How to Use Alternative Investments With Phil Huber [LIVE] (EP.163)

0:28We all need to make smart decisions with our money. Investment Conference in Chicago, a prestigious event that brings together advisors and financial experts to share cutting-edge research, expert insights, and thorough analysis, making it just a wonderful resource for financial professionals. And at this special event, I was joined by Phil Huber, author of The Allocator's Edge, a modern guide to alternative investments and the future of diversification. During the conversation, Phil and I dive deep into the world of alternatives, exploring why the traditional mix of stocks and bonds might face challenges going forward.

1:04We discussed the rise of private credit, the benefit of interval funds, and the importance of education when it comes to investing in these complex investment strategies. Now, while this conversation is tailored for practitioners, I do think individual investors can also gain a wealth of knowledge about diversifying their portfolio and understanding the nuances of alternative investments. As always, you can find links and resources mentioned during the conversation at thelongterminvestor.com, as well as live video and photos from the event itself. And with that, here is my conversation with Phil Huber.

1:47Good morning, everybody. Welcome to The Long-Term Investor. I am joined by Phil Huber, Managing Director and Head of Portfolio Solutions at Cliffwater. Phil, thank you so much for joining me here at the Morningstar Investment Conference 2024. Thanks for inviting me to be on as your guest, Peter. I've done a lot of podcasts before. This is, I think, my first live recording in front of an audience. So it should be fun. Thanks to everybody here for joining. Well, shout out to the Morningstar crew because I've done a number of live podcasts and they have an incredible setup. But it's also fun because we're in the exhibit hall.

2:22So we have lots of people walking by, but we have a full house here. Maybe we just level set, Phil, and give everyone a little bit of background on how you got to where you are today in your role with Cliffwater. I joined Cliffwater just at the beginning of this year. Prior to joining, I spent 16 years, pretty much my entire career on the wealth management side of the business, most recently as CIO of Savant Wealth Management. And so a little bit of a career pivot, but I had reached a point where a lot of my interest and attention was being paid towards alternative investments. And so I just thought I wanted to do something a bit more focused there.

2:55And I had worked with Cliffwater while at Savant and was very familiar with the firm's history, the fund platform, et cetera. And so we developed a cool role together. And so far it's been going great. Well, that's one of the things that I've always loved about your perspective on alternatives is you have the practitioner's perspective. And you wrote a wonderful book that if you all have not seen before, you should check out. It's called The Allocator's Edge. It came out in 2020. 2021. Oh, 2021. End of 2021. Okay. End of 2021. But the book uses a lot of 2020 data points. And there's a number of ideas that support the use of alternative assets.

3:32but it seemed like at the time that the most prevalent was equity and bond valuation. So I'm curious, when Phil Huber writes the second edition of The Allocator's Edge, and I know that your publisher is here this week, so maybe he's licking his chops for this, but how would you approach that argument? Talk a little bit about what that argument was for alternatives based on the future expected returns of stocks and bonds. I started the book, the first chapter was called Hindsight is 60-40, and it was meant to kind of set the table of what was the history of 6040? Why did everybody adopt that as the standard traditional asset allocation construct?

4:09And why was it facing some challenges that have potentially? I mean, the timing couldn't have been more, I guess, lucky for lack of a better word, and that the book came out end of 2021. And then 2022 was the worst year in our lifetimes, I guess, for 6040 and an environment for fixed income where no one had really seen double digit declines in bonds, certainly not me in my career. And so it wasn't any particular market timing on mine. It was just coincidence of when the book came out. And but it was very clear that it was a very extreme valuation environment, not so much maybe for stocks. I would argue the stock environment today is maybe similar to what it was when the book came out, but very different environment for fixed income today yields much higher.

4:48It took a fair amount of pain to get there. But the bond piece of that 60-40 is in a much better place than it was heading into 2022. to. Well, and I think even though that may not be the primary reason that somebody goes to alternatives, a couple of things for people that I jotted down that came directly from the book is that you see that the majority of excess returns in both stocks and bonds came in periods where either inflation was low or inflation was falling. So today we have inflation falling, but it is a little bit elevated versus what we had the past few decades. Another thing that I think a lot of investors forget, a lot of advisors forget, we have a generation of advisors who have not gone through an extended period where the US equity premium was negative.

