so I am a part of a couple different CIO forums or executive groups that host firms that are my size or bigger. And when I talk to CIOs, sometimes people are just really passionate in the story. The story, the numbers, all of it. Some are saying, well, the advisors and clients say we have to have it, and so that's why I do the work. Then you have other people who are a little bit indifferent and a little bit unsure of what they even think about their own solution. I'm usually surprised at the percentage of allocators who are confident in their allocation.

21:02Two privates, two alternatives. The more client experience you've had, I've also come to realize the less likely you are to embrace alternatives. If you're a CIO and your entire life has been spent on that path of analyst to research manager, where you were never an advisor and you never had to deal with the emotion of a client who doesn't really understand what they're looking at, that does lead to different portfolio design decisions. And I'll often tell clients, look, if I knew that I could be sitting right next to you every single time you open up your brokerage app on your phone or every time you open up our performance statement, you might actually hold a different portfolio.

21:43Not materially different, but there are things the research shows are very beneficial, oftentimes in the diversification space. And maybe I'm being overly basic here, but you diversify because by lowering volatility, compound interest works better. And remember, all I said is we just want to compound stuff. It's really all this simple. But diversification looks and feels awful in the moment. And it makes you as an advisor look stupid. Of course, international was going to underperform. Of course, catastrophic bonds are going to do poorly in a hurricane or whatever. I'm actually thrilled that we avoided the catastrophe bond bullet.

22:21That's a great example of the people who buy liquid alts like that. I mean, there's job security in it. I think they would disagree. I think if we got in a debate and I would shrug my shoulders and just say, okay, when you can run something that's simple and everyone can understand, you do risk a little bit of what do you do all day? And that even happens internally at Plain Corporal. All of a sudden, I'll pull out some of the work that we're doing at the investment committee level and people will be like, oh my gosh. Because when you say no 10 ,000 times for every one yes, it doesn't look like you're doing very much.

22:54But you do have to go through the process. And the thing about privates and alternatives in general, and this is more of a statement about the downstream movement to even just the mainstream high net worth, and then further down to the mass affluent, that makes me really uncomfortable. I'm very uncomfortable. I'm not sure that the math is compelling enough. We know how much manager skill matters and how much access matters. And it just doesn't seem like it's possible to replicate those types of benefits. And so the complexity sells. But at the end of the day, I'm just not sure that it adds a lot of benefit.

23:29I do think the space overall doesn't have to be harmful. But I would argue no matter how many zeros are in your net worth or at your institution, I'm still not sure they're necessary. I try to remain open minded because maybe we'll go forward in 10 years or 20 years. And that viewpoint of these, maybe there's something about price discovery by going down to the mass affluent that is beneficial. I have no idea. I mean, that is a real possibility. I'm working on a book for next year and there's a chapter on alternatives. And there is a sentence in there where it's like, this could be the place where I am most wrong.

24:04And I do wish Alexa that I was a passionate believer. It would actually make life way easier. So that just goes to show you as somebody who is in charge of overseeing the investment strategy. If you add complexity, everybody cheers. If you stay simple, it's much harder to prove your point. And so you do so with data, you do so with process. I have been pretty consistent in my views of holistic views since being in this role. And there's a lot of written content. It's one of the best reasons to publish. I think a CIO has become less of a person who's choosing investments and more of a person who's creating an investing experience.

24:43And you see the best CIOs are great communicators. They're also really good managers of people, which I'll admit is not my strength, but you run good teams. And the reason that's important is process. It's all about process and communicating and keeping people focused and not distracted. And I think it's just challenging when there are incentives, both in my role and to the people who are selling. And if you aren't doing anything, then how do you justify your fee? And I think in my space in particular, fees are under attack. Financial advisors who charge a percentage of assets under management are very much under attack by a group of non-profitable fee-only people.