Larry Swedroe - 11 Mar

The first edition of this book was published in 2014. In that version, we showed how investors could create more efficient portfolios using what we refer to as the science of investing. Such portfolios, built on evidence from peer-reviewed academic journals, not only have delivered higher risk-adjusted returns, but also have significantly reduced the negative impact of rare, downside events, known as black swans.

Since 2014, favorable developments have led us to conclude that the time to update the book had arrived. The most important development has been the retailization of investment strategies once solely the domain of hedge funds and institutional investors. The good news is that mutual fund sponsors have been bringing these strategies to the public in the form of vehicles regulated under the Investment Act of 1940, with expense ratios well below those of the traditional 2 percent of assets and 20 percent of profits, or 2/20, fee structure of hedge funds.

Because many hedge fund strategies involve investing in illiquid investments (allowing investors to access the illiquidity premium), fund sponsors had to develop an alternative to the open-end mutual fund structure that provides daily liquidity. An example of a strategy that requires an alternative structure is investing in longer-term consumer loans, such as a student loan. You cannot make a three-, five- or seven-year loan if the capital you need to originate it can be withdrawn on a daily basis. Another example is investing in reinsurance contracts, which typically are for one year. The interval fund structure was developed to address this issue.

An interval fund is a closed-end investment company that periodically (typically quarterly) offers to buy back a stated portion of its shares from shareholders. However, while interval funds are valued daily, their shares typically do not trade on the secondary market like other closed-end funds.

Another important development has been the fintech revolution. Firms such as Lending Club, Square and SoFi have been utilizing technology to disintermediate traditional lenders, such as banks, in the consumer, small business and student loan lending markets. Their lower costs have enabled them to offer more attractive rates than traditional banks. These firms need committed sources of longer-term capital to make term loans and provide immediate funding to borrowers. Interval funds partner with such lenders, providing investors access to these markets.

These developments have enabled retail investors to access new and unique sources of risk and returns. Each of the alternative investments we will discuss have equity-like forward-looking return expectations that show low to no correlation to the returns of the traditional stocks and bonds dominant in portfolios. The combination of equity-like returns and low correlation allows investors to build more efficient portfolios than when the first edition of this book was published.