5:33Now, you and I came into the profession in 2007, where we were in the midst of a lost decade. But just to give some perspective, if we go back to 1927, the US equity premium, which means that basically cash beats stocks, it was 30 % of the time that happened in one-year observations, 21 % of five-year observations, and 15 % of 10-year observations. So it has been really easy to be a US investor. I would argue it's been very easy to be a US advisor, a US-based advisor. And so while this isn't as prevalent of a narrative, it is still something I think people have to keep their eyes on in general.

6:13Now, the other narrative that today seems more prevalent would be the private versus public markets. So we're talking about the equity risk premium, which is public market. Can you talk a little bit about that private versus public and how this fits into the decision to go towards alternatives? Yeah, I mean, relative to when my career started, private markets are humongous today. Whereas they were, if you just look at the global market portfolio, 15, 20 years ago, the private markets were sort of a rounding error. So it wasn't a decision a lot of advisors had to think of in terms of how they build a portfolio where they're thinking, okay, how much US versus international should I have?

6:48How much large versus small cap value versus growth? I think today and going forward, you're going to start to see more advisors really think of private markets in a similar fashion where they, it's an active choice and how much should I, not should I be invested in private equity or private debt, but how much and what is that allocation decision? Having more conversations with end clients around what their illiquidity budget might be. Whereas I think historically many advisors just adopted a fully liquid 100 % mutual fund kind of ETF type portfolio. And so the toolkit looks a lot different today.

7:19There's a lot more fund structures that are becoming increasingly adopted and popular by advisors and have opened up different asset classes. So I think if you're starting with a blank slate today and building a portfolio from the ground up, it's a much different exercise and there's more options available than there were back when we entered the business. Absolutely. And I was so excited by this giant crowd. We have every seat filled and we have a big standing audience that I forgot that we probably should define alternatives to some extent because we've only really been saying privates. How would you define alternatives?

7:52There is no universal definition for it. It's in the eye of the beholder. And it depends on what people are familiar with or accustomed to owning. Real estate's a good example. Some might consider that just a classic traditional asset class, others maybe not. To me, it's more of a catch for anything not stocks, bonds, or cash. That's where I start. When you start looking at the various asset classes and strategies that people put under that umbrella, what I find is that in most cases, there's some sort of connection to a traditional asset class with a little bit of a twist. And what you find are three variables that make something that often we think of as traditional and convert it into an alternative.

8:31So one is liquidity. In the classic example, there would be private equity, which is similar to public. It's illiquid, doesn't trade, or doesn't trade often, I should say. The other would be implementation. So things like classic investing strategies like value or quality or momentum that you often see in a long-only construct, using tools like leverage or shorting or derivatives and implementing them differently in a way that removes that traditional market beta exposure and leaves you with a different type of exposure. So implementation. And then the third being what I kind of think of as packaging.

9:01So I call this old wine and new bottles, things that have existed for centuries or millennia that are just now becoming more adopted because they're more readily available through things like interval funds or other fund structures. But examples being private credit is obviously the hot topic today. Credit has been around for centuries in different formats. Reinsurance is another one that's a centuries old business model. We just now have the ability to access it as a risk premium inside of a diversified portfolio. So there's a number of examples like that where it's not new, it's just new in the sense that we have the ability to allocate to it.

9:34So just out of curiosity with the audience, can I have a show of hands if you or your firm uses alternatives in the portfolio? All right. A lot of hands. I mean, I would say half-ish is what I'm seeing. And what's interesting in my conversations, when I talk to other CIOs, when I go to other events like this, there is a similar degree of people actively using versus interested. And those who are actively using, I find in conversation, there's a lot of uncertainty about what it is they're doing. And so I'm hoping you can help them become more certain, feel more confident in some of these decisions, some of the things they can talk about with clients.

