Since my last column in which I cautioned against tossing some "alternative investment" products into client portfolios without proper due diligence, I've been contacted several times from purveyors of alternatives with statements like, "You are so right -- due diligence is critical," followed by sales material containing exactly the type of mischaracterized statistics I panned in the column. Apparently, they took my column as supportive of the sales angle that these things are cool and only advisors who are sophisticated enough to really "get" these arrangements use them for clients sophisticated to buy them.
So to clear things up, after having reviewed hundreds of these pitches over the years, I am more convinced than ever that even those with enough sophistication should steer clear. The odds these things will compensate for the many otherwise avoidable risks is low.
Before I get into why I believe this, I need to explain what I mean and don't mean by "alternative investments." Unlike several surveys I have seen, I do not consider TIPS and publicly traded REITs as alternative investments. The products I don't like are generally illiquid, expensive, dependent on purported management skill, are often hard to value, and/or lack transparency. This description fits a lot of things, but what we are pitched most often are hedge funds, private equity and non-traded REITs.
Back to what to expect from alt products. Basic math dictates that, in the aggregate, those who try to outmaneuver markets will underperform those markets. Every buy is countered by a sell so when costs are accounted for, the net aggregate result is underperformance.
The math does not say there will be no outperformers. In fact, it is a near certainty that there will be such winners. Over time, however, due largely to the yoke of cost, fewer and fewer win and their margin of victory gets smaller and smaller. The math also tells us nothing about whether a specific player will be a winner or a loser in a specific time period. The better the manager seems to be, the higher the fees can be. All of this is also true with traditional investments in plain vanilla stocks and bonds, of course.
However, in the alt world, the combination of costs from trading, management fees, sales costs and leverage are higher and make the odds even less favorable. The longer the time frame the poorer the odds, making a long-term allocation to such products questionable. In short periods, some strategies look good like short-bias products during the '08-'09 crisis, but if your concern is short term there are simpler cheaper ways to hedge.
The actual experience of hedge fund investors is likely worse than appears. Hedge fund indexes and databases are of notoriously low quality because hedge fund managers are not required to report results, causing backfill bias (managers only report after they have good performance). Survivorship bias (data vendors only supply data on funds that are still in operation) can also be a problem. Data is difficult to get, but studies seem to estimate survivorship bias alone overestimates returns by 2 percent to 4 percent and underestimates risk by 10 percent to 20 percent. The objective examinations of performance are unispiring.
Of course, not all alt products are designed to explicitly produce high returns. Many are touted as risk control mechanisms. So-called "absolute return" is my favorite. One company offered 5 percent, 6 percent and 7 percent versions. If they actually could produce a 7 percent absolute return with little volatility year over year, why would anyone want the 5 percent version? The return is a goal not an absolute.
The basic pitch for the risk-management focused products is usually something like, "It should have low correlation to equities and probably won't make as much in a bull market or lose as much in a bad market." Sounds well enough. It also sounds like what one would expect from a decent bond portfolio.
It may not be perfect, but I think it is fair to compare these products to bonds when the sellers insist they should not be compared to products trying to keep pace with equities. When compared to reasonable bond portfolios, many of these products have similar returns.
Yes, yes, I know. Bonds have risks and may be riskier now than in the past. So, don't buy long-term zero coupon Treasuries or shorter-term debt from Greece or other credit-challenged entities. When considering alts I think it is good to ask yourself if you will be compensated enough for the lack of liquidity and transparency. The products simply don't look so hot when viewed through that lens.
I'd also touch on a category of product that doesn't fit into either the market-beater or risk-manager categories because the managers can "go anywhere." I may dislike these more than any others. Even if there were transparency, not having a clue where my client's money is going to be is just not something that sits well with the fiduciary in me. How on earth can one assess if they are receiving a return commensurate with the risks taken when they have no idea what risks are being taken?
For higher costs, greater risks, greater dependency on manager skill, less transparency and limited or no access to the funds, I would have to have high confidence that we should get returns that compensate for such a structure. Thus far, I have not seen it. Other than cachet and commissions (I do not work on commission), I can't see why an advisor would be interested in locking up and exposing their clients' money to so many unknowns. Heck, I haven't even mentioned the headaches alts can cause if you care at all about tax management.
By the way, try explaining to your E&O carrier why they should cover such a product. Most won't touch them without a substantial additional premium, if at all. That alone should be a sign. Leverage, in particular, not only increases costs, it expands the range of results from the players, creating more spectacular wins and more spectacular losses.
As is typical, Wall Street has attempted to address some of these short comings and make alts more accessible to those that can't qualify as accredited investors by packaging "liquid alternatives," "funds of funds," "replication" funds and other '40 act products. The accredited investor rules are another sign of the risks. Liquidity concerns are lessened with these products, but all the other downsides remain. I can't help but wonder how many big-dollar accredited investors said no to the underlying managers before those managers decided they needed to incur the added complications and costs of being part of a packaged product.
Now, I freely admit I have biases. Most of my clients are retired, or will be in the next few years, and are living off the nest egg they built over a lifetime of labor. They are conservative and risk adverse by nature. Anything I can do to enhance their comfort with their portfolios and help them enjoy their lives, I will consider. So far, I have not even dabbled with small
allocations in alts. I can not imagine that during the crisis of '08-'09 that having money locked up would have helped any of my clients weather the storm.
There are two other risks that I don't want to over emphasize but need to mentioned. First, the lack of transparency and client understanding are two characteristics found in many of the frauds I see. I do not want to put clients in alts because I think they are unlikely to add value to my clients. I believe most alt purveyors are honest and simply think the opposite. Nonetheless, the nature of an alt structure is well suited for scam artists. Are you sure your due diligence is adequate?
Second, even if due diligence is adequate, things can go awry. Several once-successful managers shuttered their funds returning pennies on the dollar to their investors. Clients who can't see, follow or understand an investment are more likely to feel ripped off even if their manager was merely unlucky. Therefore, there is a reputational risk to advisors in this post-Madoff world.
Clients get enough excitement from the markets; they don't need to own things they can't follow or understand. They don't need to increase their costs, their risks, or their taxes. They don't need to be told they can't get to their money. They don't need to take the chance that the manager they thought was so great can make a bad bet suffering devastating losses. They don't need to invest like pension funds and endowments.
In short, they don't need alts and neither do you need them to serve your retired clients well. Go ahead, call me a naive unsophisticated simpleton but I will stay off the alternative bandwagon. The markets provide enough risks as it is and my clients can only spend cash, not cachet.
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 253-5400 or firstname.lastname@example.org