Why Alternatives?

I’m expecting lower than average returns for the US stock and bond markets over the next five to seven years. I have no crystal ball, but when stock prices trade at elevated levels, the tendency is for future returns to be muted. And, future returns from bonds will be low when interest rates are low (and rising).

Not too long ago, a fund manager half-jokingly told me “There are only two things wrong with the 60/40 portfolio… the 60 and the 40.” (This is referencing a 60% stock and 40% bond asset mix.) While this is a dramatic statement, I think there is truth here.

With these concerns in mind, I have added Alternatives (“Alts”) to client investment portfolios. The term “alternative investments” makes some investors nervous and rightfully so. The bulk of these are volatile, correlated, risky, complicated, non-transparent and expensive. As a whole, alternative investments have disappointed.

When I look for alternative investments to use in investment portfolios, I look for several characteristics:

True investment thesis – I want to understand the economic and/or behavioral reasons for this investment to perform well going forward. Many strategies use “data-mining” to find what worked. We all know that past performance does not guarantee future returns.
Solid risk adjusted performance – It’s important to understand the risk/reward profile of any investment. Some funds have a great risk profile, but low returns are often the result. I typically, look for Alternatives that have risks and returns that are somewhere between historical stock and bond returns.
Non-correlation in a variety of market conditions – When the going gets tough these holdings should not follow along. Alternatives should have strong downside capture numbers.
Does not act like other alternatives in portfolios – Each holding should be a diversifier.
Liquidity – I want to sell/rebalance holdings when necessary, so I avoid those with long-term lockups. Some of the Alternatives I use are limited to quarterly redemptions; when I use these funds, I expect increased returns due to the illiquidity premium.
Low/No leverage – I stay away from strategies that use high levels of leverage (borrowing to boost performance). Leveraged strategies are frequently “picking up pennies in front of a steamroller” and can often work well until the strategy gets squashed.
Reasonable costs – Alternative investments have higher internal/external expenses than both stocks and bonds. These higher costs cannot be so high they eat up the benefits.
Uncomplicated tax reporting – Holdings that complicate taxes (with K-1s) are often unnecessarily frustrating and can add to tax preparation costs; I avoid them.

I do not consider Real Estate Investment Trusts (REITs), Treasury Inflation Protected Securities (TIPS), commodities, or emerging market debt to fall into the Alternatives category. I frequently use these as I build portfolios, but these act too much like the stock/bond markets at times of stress for me to consider them Alternatives.

Of the 500+ mutual funds in Morningstar’s Alternatives category and the thousands of hedge funds available, very few meet most/all of the criteria listed above. Those that have met these initial screens go through additional levels of due diligence where I am digging deeper into the people, process and performance of the fund. This can take a while - often a couple of months or longer – where funds will be excluded for additional concerns. I often live with a fund (have it on my daily watch list) for some time before getting married (investing in the fund).

What types of Alternatives are in client portfolios today? I use a fund that invests in reinsurance, one that invests in private and public real estate, some funds that use trend-following strategies and one fund that invests alongside of one of the county’s top hedge fund management teams. (Have a look out for future articles where I detail each holding.)

My end goal when using Alternatives is to add diversification to investment portfolios. Companies will continue to innovate and grow and this will lead to the stock markets performing well over time. Borrowers will make their payments with interest and this will lead the bond markets to do well over time. Alternatives add other sources of long-term returns and income; these returns will steady the ride when the road gets bumpy.

Want to discuss this in more detail? Contact me!

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