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 September 2006 Interested in Alternative Investments? A Rational Analysis
Poorly informed investors are often swayed by the latest fad. It doesn't matter what it is or how it works so much as they own it and can brag about it at cocktail parties. Just as tech stocks were the fad of the 1990s, alternative investments are the fad of the current decade. Originally only in the domain of large foundations, endowments, or extremely high net worth individuals, alternative investments gained popularity during the 2000-2002 equity bear market. While stocks were sagging, they were offering investors mouth watering positive returns. Now, as with any investing fad that gains notoriety, alternative strategies are being offered to smaller investors via mutual funds or Registered Investment Advisors' (RIAs) limited partnership units. So, back to the original question: Do you own one? Perhaps more importantly, should you own one?
Alternate Alternatives Some employ both long and short strategies. Others attempt to balance the two resulting in a market neutral approach. Some hedge funds simply soup up traditional investments with leverage and/or arbitrage. One of the most popular approaches is a "fund of funds". Under this structure, the primary manager allots investors' money to different sub-managers who employ different styles and strategies. But not all alternative investments are hedge funds. Private equity funds, for example, allow investors to pool their money to invest in and sometimes even purchase private firms. These are generally structured as limited partnerships where the investors are limited partners while the general partners solicit funds, decide on which private firms to invest in, and assist in their management or restructuring. Much depends on the expertise of the general partners. The goal is often to cash out by bringing the private investments public. Obviously this doesn't happen overnight and instead can take years to be profitable.
The allure of alternative investments is mainly derived from the prospect of greater potential return. Many hedge funds offer positive absolute returns even when the traditional markets are in decline. Private equity investments hold out the possibility of considerable long-term gains, especially if their investments are taken public. But alternative investments offer investors other advantages as well. Unlike traditional long-only investments that can only own stocks or bonds, they give managers the opportunity to also sell short. This means they can use all their ideas, not only about those investments they think will go up, but also those they believe will go down. For a good manager, this can increase the likelihood of long-term success. Private equity funds open up access to additional markets which can help investors diversify their portfolios. Private equity investments have little correlation with traditional ones thus increasing the effect of diversification. Although risky in their own right, alternative investments can help lower overall risk in a well diversified portfolio. So there are legitimate and quantifiable reasons to consider adding alternative investments to a traditional portfolio. There's more to it than just Wall Street's latest hype.
Under the Hood As with any investment, the trick is discerning one from the other. To do so, you have to really kick the tires, slam the doors, and look under the hood. It's not the most interesting endeavor, but for the amount you'll need to invest and the potential losses, it's well worth the effort. Always keep in mind why you're even considering alternative investments: To enhance return while controlling risk through greater diversification with uncorrelated assets. Also remember that their greater potential return comes with greater potential risk. This is what you hope to diversify away by combining them with traditional assets, but it doesn't always happen. For example, we were recently pitched a long municipal bond hedge fund with low to almost nonexistent correlation with traditional bonds. On the face of it, it would look like a great diversifier yet upon closer inspection, it turned out to have a correlation with the S&P 500 that was roughly equivalent to that of the Russell 2000. In other words, the fund's return-enhancing strategies gave it a risk profile similar to small cap stocks but with greater risk. The fund might have been a good diversifier for traditional fixed income, but no more so than less risky small cap stocks. Which brings up a second point: Why was the fund so risky? Normally you'd think municipal bonds would be the safest thing next to Treasury securities. Why was this so different?
