The Independent Market Observer

8/6/13 – The Use and Misuse of Alternative Investments

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 5, 2013 11:41:46 AM

and tagged Economics Lessons

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I’ve been doing a lot of thinking about alternative investments over the past couple of weeks, from a number of different perspectives. But before I proceed any further, I want to make clear that the content of this article does not constitute a recommendation to buy or sell any investment of any type.

Last week, I spoke with an institutional private equity manager, a hedge fund manager, and a major Wall Street financial institution about how they can better access retail investors to sell alternative products. This kind of interest isn’t particularly new; what is new is the recognition that retail investors can be the preferred capital source instead of an afterthought. As more and more companies start to realize this, we can expect to see the current group of offerings double and triple in size, with new players moving into the market and providing strategies and products that simply aren’t available right now.

In the abstract, this is great. More choices and more competition mean better potential outcomes for the investor. As always, though, the devil will be in the details.

For starters, it is extremely important that each retail investor evaluate whether such investments should even be considered as an option. To do that, retail investors must first determine whether investing in a mutual fund consisting of alternative investments is suitable for them, based on their own needs, objectives, and financial status, among other things. Retail investors must also be sure that they understand the risks and complexities of the specific investment under consideration, and that they understand exactly how such investments may perform day by day or over longer periods of time, in both up and down markets. As always, it’s essential to read the mutual fund prospectus carefully before investing in any mutual fund.

Next, we must consider what an “alternative” is. There are, in my opinion, two meaningful definitions. One is any product that does not offer daily liquidity—that is, you can’t sell out in one day. This includes private partnerships or illiquid assets such as real estate. Another aspect of this is unclear pricing; any asset that doesn’t offer daily trading can be difficult to price. The other definition is a product or strategy that is designed to perform differently than either stocks or bonds—that is, to be noncorrelated.

Historically, most of the second definition (the strategies) has been delivered in the first definition (private partnerships with limited liquidity). What’s changing is that many of the strategies are now being offered in liquid forms, particularly mutual funds. To evaluate whether this makes sense, we first need to consider whether the strategies are well suited to a mutual fund structure at all. Second, if they are, we have to consider how they will work in our portfolios.

For a strategy to work in a mutual fund, or any liquid vehicle, it has to be largely invested in liquid assets itself. Futures, stocks, and bonds all meet this criterion. Real estate can work, as we’ve seen with publicly traded REITs, but those vehicles act differently than an investment in the underlying asset, so you lose some of the diversification potential. Private equity, with its long investment periods and illiquidity, is a poor match—unless it’s with the company that sponsors the deals, rather than the deals themselves, just as with a public REIT. So, any strategy that invests in liquid underlying assets is at least a possibility, but the farther you move from the underlying assets, the less diversification you actually get.

Strategies can be characterized by expected performance. Managed futures, for example, the largest of the mutual fund alternative asset classes, is designed to do well in trending markets—up or down. Its biggest win was in the financial crisis, where it was the only major asset class to make money. Conversely, over the past several years, returns have been disappointing—to the point where many are moving out of the asset class. Similarly, something like a long-short strategy, which both buys stocks and sells them short, typically will underperform in strong markets, like those of the past couple of years, and outperform in down markets.

Both of these strategies, unsurprisingly, have underperformed as the S&P 500 has taken off. To get upset about that is to misunderstand their use in the portfolio.

Of the liquid strategies available in mutual funds, almost all qualify as risk reducers rather than enhanced-return products. Many of the enhanced-return products use illiquid underlying assets, making them difficult to position in mutual funds. Of the others, the most attractive have not—and most probably won’t—make it to the retail investor. Any strategy has limited room to invest, and charging more to the institutional investor is more profitable than trying to go retail.

Alternatives of any sort, particularly those available at the retail level, are best used as risk reducers and diversifiers. Rather than looking to them as a way to make more than the market, consider them as storm anchors that present the opportunity to do well when the market tanks. Don’t be upset when they underperform as the market soars; instead, keep in mind their intended function in the bad times.

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