10:12That's the fun part of it all. That's why I wrote the book. That's why I pivoted career-wise is that I think a lot of advisors have figured out how they want to allocate their stock and bond portfolios. They're not reinventing the wheel. I think they're becoming increasingly comfortable with alternatives, but there's not that same degree of confidence in implementation and evaluation. So I think that's part of what I enjoy doing is just helping people figure that out. Well, and I think the answer of no, we don't do it just because you don't feel like you want to do the research, I think that you shouldn't be saying no to something that you don't understand in general.

10:46And you and I've had this conversation before, more when you were a CIO than in your current role. But our job as an asset allocator is probably to say no more often than we say yes. And to me, I often equate it to what the FDA does when they're approving drugs. The FDA wants to approve drugs, but they also want to avoid bad side effects. And so every single decision they make is a trade-off. It's a trade-off of type 1 and type 2 error, where if you don't approve something because of the side effects, you risk society benefiting from the importance of that drug. Meanwhile, if you approve everything that sort of shows to help society, you might have a lot of really bad side effects in there.

11:25Now, I will say for the sake of conversation, I'm usually more concerned with implementing a bad idea than missing out on a good one. So I say no all the time. I would say that alternatives is one of those spaces where it has taken a very long time to hone my no. And I would even say today, my no is very conditional on the individual. You're almost at a maybe now, I think. I'm still a no for more people than not. I think that they get overused. I think expectations is so, so important. And I don't think you need to be Yale or any endowment to succeed with alternatives. You just have to be humble with what it is and what it isn't and just be realistic in general.

12:07I know that you have talked to a number of people in that range. How do you feel when people say, no, it's just too complex to me? What do you do to sort of open the door to the conversation? And at least if they're gonna be a no, make it an educated no. I think there's a lot more interest in openness now post 2022, whereas it used to be easy to say no, because it's like, you know, bonds are doing what I want them to do. They're diversifying my stock portfolio. And then when that relationship changed, I think it was eye opening. okay, these relationships between asset classes that we maybe sort of take for granted and assume are going to exist in perpetuity aren't always there.

12:43And so I think it was, okay, maybe I do need a third leg of the stool or a different set of exposures to help create a more diversified portfolio. It is challenging because you are introducing more complexity to the equation, and that can be challenging to sit in front of a household or a family and explain it to if they're not financially that savvy. I think there's ways to get around that and simplify the complexity for them and everything like that. I think from an expectation standpoint, I think things that we're less familiar with tend to get a shorter leash when they don't do well. Whereas everyone kind of knows stocks for the long run, I know I'm going to get some bad years, maybe a few bad years, but I think things that are just unfamiliar and especially if it's a really uncorrelated asset, like it can be really frustrating if it's sort of flat or down when stocks are up.

13:27And I think it's just really easy to throw in the towel when it's not something you've got that same connection to like stocks or bonds. And so I think there's a little bit of performance chasing activity that can really take what could be a really great long term addition to a portfolio. But if it's not used properly, then that's going to lead to bad outcomes. I think often there's like a tendency to try to close the barn door after the horse is already out. Managed futures became popular after the financial crisis. They would have been great to own heading into it. And so that's behavioral, I guess, finance 101.

14:00one. And so, but I think from that, I think over time, lessons learned and people are more educated now. And I think there's more of a willingness to be more strategic about it as thinking of all this is more of a trade. It's more of, hey, this is part of my core allocation. Well, I know all allocators love the idea of uncorrelated returns. They just don't like the actual experience of uncorrelated return streams. And I imagine anybody here in the audience who's been an advisor in the past decade has had to talk to clients about why they own international stocks. That alone is a great example of how the people that we are trying to help make good decisions with their money are going to need education, are going to need expectations set realistically.

14:41And that really starts with us. And let's get into some of that education. You had mentioned private equity when we were talking about the growth of private markets versus public markets. What do you think is important to know about the private equity space? It's not homogenous. There's a lot of different parts of the private equity ecosystem. There's most people are familiar with, which is the buyout space. But there's mega buyouts, there's midsize, but kind of like US equities, like large, mid, small, there's large, mid, small buyouts, there's growth equity, which sits between buyout and venture.