Even the safest investment can become risky with the introduction of leverage, arbitrage, and the counterparty risk of swap transactions. This particular fund used all three. Risk, in an of itself, isn't a bad thing, but in this case, it was coming from a number of different sources and each was hard to quantify. Adding to the non-quantifiable risk was the fact that the managers -- although very experienced in running municipal bonds -- had only been overseeing this particular strategy for less than three years. That's less than a market cycle and raises the question of how well the approach would fare during periods of market stress. In general, if an investment -- alternative or traditional -- offers returns significantly greater than those of its underlying traditional assets, it must rely on an elevated level of risk. The direct relationship between risk and return still holds. It's important to be comfortable with the level of risk because once you enter into an alternative investment, you may have to stay for awhile. Most lack the liquidity of traditional investments requiring a commitment of a year or longer. Private equity arrangements often lock up your cash for 7-10 years with positive cash flows only occurring in the last few. Even if you can get out, there's usually a steep price to pay. Unlike stocks and bonds that trade on open, well-regulated markets, there is little if any secondary market for alternative investments. In order to sell, you have to have a willing buyer. Often they don't exist and when they do, you typically sell at a steep discount. If you hold onto your alternative investment, you'll be faced with higher management fees than you'll see with traditional investments. Most hedge funds have annual expenses of 1½-2% and typically tack on a performance fee as well. Funds of funds add another layer of fees since not only is the primary manger tapping your gross return, the individual fund managers are collecting their fees, too. You've got to overcome these expenses before turning a profit much less beating the return of simple, more traditional investments. And that's not all: You also have to ante up a larger sum just to participate in the alternative investment arena. Individual funds commonly set minimums around $1 million. Some are lower and others can be had for as little as $50,0000-$100,000 through partnerships established by RIAs. Even so, these are large blocks of your portfolio, probably greater than you've already allocated to certain stock and bond classes and styles. In return for these higher investment minimums, you get less transparency and greater tax-reporting complexity. Most alternative investment strategies are more complex than traditional investments. It's these strategies and trading patterns that allow them to offer greater potential return, yet you have to take much of it on faith.
Not only are the strategies difficult to follow and understand, they're also not generally reported in great detail or timeliness. In most instances you won't be getting a detailed quarterly report with a concise summary of what transpired over the period. Alternative investments are lightly regulated and have no consistent reporting structure across funds. Don't expect the tightly regulated world of mutual funds. If anything, it's the exact opposite. You won't be getting that 1099 by early February, either. Instead, you'll be lucky to get a K-1 in late March or early April. That's because most alternative investments are structured as limited partnerships, not investment companies like mutual funds. Partnerships don't have to issue their tax reports on 1099s by the end of January but instead provide partners with K-1s that don't have to be issued until the partnership's filing deadline, typically March 31. You'd better be prepared to file an extension or pay your accountant a little extra something for that April 14th rush job.
The Rational Approach Here, perhaps more than ever, you have to do your research. You've got to understand the alternative investment's strategy and unique risks. You've got to determine how it would fit into your portfolio and what effect there would be on its overall risk/return profile. You've also got to determine if the potential return would more than compensate for the ongoing fees. For example, an absolute return fund projecting a 3% gross annual return isn't much of a deal if the fees run 2-2½%. In that case, you'd probably do just as well with Treasury bills -- and with considerably less risk. If your portfolio is sizeable enough to allow your allocation to meet the minimum investment requirement and you can cope with the additional tax-reporting complexity, then by all means, seriously consider the world of alternative investments. The key is to go in with your eyes wide open. Know the risk/return tradeoffs as well as the potential downsides. If you're comfortable in the belief that alternative investments can enhance your portfolio's return and even help reduce risk, then you should seriously consider them. This is the right way to make the decision. The wrong way -- the way many investors are unfortunately making it -- is to rush in because everyone else is or because your broker has a great sales pitch. You rarely benefit by merely following the crowd, and when your broker is hot on a particular investment -- whether it's alternative investments, variable annuities, or tech stocks -- it's often because of his or her incentive, not because of the quality or appropriateness of the investment. As with any investment choice, you owe it to yourself to make an informed decision. After all, it's your $50,000, $100,000, or $1 million at stake. Once you've made your decision, there's little your broker or the investing crowd can do to help. Search this site! Just enter you key word or words:
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AVE YOU BOUGHT AN "alternative investment" yet? If not, you've probably had them pitched to you or at least heard other investors singing their praises. If you're confused by what they are or why you'd want one, you can join the crowd. Truth be told, many who own or tout them don't understand them and the role they can play in a well constructed portfolio.
