James Lange:
I’ll tell you, Larry, this reminds me of when I interviewed Jack Bogle. He talked about speculation and investments, and he said, “What do you want to do? Do you want to be an investor, or do you want to be a speculator?” And I mean, frankly, you didn’t use those words, but that’s what it kind of sounded like to me…that if you want to be an investor, not commodities and gold. If you want to be a speculator, then maybe.
Larry Swedroe:
Yeah, I think that you should invest in things that you can understand why there is a logical risk premium for them, and you’ll have the ability to stay the course over the long period of time. And then that means you will buy and hold and even have to rebalance, which is painful when things are going bad, and those assets have dropped in value. It’s easy to rebalance when things are going well although some people don’t do it because they don’t want to pay the taxes. That’s a big mistake, but you want to be able to rebalance and stay the course when you’re staying there. That’s tough for people to do when you can go through decades of very poor performance. So, you really need to be able to do that.
James Lange:
I’m sorry, poor Adam isn’t getting in. Feel free though. I’m going to put you on the spot, Larry. You said, okay, people should understand why an investment might have a higher return. You also earlier mentioned Cliffwater which invests in, let’s say middle-sized loans. What is the reasoning or what is the extra knowledge that an investor might have that might encourage him to invest in something like that (which I know is frankly, in my, your, and Adam’s portfolios as well as many of our common clients)?
Larry Swedroe:
That’s a great question. And let’s take this opportunity to broaden it as a teaching lesson. So, you mentioned earlier about reinsurance, right?
James Lange:
Mm-hmm.
Larry Swedroe:
So, you were concerned about global warming. You’re worried about all these things. So, let me ask you just a simple question, Jim. Why do you buy insurance?
James Lange:
In case something bad happens.
Larry Swedroe:
Right? And so, you are pooling that risk. When you buy insurance, do you expect to make money on average from doing so? Or do you expect the insurance company to make money?
James Lange:
I expect the insurance company to make money, but if something very bad happens and frankly, I did have a fire in my office that had a six-figure loss, and I was very, very glad that I was well insured.
Larry Swedroe:
Right? So, you bought the insurance. You made an investment to protect yourself, and you did that with an expectation of a negative expected return. The insurance company is sitting on the other side, and they’re taking on that risk. So, they’re going to charge you a premium above their cost of capital, all their expenses, and they want to earn a profit on that. They know they won’t earn it every year, but on average, they have all this data and analysis to estimate the risk, i.e., how long you’ll live, if it’s life insurance, and what are the odds of fire insurance? And they’re updating it using world-class scientists called actuaries to update their knowledge as they get new information about diseases, medical advances, climate change, etc. There are insurance companies who are writing, say fire insurance, have more world-class scientists because they’re putting billions of dollars at risk than the U.S. government does in terms of forecasting the impact of climate change.
Larry Swedroe:
So, the insurance companies are going to be charging premiums based upon their estimates of the risk, and that’s all you need to understand. They have world-class scientists who are smart people, and they’re going to charge an appropriate expected return. They may be wrong, and risks show up from time to time, but the logical expectation is there.
The same thing is true when we get to Cliffwater’s Fund. Here’s what happens just so you have a little bit of knowledge about this market, which is called private direct credit. Going into the 2008 crisis—the great financial crisis—the banks got slaughtered because they took way too much risk. We had Dodd-Frank and other regulations to strengthen the banks. The banks were forced to raise huge amounts of capital and they had to cut off lending to shrink their balance sheets. So, banks that used to make loans to these middle-market companies—companies let’s say $50 million, $150 million, or $200 million of earnings…technical term is EBITDA or Earnings Before Interest Appreciation and Taxes…that’s who the banks marketed to. The big companies sold bonds directly to the public got rated bonds. But these middle-market companies borrowed from the banks. The banks didn’t have the capital any longer. So, a private fund stepped in to fill that void and started to make those loans. Well, they’re operating like a bank, and they’re going to do the analysis, and look at that loan, require collateral, and also charge an appropriate premium.
Cliffwater has over 20 years of experience advising institutional investors on this marketplace. They analyze track records, and they choose one manager who they believe has the best track record of being conservative lender in an industry, so their expertise is in healthcare, manufacturing, financials, or whatever it is. So, you’re building this diversified portfolio, and then they buy, let’s say a $100 million dollar loan this private firm is making, and they’ll buy one, 100th of that (or $1 million dollars), and today, the fund is a $5 billion dollar fund with thousands of loans. You have a highly diversified portfolio across 10 industries, and the track record, which we have evidence now of a Cliffwater index of 20 years, shows because of the low loan to values they’re lending, typically about 50% of the value of the property that they’re lending against, so they have collateral says that they lose on average about 60 basis points a year. Now in 2008, it’s probably going to be more and in good years, it’ll be less, but that’s the average. So, if you are getting a yield, say today, I’m making it up, but let’s say, roughly 8%, and you have expected losses of 60, then your expected return is 74, and that’s a premium for the credit risk, and the fact that it’s ill-liquid. If you want your money, sorry, we can’t give it back to you, it’s on loan for five years. We can give you back 5% every quarter because we keep some liquid securities, we’re required in what’s called an Interval Fund Structure.
So, there’s a very logical set of premiums there, one for credit risk, and the other for your giving up liquidity, which you could get by buying a Vanguard high yield bond fund, which has daily liquidity. It’s about the same credit risk, historically, actually a bit worse. That yield today is 3.8%, and it’s got maturity of about four and a half years. So, some inflation risk out to about four and a half years, 3.8% yield.
I’ve got the Cliffwater fund with superior history of credit risk, yielding 7.3, or three and a half percent more. And I have one month of interest rate risk, instead of four and a half years, but I’m giving up that liquidity. To me, that’s a free lunch. I’m not taking even my RMDs yet, I’m just reinvesting. So, to me, that’s as close to a no-brainer in that case.
So, if someone wanted a bit higher yield and wanted inflation protection, these are the kinds of things we’re doing for our clients. We’re moving them away from the traditional 60/40 portfolios to take advantage of some new innovations in financial markets, like this development of the Interval Fund Structure.