October 6, 2017
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Lets Get Real on Alternative Investments
Not a day goes by where I do not receive some marketing pitch about adding alternatives into my portfolio mix. The pitch goes something like this: Reduce risk without reducing return or reduce risk and only slightly reduce return. Yes, I grossly oversimplified but bear with me for a second.
Lets start by clearly defining what an alternative investment is. If you Google alternative investments you will find they are defined as any investment that is not a stock, bond or cash. This generally leaves us with private equity, hedge funds, managed futures, real estate, commodities, and derivative contracts. However, most of the marketing I receive broadens the definition to also include arbitrage, long/short, tactical, leveraged, among others. In short, if it is not a traditional stock, bond or cash than it may be branded as an alternative. Lets take a close look at some of the issues an alternative investment may face.
Issue 1: Lack of Definition
I can tell you clearly how large cap value or growth have done year to date, but would be challenged to give a fair benchmark for aggregate alternatives. This makes accurate testing, study, or comparison for accountability in different market conditions very difficult. This is further complicated by the unconstrained nature and changing products themselves. Tactical managers, long/shorts, arbitrage, derivatives, hedge funds all exist in a world with very loose borders. Loose borders, generally make management accountability and risk management very difficult.
Issue 2: Accountability & Risk Management
Accountability and long-term risk management become difficult when you do not have a clear aggregate benchmark to compare. A weightlifter will assess the next lift based on his skill and strength. We invest client’s money with a clear understanding of historical norms, expectations, correlations and the risk they can handle. Alternatives in general have eccentric ways of correlating with risk. Obviously the type of alternative determines the specific risk, but as a theme we see extreme deviations of predictable market correlations within each sub set. Without a clear understanding of accountability or risk correlations it becomes difficult to add to a long-term portfolio with confidence. This is not to say alternatives are bad investments, but we know that all investments hold potential for risk relative to desired returns. You must ask yourself, do you have the sophistication to understand what is really going on? With alternatives we have found advisors are much more likely to miss key facts than with traditional stocks and bonds.
Issue 3: Liquidity & Fees
Many alternatives have lower liquidity. Even publically traded alternatives may have reduced liquidity behind the scenes that could pressure risk during volatile times. Low liquidity generally increases transaction cost for the client and operational cost for the advisor. Besides higher spreads, we often see added administrative, management and legal fees behind the scenes.
Why Alternatives? Ask this question first
Alternatives are generally added to portfolios because the conventional stock/bond mix is perceived to not meet the desired return or desired risk, thus a belief exist that alternatives will help.
So the key question becomes, what return or objective cannot be met by the stock / bond mix?
The answer historically has been that all return and risk levels can be met by some combination of stocks, bonds and cash over 10+ years. This answer is predicated on Stocks producing the highest return and Cash producing the lowest risk. Most, if not all, alternative investments of equal risk (ie. not using leverage or debt) will fall somewhere between Stock and Bond returns over the long run. Thus, you can generally get the desired long term return and risk without alternatives by simply combining stocks and bonds appropriately.
So why bother with alternatives at all?
If you need to hedge risk elements over shorter periods of time specific to a certain need then alternatives may allow short term objectives to be met in a more appropriate way. This philosophy tends to be far from our thinking since we do not time markets and prefer a more static risk level.
If we farmed land and needed to hedge our annual crop prices then we would change tunes quickly. But for long term retirement planning, we believe entering into the alternative investment-timing dance generally causes more harm than good. In 2007 when rates seemed low and risk was elevated a bit, many flocked to mortgage backed derivatives to harness higher returns and income. Of course we all know what happened in 2008 as these alternatives and many others correlated to the full market decline with many exceeding market risk. Similarly, we saw many overexpose to Master Limited Partnerships in 2012-2014 in search of higher income due to low rates, right before the oil price collapse. Over time we have found it is very difficult to out smart a solid mix of stocks, bonds, cash that match the desired long term risk / return.
Evergreen Conclusion
Asking the question what return or objective can not be met by a stock / bond / cash mix before investing in anything “outside the box” is most key! When you venture outside the box and into any investment that holds reduced liquidity, lower definition, and foggy accountability you will introduce other risk elements. The uncertainty of alternatives simply may not be needed to accomplish goals. If you have a very specific need that can not be met within the traditional framework of stock and bonds, then perhaps alternatives are worth a look….but be very careful and do your homework! Alternatives generally require a much deeper analysis to fully understand; something rarely presented in a sales pitch or general marketing.
If you need any help in analyzing the real risk / return of any investment, feel free to give us a call. Always glad to offer a second set of eyes!
Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.