Alternative Investment Myths: Volatility And Lock-Ups

On Alternative Investment Myths by David Merkel, CFA of AlephBlog 

I think alternative investments should analyzed the same way that ordinary investments are analyzed.  After all, I have written: On Alternative Investments and Alternative Investments, Illiquidity, and Endowment Management.  So when I read an article like this one at Militello Capital (not to pick on them, but I read it there), I say that I agree with points 1-4, and disagree with points 5-6.  What are points 5 and 6?

5. Alternative investments are more volatile than stocks and bonds.

As a whole, private alternative investments tend to be less volatile than the stock market. Why?  Because investors tend to view alternatives as long term investments, and cannot constantly trade in and out of them.  In this day and age of high frequency trading and quantitative arbitrage (by the way, do most investors even know what this even means?), it is refreshing to know that long term investments still exist.  According to 10 Myths Surrounding Alternative Investments by Nancy Everett and Mark Taborsky of BlackRock, “Adding alternatives to a diversified portfolio has the potential to provide lower volatility than a portfolio composed exclusively of traditional stocks and bonds.”

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6. Investors cannot access their capital if invested in alternatives.

As with most stereotypes, this one does not always apply. Yes, many alternatives are less liquid than traditional investments but the level of liquidity is dependent on the investment itself. Everett and Taborsky agree by stating “As with all aspects of investing, there is a tradeoff between risk and expected return and liquidity is no different. When investing in less liquid assets investors should, of course, expect to be compensated for that illiquidity through improved risk-adjusted returns.” Alternatives that are illiquid also allow individuals to invest in tangible assets. Investments you can talk to.  Investments you can visit.  When’s the last time you visited your hedge-fund?

As for point 5, anything that you measure over longer time horizons will have lower annualized volatility than what is measured over short horizons.  Whether a business is public or private does not affect the underlying volatility of the economics, though it may affect the accounting.

As for point 6, there are far more limitations in accessing capital from alternative investments than from ordinary investments.  Alternatives are not as liquid, except when times are bullish.  The same is true of condomiums, which indeed are fungible, but are rarely liquid, with a tight bid/ask spread.

As such, I don’t think points 5 & 6 are myths.   They are the truth, those that argue against them are proposing myths.

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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.