The Independent Market Observer

Meet the New Fund, Same as the Old Fund? Thoughts on Alternative Investments

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Sep 17, 2014 11:18:00 AM

and tagged Investing, Commentary

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MarketOutlook_5I am headed to New York today to speak at a conference on liquid alternatives. These types of alternative investments are often thought of as hedge funds for the masses; the idea is to take hedge fund-like strategies and wrap them in mutual funds. Ideally, this makes the expertise and money-making capabilities of all those hedge fund wizards available to mom and dad, so we can all get rich.

Many individual investors—that is, you and me—see sophisticated institutions using certain tools, including hedge funds, and believe that they would benefit from them as well. This is a major part of the argument behind the move of alternative investments to the retail market. In turn, this has set off a race among fund companies, old and new, to use hedge fund-type strategies in mutual funds. The marketing race is on.

At the same time, however, the California Public Employees' Retirement System, CalPERS—one of the largest pension systems in the world, with a reputation as one of the most sophisticated investors and a thought leader in the industry—has made a decision to stop using hedge funds.

What’s going on here?

At base, it is much simpler than you might think. The key to investment outperformance is doing something different from everyone else. Howard Marks of Oaktree wrote a wonderful piece on just this topic, which I highlighted a while ago.

At one time, hedge funds were doing just that—something unique—and generating outsize returns, which is why the institutions bought in. Now, that is not the case.

Average hedge fund returns have been disappointing for the past several years. In the financial crisis, strategies that were supposedly “hedged” fell with everything else. The reason for this is that, in the financial markets, success breeds failure. Eventually, others figure out what you are doing and copy you. Money flows in. Profit opportunities are spread thin and then disappear.

Limits and limitations

Most (not all) hedge fund strategies are now well known. Most (not all) hedge funds have lost much of their edge. The entry of large amounts of retail money will further dilute the profit opportunities.

The reality is that financial markets are finite, and available opportunities are limited in number and size. Small-capitalization stock investors have known this for a long time, and, for this reason, they typically close their funds at what, for the industry, are small sizes.

The notion that alternative strategies are unlimited in size is just silly. There has to be someone on the other side of every trade, and there are a limited number of people willing to cover any given bet.

The bottom line

Does this mean that alternatives, or hedge funds, are done? Certainly not. Diagnosing the problem also gives you the answer. The key to future success will be doing something different.

What will that be? That, my friends, is the hard part.

When looking at strategies that promise different behavior, which is what alternatives are intended to do, ask yourself what's really different about what they're doing. If the answer is, “not much,” you have to ask yourself why—and if—doing the same thing should yield different results.

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