15:11And then of course, there's venture, which is more early stage and riskier end of the spectrum. And so there's a lot of different ways to approach private equity. There's a lot of different ways to invest in it too. There's primary commitments. So just investing in a fund, like as it's in its fundraising period. And that's typically like a 10 to 12 year life, then a few years of your capital being called and invested and then a harvest period, et cetera. That's a tougher dynamic for advisors just given how illiquid it is, trying to explain J curve dynamics to a client where it's like all this money is going out, they're not seeing anything for a few years.

15:43So it requires a lot of patience. There's secondaries, which is growing rapidly. And so I think that's part of why companies are able to save private longer is this emerging and growing secondary ecosystem where you can purchase interest in a fund later in its life cycle, like not necessarily right when it's starting, but maybe at its inflection point where it's fully invested, you know what the underlying portfolio companies are. There's less of a J curve. There's a shorter path to liquidity. So there's a lot to like about secondaries for investors in general, but specifically for RAs and I think secondaries as well for folks that prefer evergreen structures, secondaries can play a big part in those.

16:19And then there's co-investing, which is riding shotgun, if you will, next to a GP where they have a portfolio company that I want to invest in. Maybe there's$100 million of capacity. They've got budget for 70 in their fund, but can't go higher for purposes of concentration, what have you. So they might farm out the rest of that to some of their limited partners to invest directly in the company. And that's interesting because those tend to be no fee, no carry, no way to reduce the cost of owning private equity. So it's a very complex ecosystem and There's a lot to learn and understand about it.

16:49But that's part of what we try to do at Cliffwater is package strategies in a way that the advisor doesn't have to make all those granular decisions around how to invest across the space. Well, I think that private equity, at least when I'm speaking to in clients and they say they want private investments, that's what comes to mind for them first. To me, though, the thing that I hear people talking about more in industry at events like this in the office is private credit in general. And maybe you can go through some examples. Private credit can mean a lot of different things. But let's start with this.

17:24Maybe can you start by explaining why private credit has seen such explosive growth, the bigger external factors that have led to it becoming a bigger place in the economy in the first place? I think a couple of things. One is private credit is not as new as people might imagine it is. I think because you're hearing so much about it today, it seems like it just sort of popped up overnight like a few years ago. One of the things we pride ourselves on at Cliffwater is being really early to private debt. Cliffwater was founded in 2004. Our founder, Steve Nesbik, used to lead consulting at Wilshire Associates before founding Cliffwater.

17:57around kind of the early 2010s, he started to really take notice of this growing asset class, who the managers were. From Steve's view, it was like, okay, for there to be an asset class, there needs to be an index or a benchmark that people can reference for allocation decisions and risk management and just understanding the long-term history. So he set out to do that. Even though we manage funds and we have a consulting business, we also have a index business as well. We created what's been kind of the go-to benchmark for the direct lending space, which is called the CDLI, which is the Cliffwater Direct Lending Index, which basically what it does is goes through quarterly SEC filings from private and public BDCs and looks at all the underlying loans in those portfolios.

18:39And what that's been able to do, the index went live in 2015, back tested to 2004. It basically gives a roughly 20-year history of how the asset class has performed, what yields have been, what credit losses have been. And so it's been a great way for a lot of allocators, both institutional and advisors, to get more comfortable with the asset class in general before they start making manager decisions in terms of products. We're proud of that index because I think it's really helped set a reference point for what it is. And ultimately, if you're not familiar with direct lending, it's lending to corporate America by and large.

19:13Corporate America is huge and you have very big companies like Apple and Exxon that can tap the investment grade bond market. And then you have non-investment grade credit, which has historically been high yield bonds, also publicly traded, broadly syndicated bank loans. And then you have private debt now taking a lot of wallet share from those areas. And so what's happened is the growth has been significant, but it's not without reason. And so really the vast majority of direct lending, what we define as like middle market companies, think like 10 to 150 million dollars of EBITDA. And this is a huge part of the American economy.

