Should You Put Money Into Alternative Investments?: A Trendy Investment Pick So Far Disappoints Some Investors

What is alternative investing and should you consider using alternative funds or strategies in your portfolio?

That is the issue that some are debating as the recent bull market continued. Investors enjoying recent fat stock returns and using conventional diversification strategies, those ignoring alternative investments, could be sorry in the next crash.

That is the implicit message of those who argue for a now out-of-favor investing style, alternatives (See note: What Is an Alternative Fund?). It’s a broad asset class that became popular in the wake of the crash of 2008, shunning long-only investing while promising downside protection. But how can an advisor know this kind of investing will do what its supporters claim it will do?

The problem is that alternative funds, often sold as insurance against bad markets, have short track records. Most are less than 10 years old, so they’ve experienced a period of mainly good markets. Indeed, of the 20 largest of these funds, only three go back beyond 2008.

One leading fund industry observer says alternatives are theoretically a good idea, but possess their share of problems. John Rekenthaler, Morningstar’s vice president of research and a fund analyst, maintains that alternatives still can be an effective part of a portfolio.

“The idea of having lower-volatility assets that are only loosely correlated with stocks (if they are correlated at all) makes sense. You can’t argue with the math,” he says.

Alternative investment supporters, who note that the style has only become widely available to individual investors since the crash of 2008, think people who shun these funds sometimes misunderstand them, and that advisors who don’t recommend them to clients aren’t effectively diversifying. (See note, “How Do Alternatives Work?”) It’s not enough for investors, seeking to diversify, to just have bonds and stocks or real estate or foreign stocks and believe the central bank’s mistakes won’t affect them. In the last crash, both bonds and stocks had problems simultaneously.

A Period of Uncertainty

Indeed, in a period of uncertainty, “it will become even more important to find investments and strategies that are not sensitive to the performance of stocks and bonds, and will not be so strongly impacted by central bank actions and changes of directions,” writes Michelle Borré, an alternative investment strategist with Oppenheimer Funds.

Not surprisingly, Borré’s argument for alternatives is their record in difficult markets. She cites three bust/bad periods when alternatives—then only available to well-heeled investors with lots of money to invest—performed better than conventional long-only funds. The latter, Borré argues, tanked. That’s because, she argues, they were more correlated with the stock market than diversified.

“During the financial crisis [of 2008], the correlations spiked across the board and for some asset classes—like real estate and international equities—correlations went to 1,” Borré writes in her recent paper for Oppenheimer Funds, “Alternative Strategies Now and Going Forward.” “That created a lot of problems during the crisis for those who relied on these traditional asset classes for diversification.”

However, some investors who bought into the diversification argument after 2008 are unhappy. They see alternatives as a category that has been beaten up and outpaced over the last eight years as interest rates stayed low and equity performance shined. “Most funds have relatively short track records while performance of longer-tenured funds has been disappointing,” according to a recent Morningstar Landscape report.

Many disaffected investors agree. They see alternatives as a category that has been beaten up and outpaced over the last eight years as interest rates stayed low and equity performance shined. “Most funds have relatively short track records while performance of longer-tenured funds has been disappointing,” said a recent Morningstar Landscape report.

More Bad Marks for Alternatives

But there are numerous other criticisms of alternatives. Many of the strategies are controversial. Opinions diverge widely about alternatives, even within organizations like Morningstar. Part of the critics’ argument is that multi-alternative funds can be difficult to find a common standard, or benchmark, to evaluate performance, according to Josh Charlson, a Morningstar analyst who follows alternatives.

There are many different strategies that fall under the name “alternatives.” Among those are global macro long-short equity; domestic and global long-short credit; and domestic and global managed futures, to name just a few.

Skeptics like Charlson argue that, because managers use so many different strategies, the funds can be pricey and a bad deal. But Charlson’s colleague, Rekenthaler, says he would use these funds as a long-term play because they are probably safe. Yet even he admits that the recent returns of alternatives have been a problem.

