How can you be paid to take risks you don’t understand?

Let me state right off the bat: I love alternative investments. Today there are a huge range of opportunities to invest outside of the public markets, and I’ve written about some of them in the past:

• Wunder Capital. You can buy unsecured notes from Wunder Capital that are paid back from repayments on solar panel installation loans.
• Rich Uncles. Rich Uncles is a non-traded REIT that invests in commercial real estate and passes the rent through to investors each month.
• Lending Club and Prosper. The original crowd-funded loan marketplaces let you contribute to personal loans made to individual borrowers.
• Kickfurther. You can contribute to inventory purchased on behalf of small merchants, and are paid back as the inventory is sold.
• Kiva. It’s kind of hard to describe what Kiva does, but basically you can claim the principal repayments of loans made to individual and groups of borrowers around the world (you don’t earn any interest, but can fund transactions with rewards-earning credit cards).

Why, you ask, would anyone invest in one of these vehicles? Good question!

The primary reason these vehicles are attractive is that they offer the possibility of higher returns than investments on the public markets. I say they offer that “possibility,” but in fact they seem to practically guarantee it in their public advertising. Wunder Capital’s “Wunder Term Fund” has an “Annual Target Return” of 8.5%. What does that mean? Well, once you open an account you can read the offering memorandum, where you’ll find out your notes are a “risky and speculative investments,” that you “should not purchase Notes unless [you] can afford to lose their entire investment,” and that the notes “are not secured by any assets of Issuer or any other party, including the Underlying Loans.”

A second reason you might invest in one or more of these alternatives is out of a belief that the investment is uncorrelated with your other investments. For example, you might think that homeowners will continue to repay their solar panel installation loans even if the stock market experiences a sustained drawdown.

And of course many of these investments have some kind of emotional hook, like investing in environmental sustainability, women in the developing world, or small businesses.

Return is supposed to correspond to risk

When financiers and academics get together they meticulously calculate what they call “risk,” which is generally used to refer to the amount an asset’s price fluctuates (either up or down). Since “riskier” assets offer the possibility of loss if the owner is forced to liquidate them (since the asset might be fluctuating down at the time of sale), the owner demands a higher return on their investment.

You’ll sometimes hear about the “equity risk premium,” which refers to the added return investors demand to hold stocks instead of less-volatile bonds, but you can call anything a “risk premium:” long-dated bonds have a “duration premium,” lower-rated bonds have a “credit premium.”

Alternative investments pay a lot of premia! Wunder Capital’s Wunder Term Fund 8.5% “Annual Target Return” logically is the combination of an issuer risk premium (Wunder Capital could go bankrupt), a borrower risk premium (homeowners could stop repaying their loans), a liquidity premium (investments can’t be liquidated until the 84-month term is up), a duration premium (if interest rates on safe bonds go up in the next 84 months then the value to investors of the risky Wunder Term Fund will fall due to higher risk-free returns elsewhere), and probably a couple more I’m forgetting.

You will never know if you’re being paid enough for the risks you’re taking

The problem with these investment vehicles is not that they’re risky. Risk is lucrative! The problem is that they are so illiquid that there is no meaningful way to determine if you’re being paid appropriately for the risks you’re taking.

If you invest in a fund with an 8.5% “target return” that actually does return 8.5%, were you overpaid for what was, in fact, a risk-free investment? If the investment instead becomes worthless were you underpaid for what was, in fact, an extremely risky investment?

It’s impossible to say because there’s no way to measure the fluctuation of the liquidation value of the asset, so there’s no way to determine what kind of return it merits. Even the secondary market for Lending Club notes doesn’t give insight into the market-clearing price of notes over time since notes themselves aren’t fungible and a given note isn’t always for sale (many, if not most, notes are held to maturity).

I love alternative investments, but not these

When I say “alternative” investments I mean everything outside the publicly traded markets, and it turns out there are a lot of things outside the publicly traded markets. On a recent podcast episode I heard a financial independence blogger say that he had earned $40,000 in the previous year from his blog (selling credit cards, I assume). Well, to earn $40,000 from Treasury bonds you’d need about $1.34 million worth at 2.99% APY. Writing a financial independence blog is a highly risky, illiquid asset, so you can slice and dice the return however you like: maybe he has a $670,000 asset yielding 6%, or a $335,000 asset yielding 12%. Obviously I’m not talking about return on invested capital — the website probably costs a few hundred dollars a year to run. Rather, I’m talking about the risk-adjusted, capitalized value of the income stream.

The fact is, there are countless opportunities to deploy capital outside the public markets in order to earn a higher return without introducing the risks involved with the prepackaged alternatives I listed above. If you want to invest in real estate, invest in real estate (I recommend Vanguard mutual funds, but obviously you can just buy houses and stuff too). If you want to get paid by homeowners who install solar panels, become a solar panel installation technician. If you want to invest in retailing knick-knacks, become a knick-knack merchant. These aren’t risk-free investments — that’s not the point. Rather, these are investments where the risks are apparent and, most importantly, you receive the entire risk premium without having to divvy it up between middlemen.

If you’re not happy that the Federal Reserve has depressed the return on publicly traded assets, you have two options: you can invest more in the public markets to make up for lower forward-looking returns, or you can take the hint and seek return elsewhere.