19:49a couple hundred thousand companies that fall under that definition. I think it's about a third of private sector GDP, six trillion or something like that in revenues. This is a huge part of the economy that needs financing. And not every middle market company is sponsored by a private equity company. I think it's about maybe 15 % or so have private equity sponsors behind them. And that's pretty much the vast majority of direct lending is lending to companies backed by private equity sponsors. And so really, when you look at the trajectory of growth of direct lending, it's gone alongside the growth of private equity and that need for buyout financing, which historically used to be provided by banks.

20:27And post-GFC, banks stepped away from doing a lot of that lending. And so it's been partly regulation-driven. I think also private equity sponsors just prefer to work with private lenders because of that speed and certainty of execution that we can offer them. And that's why there's a yield premium there. They're willing to pay that yield premium in exchange for that reduction of uncertainty. Well, the institutional adoption of this space has been really high because one, you're earning a higher yield. There's a lot of demand. It's easy for the dollars to find loans, or at least it has been the past decade.

21:00As you mentioned, the banks stepped out of this area of the market post-financial crisis. But also, historically, at least, the covenants have been more beneficial to the lender than you might have gotten in high yield or junk bond issuance. And so that's been really attractive to a lot of institutional investors. Now, there was actually something in The Economist, I think two weeks ago, pointing out that at some point, too many dollars chasing it can weaken covenants. But that really means that not all private credit providers are created equal. You have to make sure that the manager is maintaining some of those really strict preferential covenants that make these, even though you're going to earn the illiquidity premium, that you're a little more protected than you would be in a traditional high yield junk bonds.

21:47Any thoughts on that? It's credit. It's not a free lunch. Those yields are for not taking risks. So for us, it's, you know, your upside in the asset class is your yield and the credit losses and expenses and fees are what gives you your net return. So that's how we think about building a portfolio. And back to my comment earlier about the benefit of Cliffwater being really early to private debt is that our research team got to know all the players really early. And there's over 300 direct lenders today. We know all of them. And we probably think about 50 of them, what we would call A-rated lenders.

22:19And when we build products like our interval funds, the idea is we don't originate loans at Cliffwater. We work with investment partners. We have about 20 institutional quality lenders that we work with that we think are top tier, top quality that we think, again, can help mitigate losses when credit cycles emerge. And so that is a big part of it is that not all lenders are created equal. I think a rising tide can at times lift all boats. But then when the tide goes out, as Mr. Buffett would say, well, everybody knows the quote. So that's one aspect. And I think it's an asset class that you want to be very diversified in.

22:51Not so much for quote unquote alpha. It is more of a beta asset class. There's not as much dispersion between manager returns as you'll find in venture capital or private equity. But in our view, I always like to say, if you have a big blow up in credit at the scene of the crime, you're going to find leverage and concentration. And so that's really what we try to do in our products is how do we use modest leverage, but not extreme and not have any one single position able to blow us up. And that's what's funny is when risk and return are so closely linked, this is the one place You don't want risk.

23:25Risk management seems to be so much of what returns are. And I think that's one of the benefits of the interval fund structure is there's regulatory limits on how much leverage you can use. It's a half a turn of leverage. If you look at private BDCs, which is another way that a lot of advisors access private credit, they can go up to two turns leverage. Most don't go that far. They usually one turn a little bit higher. But when you look at how we invest, I think in our main fund, CCLFX, our top 10 holdings are about 5 % of our portfolio. If you look at the average of the top 25 BDCs, they have typically around 40 % of their portfolio in their top 10 holdings.

24:03And so for us to work with 20 different lending partners, it allows us to create a portfolio that is not an index fund, but in many ways mirrors the spirit of an index fund, which is broad diversification, over 3 ,000 credits, that sort of approach. Now for everyone in the audience, and then for those listening on the podcast or watching on YouTube later, or this will be replaying on Cheddar's media channel in a few weeks, I think. You go to a lot of panels and you assume they're sponsored and you hear Phil talking about Cliffwater. And this is my podcast. I just invited Phil because the book was so well written.