Safe, Rekenthaler adds, “doesn’t do much good if the fund can’t beat cash. Alternatives have low expected returns because people are willing to pay up for alternatives and accept lower returns in exchange for those low correlations.” Add on top of that high expense ratios and sometimes sales charges. Rekenthaler, who says the average expense ratios are about 2%, says “there’s not much left for shareholders” once those costs are subtracted.

“My Head Is Spinning!”

Critics also complain that the strategies for many alternatives funds are so involved it can be difficult to understand, much less evaluate, them.

That’s because alternatives typically hold more non-traditional investments and employ more complex trading strategies. These include hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions.

Alternatives also approach diversification in many ways (See note: “Some Alternative Strategies.”) Some funds, for example, invest in hedge funds through managed accounts. But this strategy, says Morningstar, decreases transparency. One must start looking at the various sources to measure underlying performance.

Multi-alternative funds can also be difficult to benchmark, given the wide range of strategies. Many managers pursue absolute return objectives and most are pricey. Still, supporters say this flexibility, this freedom to pounce on opportunities, is why these funds can dodge bad times.

One of the biggest problems with these funds, say critics, is that they are trendy. They have been widely available to retail investors only over the past few years as they became popular in the wake of the crash. But those were also fat times for conventional investments, and alternative returns were poor.

“Most funds have relatively short track records, while performance of longer-tenured funds has been disappointing,” Charlson says. “There has been some disappointment in these funds.”

Indeed, since the financial crisis, alternatives have been badly lagging equity market returns. That point is conceded by many alternative fund supporters.

“Some investors, reviewing the recent stock market, ask why do I need alternatives? I’d rather just take these strong recent returns and low volatility,” says Walter Davis, an alternative investment strategist with Invesco Funds. But Davis says critics are unfair, that they don’t understand the goals of these funds and the market conditions in which they can do well (See note: “The Goals of Alternatives.”)

A Plea for Alternatives

This is a sentiment understood by those who run alternative funds. “Since 2008, there really hasn’t been an environment in which these funds have been needed; equities have done well since 2008 and interest rates have continued to slide,” says Lowell Yura, the portfolio manager of the BMO Alternative Strategies Fund. He says that “investors need to recalibrate their expected returns on these funds.”

Judge them when markets are tanking, not when the sun is shining, Yura adds. “If people think alternatives are going to outperform the stock market in a bull market, they are misunderstanding these funds.”

He contends that these funds are much better designed than conventional ones to weather disastrous markets.

“The traditional 60/40 portfolio is dominated by equity and business cycle risk along with a bit of inflation and rate risk,” Yura says. The key to effective alternative investing, he says, is reducing these risks.

But how?

One of his themes is concentration—he tries to use only 10 managers where other funds might use 20 or more. Another theme is risk balancing. He aims to offset the traditional risks in long-term strategies with other types of risk, and ensure they don’t overlap, he says. The traditional equity/bond business cycle risks are the kind most investors already have plenty of, he says.

They’ll Never Work

However, a longtime market observer who has studied these funds and alternative strategies contends these funds have been bad deals for well-heeled investors. Those investors bought them as hedge funds and got a bad deal; so, will the retail investor now.

“These alternative investment funds have never worked. Not during bull markets or bear markets,” says Ed Siedle, a former Securities and Exchange Commission attorney. He now works with Benchmark Financial Services, a firm that investigates financial products.

But Invesco’s Davis says critics misunderstand these funds and how they work. “Alternatives underperform equities in bull markets and outperform in bear markets.”

Davis adds that the concept of alternative investments has been around for many years in an institutional format and has worked.

And that is part of the controversy. The funds became popular in the wake of the 2008 crash as a downside portfolio protection, with the biggest ones starting up afterward. So, the funds have never had the advantage of tailwinds, say their adherents.

But Siedle doesn’t accept the argument that investors must simply wait for the market to turn. Besides their lack of track record, he warns, the structures of these investments are dangerous.

“Alternative investment managers, unlike long-only managers, have the ability [to] go almost anywhere and do invest almost anywhere. Often, you don’t know what these managers are doing; they can change strategies so fast,” according to Siedle.

