What makes an investment alternative?

Stock Investment Lesson PainAnandKZ / Pixabay

What makes an investment alternative?  Typically, it is because not many institutional investors own it.  But why don’t they own alternatives?  What attributes can characterize them?

What makes an investment alternative?

  • Lower Liquidity – this can take the form of long lockups for private equity, liquidity limitations on hedge funds, Real Estate LPs, etc.
  • Limited market for trying to sell out of limited partnership interests early
  • Can go both long and short financial instruments, use derivatives
  • Can hold commodities and collectibles (Art, wine, who knows…)

Typically, the form of the investment is a limited partnership.  The limited partnership can own all manner of assets, and short some of them also.

As with most valid investment ideas, those that get there first do the best.  You don’t want to be the last one to the party — you buy into a saturated market at an overvalued price.  Far better to avoid the market than to be the last one in.

You have to understand, there is nothing truly different about alternative investments.  They may invest in private businesses, and lever them up, but the returns aren’t greater than if we levered up public companies to the same degree.

They may go long and short, but there are so many trying to do it that the limits of arbitrage are tested, which is a major reason for why hedge funds are doing so badly.  When you have a lot of parties trying to make differential bets, the reward to the exercise declines.

Briefly, while working for Finacorp before it liquidated, I had the opportunity to give advice to some large pension plans that were charging into alternative investments in 2009.  I counseled them to stick to more liquid investments, because alternative investments had become common.  Alternatives are not magic — you have to evaluate them like any business, and ask whether the entry price discounts a high return or a low return.  Are the commodities/collectibles in over- or under-supply?  What possibility might you face of needing to raise liquidity at an inopportune time?

There are two matters affecting any investment:

  • Underlying behavior of the asset in term of its relative value, and
  • Behavior of those who hold the investment, their perception of relative value, and their need for liquidity.

To give an absurd example, think of Bernie Madoff.  The actual value of the assets never did anything.  But parties owning interests in Madoff’s “fund” needed to raise liquidity when the public equity markets plunged in 2008, which led to the insolvency.

Investor behavior affects asset prices.  Big surprise, not.  This is Ben Graham’s voting machine.  The weighing machine eventually catches up when there are liquidity events where investment vehicles get dissolved for cash or other securities.

This is not to say that there is no superior management talent with respect to alternative investments, but that it is subject to the same limits as public investments.  As more capital is allocated to a manager, he moves down his list and says, “Okay, what’s the next best thing to which I can allocate capital?”  Too much money kills even the best of managers.

Perhaps the best way to go is to focus on the Seth Klarmans and Howard Marks of our world, and be opportunistic.  Hold cash when it makes sense, or send it back to the limited partners, but invite them back and invest heavily when conditions warrant.

My view is this: given the wide level of investing in alternative investments, there is no reason why they should outperform, and no reason why they should be uncorrelated with other risk assets, because the same owners own both.

Via: alephblog.com

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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