From the October 2013 issue of Research Magazine • Subscribe!

October 1, 2013

Finke: Facing Alternative Investment Reality

Unconventional assets have a role, but expectations have risen dangerously

Illustration by Matt Collins Illustration by Matt Collins

Alternative investments are shining as old-school investments seem to be losing their luster. Short-run bonds are stuck with negative after-inflation yields. Long-run bonds may be even worse as they promise both low yields and big future inflation risk. Stocks priced at today’s Shiller cyclically adjusted price per earnings (CAPE) ratio of nearly 25 have returned about 2% after inflation over the subsequent decade. Investors looking for yield are looking for new alternatives. Are alts the answer?

There’s definitely a place for non-traditional financial assets in modern portfolio theory. In fact, MPT says that the optimal risky portfolio consists of all capital assets including alts. So an advisor following MPT will want to include assets such as commodities or private equity in a well diversified portfolio. Many of us know how to find the right equity fund, but alts are a different animal and finding the right species often requires a good DNA test.

The alt story goes something like this. All assets are priced based on risk. Stocks and bonds are sold on competitive markets that are often strong-form efficient with many expert traders who keep prices fair. Other markets may not be quite so efficient. Warren Buffett spent years locating private business owners whose firms weren’t quite large enough to lure an investment banker into taking them public. By buying these smaller private firms, Buffett essentially turned Berkshire Hathaway into a publicly traded asset that gave investors access to untapped alternative investments.

If alternative assets are infrequently traded, then they might generate excess returns. Berkshire Hathaway has done pretty well buying private business assets. So have many venture capitalists. Their low correlation with stocks and bonds may also provide significant potential portfolio benefits. In a perfect world, alternative investments have a lot to offer.

Hedge That Bet

Bear in mind that the world isn’t perfect. The SEC exists because markets work better when investors have full information and legal protections. We know that investors don’t do well in countries where information can be hidden from investors and where shareholder rights are violated. Operating in a slightly murkier marketplace often means information is more opaque and investors are vulnerable to bad behavior.

Hedge funds are a great example. Freed from the shackles of the SEC’s Investment Company Act that constrain mutual fund managers, hedge funds can identify attractive markets, exploit mispricing opportunities, and take advantage of new opportunities to capitalize on factors providing excess returns. Since there is evidence that more active mutual fund managers tend to outperform, even greater freedom may lead to even higher performance.

But hedge funds can choose what information about returns and assets under management they disclose, and this can drive academic researchers trying to analyze performance up the wall. Spotty reporting means that there’s a lot of disagreement about whether hedge funds are a valuable asset class or a remarkably effective way to turn dollars from institutions and rich investors into Picassos and oceanfront estates owned by a few fund managers. Efficient market types are the most passionate critics of hedge funds.

What’s the problem with hedge funds? The first is their fees. The traditional 2% of assets and 20% of gains make even the most expensive mutual fund seem like a bargain. The second is that rewarding fund managers for achieving gains while not punishing them for losses looks suspiciously like giving them a free call option. If the value of their portfolio goes up, they cash in. If it goes down, they write nice letters to investors explaining how unusual market conditions foiled their excellent plan, and then collect 2%. If all else fails, the manager can always just close down the fund, return cash to investors, and start a new one.

This all sounds like a pretty sweet deal for hedge fund managers. Which makes the seemingly unending flow of assets into hedge funds over the last decade a mystery to many economists—particularly those at academic institutions that increased the share of hedge funds in endowments from less than 5% in 2000 to over 20% by the end of the decade.

Professors Bill Fung of the London Business School and David Hsieh of Duke have worked to collect the most complete data on hedge fund returns and have come to some interesting conclusions. First, a lot of funds don’t report returns. In a 2013 article published with Daniel Edelman of Alternative Investment Solutions, they found that the share of hedge fund assets invested in firms that do not report information to public data sources increased to more than 38% by 2010. They also found that small hedge funds and very large ones tend to have the best performance. And the great recession killed hedge fund performance, driving alphas for all categories to insignificance between 2002 and 2010.

