These days the mention of alternative investments within the investment community is a bit like bringing up the presidential election, an interesting topic for sure, but you are likely to run into some pretty strong opinion or resistance, no matter where your personal views lie.
Before diving into the debate of whether or not an investor should turn to “alternatives”, it makes sense to talk about just what an alternative investment is in the first place.
Not Stocks, Not Bonds, Not Cash
In the broadest sense, an alternative investment is any asset or asset class that does not fall under the traditional classifications of stocks, bonds, and cash. Thus investments in gold and real estate investment trusts would be considered alternatives.
More commonly, however, the term is used to describe investment strategies or investment products that are not traditional stock and bond investments. Hedge funds, private equity funds, managed futures, and their associated strategies are what typically come to mind when using the term alternative investments.
While hedge funds been around for decades, their popularity began to take steam in the aftermath of the bursting of the dot.com bubble. After the financial crisis of 2008, the movement really took off.
Modern Portfolio Theory and Systemic Risk
A significant factor in the popularity of alternatives was the disappointment many had regarding the effectiveness of Modern Portfolio Theory (MPT) in the face of significant market declines. MPT asserts that overall portfolio risk can be reduced by investing in riskier individual assets (or classes), whose returns do not correlate with each other. That is when one asset is up; the other one is down. Before the widespread use of MPT, risk management via asset allocation generally focused on reducing the riskier assets (stocks), and increasing less risky assets (bonds) and cash. With MPT, an investor wouldn’t practice risk management by reducing a 70% Stock 30% bond allocation to 60/40, he or she might keep a 70/30 mix but make sure the 70% stocks consisted of numerous stock types that were not supposed to move together.
A 2010 Wall Street Journal article discussing the frustration many investors felt described the theory’s short-comings noting that “past figures for risk, return and correlation is not always s a good guide to the future. In fact, they may be downright misleading.”
Thus, investors can turn to alternatives for a couple of reasons. They may be hoping for outsized gains, but more often they are seeking equity (stock) like returns that don’t correlate with stock and bond markets, or to be more precise that can deliver positive returns in down or flat markets.
Hedge Funds, Private Equity, Liquid Alternatives, and Managed Futures
Hedge funds come in many shapes and sizes. Strategies include (not limited to): global macro, fixed-income arbitrage, market neutral and long/short funds, risk-arbitrage (mergers), and funds of funds.
There are also some roadblocks to investing in hedge funds. First, they are restricted to high net-worth “accredited investors”. They generally require substantial minimum investments of $500,000 or more. Holdings are typically not very transparent, and liquidity can be an issue as withdrawals are usually only available quarterly with significant advance notice. Expenses are notoriously high as most funds utilize a “2/20” fee structure, meaning an annual management fee of 2%, PLUS an incentive fee of 20% of any profit.
In recent years liquid alternatives, hedge fund type strategies in a mutual fund or ETF form, have become increasingly popular as they don’t come with the disadvantages as mentioned earlier.
Private Equity (PE) funds are similar to hedge funds in terms of access and fees, but generally are significantly less liquid than hedge funds. PE funds are often centered around real estate development or buying and selling entire companies and accordingly require long lock-up periods of investor capital for five to ten years.
Managed futures typically invest in long/short strategies in commodities or currencies. They can also carry significant fees and leverage due to the nature of the underlying investments. They are sometimes similar to hedge funds in returns and risk characteristics. And while they do require minimum investment amounts, such minimums are generally substantially lower than that of hedge funds.
Bad Timing or Bad Investments?
Alternative investing and hedge funds, in particular, have come under intense scrutiny of late. Growing concern about fee structures along with dismal performance (as a whole) has lead to high profile defections from the California Public Employees Retirement System (CalPERS) and other state pension boards.
While both concerns are legitimate, for individual investors, liquid alternatives can directly address fee issues. Performance (or lack thereof ) of hedge funds and alternatives is a more complex issue. Given that the golden rule of successful investing is to buy when others are selling, investors should not be too quick to dismiss the potential use of liquid alternatives as part of a core-satellite investment strategy.
Now that we have taken a look at what alternative investments are, we will visit the topic of who (if anyone) should use alternatives in an upcoming article.
DISCLAIMER: Nothing in this article should be construed as a personal recommendation or advice. Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any investment security. Barnhart Investment Advisory clients and principals may hold positions in any securities mentioned in this article. Investors should conduct their own due diligence and seek the advice of a financial and/or investment professional before making any investment decisions.