Understanding the Potential Risks and Rewards of Alternative Investments
“It is what you don’t expect … that most needs looking for” -Neal Stephenson
Today, Investors are confronted with constructing or restructuring an asset allocation model in an environment where traditional equity and fixed income securities are fully valued. As a result, investors may be facing a period of nominal or negative returns from both of these traditional asset classes. In this environment, alternative investments may play a pivotal role in providing investors with broad diversification, lower correlations, and as a result, enhanced downside protection.
However, the successful implementation of an alternative investment strategy requires an in depth knowledge of a broad range of industries, investment products, asset allocation strategies, correlation statistics, and the investors financial goals and risk tolerances. We urge investors to tread lightly—performing their due diligence while soliciting the support of experienced professionals.
What is correlation, and why is it important? In the statistical lexicon, correlation is the covariance of the performance between asset x and y divided by the standard deviation of the performance of both asset x and asset y multiplied together. We prefer a simpler method, which requires opening a modern spreadsheet program and typing =CORREL(x, y).
Either process generates a number between one and negative one, which represents the correlation coefficient of the two asset classes i.e. the statistical similarity in the pattern of returns between the two. A correlation coefficient of one means that the two asset classes move together perfectly, zero represents an indeterminate relationship between returns, and negative one means that the returns move opposite of each other. Determining the correlation coefficient between assets and classes of assets is important because it demonstrates the similarity of the returns over a period of time.
Over different periods of time, correlations shift. The Global Financial Crisis created anomalies among assets that had been correlated for years. Proper asset allocation dictates the creation of a basket of assets with appropriate amounts of diversified correlation to guard against low probability events that could drastically affect asset values—this is referred to as tail risk. The average investor has been told to diversify among equity asset classes and to maintain a bond allocation appropriate to their age and risk tolerance. Now, the investor looks at a portfolio at a time when the S&P 500 is trading above $2,000, sovereign bonds are commanding record low yields, and spreads for credit instruments are narrow. With most investors still feeling the sting of 2008, there is an increasing appetite to look for instruments that are uncorrelated to the stock market, while providing a steady return. This is driving investors to look at alternative investments.
Alternative investments are generally considered products of the following types: REITS (Real Estate, Mortgage, Timber, etc…), commodities including precious metals, private equity and venture capital funds, hedge funds, funds of funds, other real assets, and funds that concentrate in interest rate and volatility management. Some investors will look at the list above and realize that these types of investments have a high barrier to entry; other investors will look at this list with a smug grin as they look at their diversified portfolio of exchange-traded funds (ETFs).
The product growth of the ETF industry and the utilization of these instruments are astounding. A quick look at offerings from the bigger names in the ETF realm will demonstrate that one can purchase shares of these funds for exposure into almost any sector available to institutional investors. Certain ETFs also allow one to take theoretical short positions against asset classes as well as leveraged plays. Indeed, many have called ETFs the democratization of investment. Furthermore, there is some belief that active managers will disappear due to easy allocation through low-cost passive ETF strategies.
While ETFs may be democratizing the investment world, this process is far from over. Many purport that ETFs have leveled the playing field between retail and institutional investor. While we agree that this is happening, we do not believe that it has happened: many ETFs carry risks that may not be appropriate for the allocation desired; ETF fees are not universal, and some are inordinate; investors for the most part have little ability to assess the financial acumen of the investment team in actively managed products. In short, we believe caution is prudent and due diligence is required if an investor wishes to access the alternative investment arena through ETFs.
Most investors look to the alternative space for two reasons: 1. low but steady return streams uncorrelated to the secondary equity markets, and 2. insurance in the case of a large market correction which could negatively affect the value of all the assets within their portfolio. Again, alternatives are not only viewed as steadily-appreciating, uncorrelated investments, but also as attractive for an overall asset allocation strategy to mitigate so-called tail risk.While the ETFs we investigated appear positioned to meet the first bogey of stable, uncorrelated cash flow, the second bogey—themitigation of tail risk—looks questionable.
Many view derivatives as risky instruments—Warren Buffet hedged his 2002 sobriquet of derivatives as financial weapons of mass destruction to mere rat poison if used en masse—yet these instruments are readily consumed through many popular ETFs. We examined the holdings of a recently released ETF that claims to give investors exposure to multiple alternative strategies. While the fees were within reason, we were taken aback when we downloaded and manipulated the holdings data. Our particular ETF was invested as follows: fixed instruments were used as collateral for shorting near-term volatility, while going long on the following two months of volatility; the collateral was also used to fund a futures contract speculating on rising Eurozone interest rates; long and short foreign exchange contracts balanced each other as the fund prospectus explained that it was implementing exposure to the carry trade; similarly, the fund balanced a short on the S&P 500 through futures contracts with long exposure to small allocations to roughly 40 equities. The fund has little performance for a track record and a management team that one is unable to assess. It seeks to provide excess performance above a proprietary benchmark developed by an investment bank to cover multiple alternative strategies.
We believe that retail investors can become the subsidizing facility for proprietary products developed for institutional investors. Back in the ‘80s and ‘90s, this happened with the allocation of volatility during the distribution of CMOs. In the face of mass financial innovation within the ETF industry, we urge caution to retail investors seeking exposure to alternative investments through these instruments. It is commonly stated that while one may enjoy sausage, one does not want to witness how the sausage is made. In the case of ETFs, one should thoroughly understand the recipe. We believe that there is a lot of risk in alternative ETFs that is unnoticed by many investors.
So, what should investors do? How can alternatives be utilized? We are not dissuading investment into alternatives through ETFs. However, we are urging caution and due diligence. We also believe that there are investments that achieve similar performance bogeys, which drive the reach for alternatives. We did not discuss REITS, however, they can create a solid cash flow due to their structure. As with alternative ETFs, REITS have risks, and one must be wary of both the valuation and yield. Alternative credit strategies are also available in ’40 act and ETF flavors, which have both the cash flow and, depending on credit quality, variable amounts of risk. Again, it is important to do your homework. Similarly as we recently argued, municipal bonds are relatively safe and usually tax-free instruments with good yields. Gold has relatively little correlation to the equity markets; however, a discussion of the structure of popular gold ETFs is an article unto itself. There are many vehicles that can be deemed as alternate investments.
What investors need to ask themselves is whether an investment into alternatives through ETFs is appropriate for the assumed risk. These ETFs potentially expose investors to fractional interest in ersatz institutional portfolios. The institutions have the advantage as they can evaluate management and their access to boutique investments is more plentiful than retail, usually for lower fees. As it stands, our opinion is that alternative ETFs may be worth investment as part of an overall asset allocation strategy. However, these ETFs create different risk prospects and different fee structures than what has been sold to the investor as a relative safe haven.
We plan to continue our evaluation of ETFs as investment vehicles for investors. It seems that certain alternative ETFs may be useful in portfolio diversification through decorrelation. What is important is to assess the risks inherent in these investment vehicles and to establish whether the allocation accomplishes the advertised objective. Not all bonds are created equal—neither are all ETFs.
Good Fortune!
Bob Andres is editor of The Andres Review and founder of Andres Capital. Bob’s career includes stops as: chief investment officer at Merion Wealth Partners, chief investment strategist at Envestnet (PMC division), co-founder at Martindale Andres & Co., a firm he grew to $2.4 billion before its sale, President at Merrill Lynch Mortgage Capital, etc. He has been quoted and featured in various media: CNBC, Fox Business, Barron’s, Institutional Investor, etc.
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