What to Expect From Alternative Investments

Investors should have realistic expectations about alternative investments.

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Tim McCarthy
Tim McCarthy

Many investors bought a variety of alternative investment funds hoping not only to get superior performance, but to diversify their portfolio risk. They have often been disappointed on both fronts. And such frustration is likely to continue.

Investors themselves are partly to blame. All too often, they buy and continue to hold a particular alternative fund based on two premises:

  • Each year, they expect the fund to beat the Standard & Poor’s 500 index.
  • They want the fund to have daily liquidity at all times.
  • Why do these types of customer requirements and evaluation metrics frequently lead to unsatisfactory performance?

    First, what happens if you insist on doubting your money manager every year he or she does not beat such a broad-based public stock index? You can’t then expect your money manager to drift too far into a strategy that dramatically distances itself from the S&P 500. When you look at various strategies that do have low correlation from this overused index, there are years where the performance can be substantially higher or lower than most of the broad public stock indices. But since most investors only want the years that are higher in performance, and since such market timing is nearly impossible to consistently do, the managers end up having to stay close in exposure to the index and at times have to pay for expensive hedging techniques.

    Secondly, for daily liquidity funds to work well, it is best when the underlying securities or instruments also have broad market supply and demand. That way, there is liquidity, even in times when prices are declining. But depending on the particular alternative category, many funds are often not so “alternative” if they closely mirror publicly traded markets. One of the older tricks managers employ is to say, “No worries – we make a market in the fund that is made up of illiquid securities by offering to buy if you would like to sell.” And history has shown us that inevitably, when the next financial crisis comes, they won’t be able to support such a bid as most everyone is selling and no one is buying illiquid underlying securities.

    In severe market crises, you likely won’t have daily liquidity in many of these types of funds as we saw recently in 2008 and 2009. History has shown that an investor in some of these funds had to wait a year or more before normalcy returned to the market and they were able to liquidate. Of course, there were “bottom fishermen” who would quote you a price, but at a range that is often less than half of what you paid, which is hardly a good alternative. Thus, when you see an alternative fund based on underlying illiquid securities and they say the fund has daily liquidity, ask yourself, “Would you buy an umbrella that works well except for when it rains?”  

    Of course, there is much variety in the vague classifications of alternative funds. If you buy an alternative that is truly a short-only or a “bear” strategy, that fund will likely go up or be flat when the market is tanking. However, you have a lot of risk in such a fund because these funds will often get hammered when markets are rising. Similarly with market-neutral funds, although they may not decline as much in bad markets, they certainly won’t allow you to take full advantage of market rises, especially when additional hedging costs are considered. It is no wonder, then, that many experienced investors are questioning whether the average alternatives fund that charges 2 percent a year, plus takes 20 percent of profits, is really worth it.

    The answer is that it can be valuable to carefully mix in a small amount of alternative exposure into your broader portfolio. However, if you expect each fund to give you the low correlation you desire over the long haul, then, it is likely more wise not to expect those funds to beat the S&P 500 each year. Rather, you should focus on how the fund did versus its underlying asset class (looking at stocks, bonds and money market investments as a whole) as well as look at true competing peers in this category. For instance, if the fund is focused on commodities, how did the fund do versus that particular index, and versus its direct peers in that space? To be realistic, seeking low correlation means that such appropriately structured alternative funds won’t outperform any general index every year by definition. But what you are getting is the effect of smoothing out your long-term portfolio volatility, which has value over your long-term financial plan.

    Where can you get help in evaluating the various alternatives available? Recognize first that the information on many alternatives is often not as readily available for comparison purposes versus the standard long-only publicly registered mutual funds. However, there are increasingly better sources for comparison information such as Preqin, Barron’s and Evestment’s HFN indices, a hedge fund industry research outfit. Given alternatives’ complexities and how much work it is to fully research, employing an advisor in the alternatives space makes a lot of sense for investors. Just make sure you get more than one opinion before making your final selection.

    One point to emphasize for the more affluent investors is that since they should be investing for decades rather than quarters or a single year, it is OK to have some portion of your portfolio in illiquid categories that have a chance to outperform over a decade or more. Many proven managers will tell you that if they know that their client’s money is “sticky,” i.e., not going to be pulled on short notice, it allows the manager to make investments in opportunities that will take longer to come to fruition, but should result in higher and different types of returns.

    The lesson with alternatives is that if you insist on a manager doing the impossible, then more often than not, you will be disappointed.

    Tim McCarthy is the author of “The Safe Investor,” released in February 2014, and former chairman and CEO of Nikko Asset Management Co. He has also worked at other large financial institutions such as Fidelity Investments and Merrill Lynch.