The great recession created a problem for hedge funds. Many believed that an important benefit of hedge funds is as a, well, hedge based on their low correlation with conventional assets. They certainly didn’t act like a hedge between late 2007 and early 2009. The figure shows returns for fund of funds (the way most of us can invest in hedge funds) against the S&P 500. Hedge funds fell just as much as the S&P. The only difference is that they didn’t recover as much after the recession. An asset that crashes just as hard as a conventional one in bad times but doesn’t perform as well in good times doesn’t do much to improve a portfolio.

Another look at the figure shows that hedge funds did a lot better when the market fell during the dot-com bust 10 years ago. An analysis of fund of funds performance (which represent a little more than a third of total hedge fund assets) published by the same authors in 2012 backs this up. Before July of 2007, fund of funds consistently produced alpha for investors. After that, not so much. Warren Buffett bet New York money manager Protégé Partners in 2008 that the S&P would beat five fund of funds over the next 10 years. It’s not looking good for the hedge funds.

The problem might be that, once again, small investors have arrived a little late to the party. Once the word got out that hedge funds were beating the market, a lot of money flowed into the industry. There are only so many great ideas. A new analysis of hedge fund performance by Georgetown professor Turan Bali and his co-authors finds that performance among hedge funds can be traced to their systematic risk, or beta. The early money seems to have captured the best ideas, but each additional dollar is less likely to find alpha. And when you add fund-of-fund fees on top of generous hedge fund management fees, it becomes even harder.

Staying Neutral

Another popular new gateway into alternative investments for individuals is so-called market neutral mutual funds and ETFs. Market neutral funds are a bit of an enigma because there really isn’t a standard definition of what market neutrality means. It should mean that the fund is uncorrelated with the market. Many market neutral funds do this by going both long and short on assets within the same category to hedge away systematic risk. They then earn some extra money either by renting securities in the options market or by selecting underpriced long assets and overpriced short assets. They don’t try to capture a risk premium and therefore may be viewed as an alternative to safe assets within a portfolio.

A quick sorting of market neutral funds on Morningstar shows a surprising range of one-year returns from minus 9% to a positive 5.7%. The average? Exactly 1%, or a bit higher than short-term government bonds. But the strategy does involve more downside risk—particularly during an extended market decline, as well as some tax headaches from short-term capital gains.

An investor who hopes to capture some of the opportunities from investing in private equity can either invest directly in a publicly traded private equity firm like Blackstone or in an index of publicly traded private equity firms (for example the Powershares Global Listed Private Equity Portfolio, an ETF that goes by ticker symbol PSP). Although there is evidence that private equity has outperformed public equity historically, there is little evidence that these recently created avenues for private equity investment are worth seeking out. Since its inception in 2007, PSP has underperformed public equity indexes while correlating strongly with the market. As with hedge funds, it may be that opening the gates to the masses means it’s time to go home.

A big issue with some alternative investments is that their value is squishy—particularly when those who manage the funds are subject to less stringent standards. This imbalance of information between managers and investors creates opportunities for abuse despite the theoretical possibility of added gains from investing in non-traditional assets. This problem has become particularly acute in the market for non-traded REITs, which have been the subject of a large share of FINRA enforcement actions this year.

Since the valuation of assets held by non-traded private equity and REITs can be subjective (by definition they aren’t publicly traded), who’s to say what they are really worth? One of the pitfalls of alternatives is that they may not have the safeguards of better-regulated plain vanilla assets. But with safeguards come rewards that only arise from taking market risk.

The newest research on alternative investments illustrates how hard it is to consistently get more bang for your buck than the average investor receives with a conventional portfolio. Perhaps most worrying is the extent to which both individuals and institutions are looking to alts to help reach goals that may be unrealistic in a low-yield market. Are you willing to take that bet against Warren Buffett?

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