Siedle also complains about their expense.

“It is not widely acknowledged,” he recently wrote, “that undisclosed fees and expenses as high as 8% may dwarf hedge and private equity disclosed fees of 2%. With monumental total (disclosed and undisclosed) fees and expenses, it is no surprise the net performance of these funds has been unimpressive.”

Just Wait Until the Bears Start Growling Again

Yet alternative supporters say it will be the traditional long-only funds that will have unimpressive numbers in the next bear market.

“I would say our fund would be down only a quarter of the losses in the next market crash,” Yura says.

Still, Yura warns these funds won’t make a difference unless they are a substantial part of a portfolio. He says if an alternative investment is less than 10% of the whole, then it will have little effect on returns. Invesco’s Davis agrees.

Everyone concedes this point. These funds should be judged over the long term, which includes a full market cycle with a bearish period. Still, Morningstar’s Charlson says he won’t recommend alternative funds because most are “unlikely to outperform over a full market cycle.”
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Note: What Is an Alternative Fund?

Morningstar defines a multi-alternative fund as one that encompasses multiple underlying alternative strategies. At least 50% of the portfolio should consist of those alternative strategies. Generally, these funds should exhibit other characteristics investors expect from alternatives funds. These include consistent gross short exposure of 20% or more or low beta and less correlation to traditional asset classes.

Alternatives—Some Common Strategies

Multistrategy

The multistrategy approach is by far the most common in the category, representing about two-thirds of the category. Multistrategy funds allocate to distinct alternative strategy sleeves in the portfolio, using a variety of techniques and structures. Within the multistrategy bucket, there are several distinct subtypes.

Multistrategy: Fund of Hedge Fund Managers

These funds have taken advantage of the increasing numbers of hedge fund managers willing to offer versions of their strategies to mutual funds for a straight management fee, with no performance fee. Roughly 40 funds follow this approach. Typically, the mutual funds are structured through managed accounts, where the hedge fund managers’ trades are disclosed to the advisor each day. One of the characteristics of this structure is the access that mutual fund holders get to hedge fund managers typically unavailable to individual investors. A downside comes from the higher management fee demanded by the subadvisors, making these investments far more expensive than the typical mutual fund or even than the average alternative mutual fund.

Mutual Funds

There are also around 40 multistrategy funds that employ a traditional fund-of-funds structure. In these vehicles, the managers allocate to other ’40 Act mutual funds to achieve the overall objectives of the fund. These funds often incorporate an additional layer of fees, but on balance their all-in fees have been lower than those using hedge fund managers in separate accounts. Thus, two of the key benefits of this approach are lower relative fees and greater transparency, as investors can observe the discrete performance of the underlying funds. A drawback is that it may be harder to find truly differentiated strategies or those that rely on less-liquid securities in a mutual fund.

Multistrategy: Single Manager

Single-manager multistrategy funds rely on the internal expertise of the asset manager to allocate across teams or strategy types within the firm. There are significantly fewer funds pursuing this approach (around 15), as few firms possess the breadth of expertise across multiple alternative strategies required to successfully execute it. Further benefits of the single-manager design are lower fees—as there are no additional layers of fees and management is typically leveraging common resources—and the more seamless coordination among the underlying strategies.
Source: Morningstar

Note: The Goals of Alternatives

Alternative investments are designed to achieve a number of key objectives that help investors build wealth, preserve wealth and enhance income, says Walter Davis of Invesco Funds. Among other things, they can:

  • Generate more consistent and less volatile returns;
  • Cushion a portfolio during times of stock weakness;
  • Increase the current yield during a low-rate environment;
  • Reduce the effects of inflation or rising interest rates; and
  • Benefit from opportunities outside of stocks and bonds.

 

 

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About The Author

Gregory Bresiger

Gregory Bresiger is an independent business journalist from Queens, New York. His Personal Finance articles have appeared in publications such as The New York Post & Financial Advisor Magazine. He is the author of the eBooks “Personal Finance For People Who Hate Personal Finance” and “MoneySense”.