My plan was to write about something other than alternative investments this month, but the messages I received since my last column, "Why I Won't Use Alternative Investments," have prompted me to continue the discussion. The messages fell into three groups. The first group was the largest and basically agreed with my conclusion that keeping clients out of the alt world is probably the best choice.
The second group was a few purveyors of alt products, particularly products that sought to address the liquidity issue through an ETF, '40 Act fund, or a separately managed account format. A couple of these offerings do indeed improve liquidity somewhat for the end client, but none reduced my concerns on other issues.
The third group was either considering using alts for the first time or had put some alts into client portfolios and was revisiting the decision. This group typically expressed some relief that others were also doubtful and experienced some confusion, because despite seeing many reports that indicate a move into alternatives is a wide-reaching trend, they see few peers, and fewer clients, clamoring for alts.
Group one already agrees with me and group two will likely never agree with me, though I did have a couple of people who worked in the alt field tell me I was understating the issues and I was more right than I let on. It is the dabblers in this third group I am writing to today.
First, your confusion about the reports of a move toward alts is understandable. I get a lot of surveys about alts and many, if not most, are badly done. Just this week, one asked "Do you anticipate your use of the following will increase, decrease or stay the same in the next 12 months?" On this list were TIPS, REITs and ETFs. So according to this survey, I am a user and, since we will probably use a few more ETFs, I am part of the trend toward using more alts.
I have no doubt there is a trend, but these poor attempts to quantify it reinforces my concern, expressed in prior columns, that too many advisors are hopping on the bandwagon for bad reasons. We teach our children that just because "everyone" else is doing something doesn't mean we should also. Surveys like this make me wonder just how big a group "everyone" is in this case.
Cerulli Associates is a credible research firm. Its annual survey of the retail alt marketplace highlighted the drivers of flows into alt funds cited by asset managers. The recipients of the survey were asset managers, not clients. The survey actually showed only 21 percent of respondents cited demand from clients as a driver of the use of alts, a decrease from 27 percent the year before.
This contrasts with the 89 percent that agreed investors need alts to optimize portfolios on a risk-adjusted basis, the 72 percent that named expectations of future returns and a need to offer a variety of asset classes, and the 79 perent that need alts to differentiate. These drivers are wholly consistent with the pitch from the product providers, typically, "In today's economy, with historically lower expected returns from stocks and bonds and low correlations, alts are an important asset class." This is rubbish.
Alternatives investments cannot be an important asset class when they are not even an asset class.
Looking for an official definition of "asset class" proved fruitless. Panthera Leo, is the scientific name of the African Lion, king of the jungle. While not free of debate or refinement, life forms are categorized by a well-established protocol and nomenclature. Finance isn't so tidy. There may be as many definitions of "buy and hold," "tactical," "diversification" and the like as there are articles debating whether they work.
Since we use the term "asset class" most often in discussions about Modern Portfolio Theory, we consulted Harry Markowitz's original "Portfolio Selection" (Journal of Finance, March 1952), the paper that started it all. The term does not appear anywhere in the paper. This is about as close as Markowitz got: "In our analyses, the Xi might represent individual securities or they might represent aggregates such as, say, bonds, stocks and real estate."
Google managed a few definitions, like this one: "A set of assets that bear some fundamental economic similarities to each other, and that have characteristics that make them distinct from other assets not part of that class." (Greer 1997). We can wordsmith if we like but the crux is correct. An asset class has to be about the assets in the class.
Tell me, what do the assets of a private equity, a managed futures and a hedge fund product have in common? Maybe, probably, nothing. Heck just in the hedge fund universe a market neutral, a convertible arbitrage, an event driven, a short bias, a fixed income and a global macro product may have no underlying assets in common.
The bigger issue than the similarity or lack thereof of the underlying securities in these products is poor economic fundamentals. What drives the returns? From what do we expect a return? For boring bonds, the issuer owes us money. For stocks, we own a share of the profits. For alts, the return is expected based on trading tactics, positioning and in many cases leverage. They are supposed to be better because the managers will out maneuver market forces. Whether real or only purported, manager talent is not a fundamental economic driver.
Setting aside any cachet angle to the presentation, let's look at the elements of the pitch, "In today's economy, with historically lower expected returns from stocks and bonds and low correlations, alts are an important asset class." I'll look at the three parts -- correlation, return expectation and today's economy.
Do you remember the Super Bowl Indicator or the Hemline Indicator? Any rational person knows these have nothing to do with markets. Correlation is not causation and can be merely coincidence. Neither is non-correlation necessarily something special. Stuff cash in a mattress and that perfectly consistent zero return will enhance many a portfolio's performance in back tests. The zero standard deviation and low correlation can help a lot with respect to risk-adjusted returns. I doubt you are adding a mattress category to your allocation pie charts, yet many firms are adding a slice of alts based largely on the statistics conjured.
I would not be surprised if future returns were low by historical standards, but I have enormous doubts about whether alts will make things any better if returns are low. Returns on large U.S. company stocks have been below average for some time. I do not see where, as a group, alts added any value versus globally diversified portfolios. A few outliers did well in spurts, but I can't get enthusiastic about betting on finding outliers and riding a brief good run.
The Ivy league endowments got a lot of press for their use of alts. Yet with all their resources, they experienced disappointments, particularly in '08-'09. If big endowments can be frustrated with alts, even warning people away from mimicking their approach, maybe alts aren't as important as the sales literature pointing to endowments' use of alts suggest.
"In today's economy ... " Give me a break. How many times have we heard that one? The more this point is harped on, the more I wonder if we are still talking about investing. The shorter the time frame, the closer we are getting to speculating, not investing. With many alts, all you are really doing is paying someone else to speculate with your clients' money. There is a place for speculation in the world but it isn't in the portfolios that are supposed to support my clients' retirement income.
If you want a part of your clients' portfolios dedicated to speculation and you are able to do the due diligence and you are comfortable with a product with low liquidity, high costs, dependence on managerial skill, low transparency, tax inefficiency, that is often hard to value, that your E&O carrier won't cover, and your clients won't understand, well then good luck to you.
I may never get another invitation to be on an investment panel again after these alt columns but that's OK. Call these things "tactics" or "speculations." Heck, in the case of hedge funds, the diversity of what the managers are doing is so vast, we should label most of them "2 and 20s" because the compensation structure is about the only thing they have in common. Please, really, stop calling alternatives an "important asset class." They aren't.
Dan Moisand, CFP, has been featured as one of the America's top independent financial advisors by most leading financial advisor publications. He has spoken to advisor groups on five continents on topics such as managing investments and navigating tax complexities for retirees, retirement readiness, and most topics relating to the development of the financial planning profession. He practices in Melbourne, FL. You can reach him at [email protected]