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Alternative Investments Are Popular, But Why?

By Philip Springer on September 6, 2013

Mutual and exchange-traded funds that focus on so-called alternative investments took in $6.6 billion in net new cash this year through July, up from $741 million for all of 2012, according to Morningstar Inc.

This is perplexing, for one simple reason: These funds’ overall performance has been terrible, with most of the 13 alternative categories that Morningstar tracks trailing the performance of most equity and even fixed-income categories over one, three and five years.

What’s more, most of the alternative winners aren’t really alternative investments.

You see, it’s necessary to make the distinction between alternative asset classes and alternative strategies that use traditional asset classes.

An asset class has unique characteristics that distinguish it from other types of assets. The two most common factors are economics and supply/demand. Stocks and bonds are two mainstream asset classes. Real estate and commodities are the best-known alternative assets.

But what makes many other categories different aren’t the assets but the strategies. In other words, the managers trade traditional assets in different ways. Examples include funds that go both long and short and those that use leverage.

Another popular category is “global macro.” Investment decisions typically are based on forecasts and analysis about interest-rate trends, international fund flows, political changes, government policies and other broad factors. The managers typically use a variety of mainstream and alternative assets, such as stocks, bonds, currencies, futures and derivatives.

Private equity may or may not be an alternative class, depending on how the managers invest.

Most hedge funds invest in traditional assets. Some use various alternative strategies while some don’t. Some focus on alternative investments.

Owning more asset classes should provide additional portfolio diversification. But the results from investing in funds that use alternative strategies depend primarily on the managers, regardless of how different the returns may prove to be from the rest of your portfolio.

The Yale Model

Alternative investing started to become popular in the late 1990s because of the success of the so-called Yale Model, named after the university endowment fund that did so well at it.

Yale’s superior performance has continued. In the 10 years through June 2012, the latest reporting period, the Yale endowment returned an average of 10.6 percent annually, much better than the S&P 500’s 7 percent.

From the Yale Model grew the idea that large investors, such as endowments and public pension funds, could generate superior investment returns by moving a large chunk of assets from stocks and bonds into hedge funds, private equity, real estate and other alternatives.

Thousands of institutional investment funds adopted this high-cost approach in various ways, with widely varying results that deteriorated over time and collapsed during the financial crisis.

These other institutions were unable to achieve Yale’s level of success for three basic reasons:

Reason #1:
They didn’t have all of Yale’s many advantages. Among these are a full-time staff of expert analysts to evaluate potential investments; access to the best investors and a broad range of opportunities; the clout to negotiate favorable fee structures and other terms; no taxes on profits; and a very long-term view.

Reason #2:
In recent years, alternative investments have become more accessible, more easily traded and more popular because of exchange-traded funds, mutual funds and other products. But a true alternative investment is unlikely to be liquid and popular.

With increased popularity, high fees and lower management expertise, it’s only natural that these assets and strategies have done less well, both in diversifying portfolios and in absolute returns.

Reason #3:
Since 2008, when the financial crisis kicked in, followed by central banks’ monetary and quantitative easing, different assets have become more correlated to each other. So diversification to alternative investments has paid off less than it used to.

Leuthold Group LLC recently studied the performance of commodities, real estate investment trusts and hedge funds and found that their “correlations to equities have risen dramatically” since 2009.

Unfortunately, individual investors now are buying into the deeply flawed “alternative” idea.

Over the last five years, the S&P 500 has returned an average of 8.3 percent. Here are the annualized returns over that time period for the 13 alternative-fund categories Morningstar tracks:

Trading-leveraged debt: 4.9 percent.
Long/short equity: 3.9 percent.
Trading-leveraged equity: 3.5 percent.
Multialternative: 1.7 percent.
Multicurrency: 1.1 percent.
Market neutral: 0.3 percent.
Managed futures: -3.7 percent.
Trading-leveraged commodities: -7.0 percent.
Trading-miscellaneous: -8.3 percent.
Trading-inverse debt: -11.7 percent.
Trading-inverse commodities: -18.0 percent.
Bear market: -24.9 percent.
Trading-inverse equity: -28.9 percent.

Need we say more?

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