Alternative Investors are Asking the Wrong Questions
As the registered investment advisor space continues to grow, and the use of Alternative Investments by those advisors continues to grow; we find ourselves talking with more and more ‘RIAs’, helping them truly understand what’s under the hood of the managed futures labeled mutual fund or private placement they’re considering.
Which brings us to Wealthmanagement.com, a popular spot for advisors to keep tabs on the industry and find commentary and research to help in their ongoing education, where our own Jeff Malec has been asked to post a few pieces on Alternative Investments:
Investing in alternatives has become all the rave the past few years, but there isn’t quite as much literature out there as in the traditional investment space (by a factor of about 1000 to 1), which leads to a lot of well intentioned due diligence and pre-investment questions to really miss the mark.
The essential question is: “how has it performed recently?” But that’s just the tip of the questionable question iceberg. Here’s a few more we hear from time to time, with suggestions for more insightful inquiries:
Question/Idea The Flaw(s) in the Question A Better Question How much is it up this year? The performance day to day, month to month, and even year to year is virtually random – Remember: past performance does not indicate future results. Can you explain to me why the investment is up/down/sideways so far this year (or in xx year) for me to better understand your investment philosophy? Every alternative investment will help diversify my portfolio with non-correlated assets. There are a lot of products out there that have ‘alternatives’ on the label – but when it comes to return drivers and true diversification – not so much. Many of these alternatives rely on freely moving credit markets, a rising economic environment, and strong corporate earnings. How is the investment likely to react in a concentrated sell off across asset classes? What are the main return drivers? Is the Sharpe Ratio high enough? The Sharpe has numerous flaws, outlined here, but what you need to know is that there’s more to risk than volatility. How are the returns per unit of: downside volatility, the max drawdown, and average annual drawdown? Am I getting commodity exposure? A yes answer here doesn’t help. How much? Long and short? One popular ‘trend following’ model doesn’t even go short energies… a tough pill to swallow as Crude went from $100 to $50 What percent of historical returns have come from physical commodity markets? Does the investment go both long and ‘short’ commodity markets? I need daily/weekly/monthly liquidity… does this investment allow me to get out quickly? Daily liquidity is like sleeping with a gun under your pillow for protection. You’re more likely to accidentally shoot yourself than protect anything. Needing instant liquidity for investments that can take 3-5 years to run a full cycle is a mismatch. What are the liquidity constraints so I can fit this into the appropriate liquidity bucket in my portfolio, and know whether or not I can count on it in a pinch. This is a managed futures program… great! I’ve been looking to add that asset class to help protect my portfolio in a market correction. There are a lot of products that trade futures markets, but are anything but classic managed futures programs, trading stock index futures and such or doing counter-trend models. Will this provide the negative correlation/crisis period performance managed futures are known for?
Adding ‘alternatives’ to your portfolio has never been as easy as today with the plethora of so called ‘liquid alternatives’. And the marketers have never had such an easy time separating the uninformed from their money in their bids to raise money for these funds. For example, a prominent national firm we will leave unnamed put out a 5-page piece explaining how to utilize 15 different hedge fund strategies in portfolio construction. It has all you would ever need to know about these highly complex investments, dedicating four to six sentences to each one!
Four to six sentences. That’s all you need to know? So much for the Chartered Alternative Investment Analyst designation or decades of experience with the asset class. Just grab the nifty cheat sheet here and start building portfolios – what could go wrong? What could go wrong indeed – how about mismatched performance with investor expectations, high fees, poor relative performance to benchmarks, a concentration in the largest managers counterparty risk, credit risk, and the propensity of the correlations and relationships listed all blowing up during a crisis.
Marketers, take note: keeping it simple is how you sell a complex idea to investors. Investors, take note: it’s a lot more complex than that—you have to ask the right questions.