I spent my vacation surfing in Indonesia this summer, which meant I spent a lot of time thinking about investing in alternatives. What does surfing have in common with alternatives? Plenty. Looking at a wave, you have to decide if it’s worth riding—is it a trend or just a directionless event? I had to make constant risk-reward calculations, and sometimes I passed up an opportunity. “If in doubt, paddle out”—a surfer’s bylaw—sounds like the advice Warren Buffett gives: “You don’t have to swing at everything.”
When you become a surfer, you have to pay attention to not just the local weather, but weather thousands of miles away. Straddling my surfboard, I watched swells approach that had been formed months earlier by huge winter storms deep in the Antarctic Ocean. They had rolled across thousands of miles to reach Indonesia in August.
Similarly, big global macro events that originate halfway around the globe break on our shores. Remember what happened in March: The minds of investors from London to Los Angeles to Singapore were focused on Cyprus, a tiny island with fewer than 1 million inhabitants, when its banking sector needed a bailout. We continue to feel the ripple effects from Greece’s economic crisis, Egypt’s political turmoil and China’s slowdown.
Thirty-five years ago, my friends and I would go on surf safaris to Mexico. Fueled by hot dogs and beer, we would take our chances on finding the good swells. Today, we rely on sophisticated wave-predicting software. When experts say 15-foot swells will hit the beaches of La Jolla, they usually get it right.
Extreme waves—“rogues”—are enormous waves that appear quickly and out of nowhere. They can be twice as big as surrounding waves, with steep sides and abnormally deep troughs. Because they are so rare, rogues are still poorly understood.
It would be impossible to surf—or invest—if we lived in fear of rogue waves, but there is a disturbing air of complacency among investors today. As I write this, equities have rallied over 100% from their lows in March 2009. Take a look at chart above. It shows the two most recent times that the S&P 500 crested before losing 50% of its value.
Steep declines, abnormally deep troughs and poorly understood could also be used to describe the 2008 financial crisis. I don’t expect another rogue wave to hit us as it did five years ago. “Past performance is no guarantee of future results” works both ways, after all. In fact, I believe the market has plenty of room to go, but I also think it’s a good time to pull back from long-only portfolios. Not only are the indexes flirting with record highs, but there are signs that the market’s lock-step behavior has ended.
If you look at intramarket correlations, it’s clear that stocks are much less correlated than they were a year or two ago. That means skilled portfolio managers have a chance to show their stuff. One of the best ways they can demonstrate their skill is with a long-short equity strategy. Until recently, that strategy was limited to hedge funds which, with their high minimum investments and high fees, excluded a lot of investors. Since 2010, however, the introduction of so-called “liquid alternatives” has opened the way for individual investors to hedge via long-short equity mutual funds. Some are designed to potentially take advantage of the upside in the market while also preserving value on the downside.
Uncertainty is still the big wave out there. Long-short equity funds won’t eliminate that, but they let you get off the beach and paddle out.