Making Systematic Risk Disappear, Not Really

Making Systematic Risk Disappear, Not by David Merkel, CFA of The Aleph Blog

Yesterday I was at a conference for Registered Investment Advisors. There were about 11 of us in the room, and a variety of different parties pitched us on their services. Some of the pitches were harder, most were softer.

Two of the presentations I felt were deceptive, though I don’t believe the presenters intended to be deceptive. The idea was, you need to provide alternative investments to your clients, because clients can’t earn what they need to in stocks and bonds. Private equity investments and real estate outperform stocks, and we have new durable income vehicles that outperform bonds. What’s more, we can remove a lot of volatility from the portfolio.

Systematic risk: Investments behaving like a shadow bank

Imagine for a moment that you’re investing in two private companies that after you buy them, you will have to own them for 10 years. The money is committed, and you have no way to get liquidity from the companies until the 10 years are up. One of the companies will leverage up a little bit, and invest in stocks. The other company will leverage up a great deal, and invest in bonds; it will behave like a shadow bank.

Now imagine on your brokerage statement, that your broker does not have to mark the positions to market.  After all, the corporations are not publicly traded and so the companies are valued at the amount of your investment until they dissolve and pay out their proceeds at the end of 10 years.

Does this method of investing limit volatility? It looks like it does, but it really doesn’t. Your investments are subject to all of the vicissitudes of the stock and bond markets, and then some, because the private companies took on some leverage. Though the values may be constant on the accounting statements, the volatility of the investing will be delivered in full at the end of the 10 years.

That’s the way some of these alternatives work, except they get applied not to public stocks and bonds, but private companies, real estate, mortgages, etc.  They are subject to the same economic forces as the public stocks and bonds, and once you strip out the effect of the additional leverage they perform about the same.

The story was told that this is the way that the wealthy got wealthy, by investing in private corporations, and investing in real estate. This is true as far as it goes except that the wealthy concentrated their investments in a few real estate projects and a few corporations that they themselves actively managed. Those offering alternative products investing in private equity and real estate are investing far more broadly in order to reduce risk. Even if the investments do well, you won’t get wealthy off them, though you might do well.

Systematic risk: Concentrated investments

What is also not mentioned is that many more people who try to become wealthy by concentrating their investments fail. If this were easy, everyone would be doing it. The volatility is not eliminated; far from it, the volatility is amplified, and for those wealthy that succeed, that was the road to wealth for them.

As with public equity and bond investments, you will find that there are talented managers who can outperform the rest. Many of the talented managers in private investments limit the amount they manage, and money from new investors is not welcome.  The best managers of alternative investments are not open to the public, and not to these private investment middlemen as the conference.

The same logic applies to hedge funds. There are many different types of hedge funds, and performance data for them is dirty. Some managers are good, some are bad, and on average they’re about as good as markets they invest in. As for some of the data abnormalities, the good ones get into the databases before they’re actually taking money from outside clients which overstates the returns to clients. The bad ones exit the databases early, so the returns on their failure do not get reported.

Though some notable managers will do well, average managers will not outperform investments in public stocks and bonds. This is another case where the actual underlying investments matter more than the legal form that the investments take. Private and public investments exist in the same economy and get roughly the same returns. This should be no surprise.

The upshot of what I’m trying to say is that if you are not investing in alternatives, don’t feel bad because you’re not missing anything on average. Just beware slick marketing pitches designed to make you feel inferior because you’re not one of the “cool kids” investing in illiquid private securities.  After the next bear market, many “cool kids” will find that they lost a lot of money along with everyone else, if their alternatives mature in the bear market.

Systematic Risk: A Final Note — Fixed Income or Banking Income?

I also believe that income investors in some of these new approaches will be the most disappointed in the next bear market. When I was a portfolio manager managing mortgage bonds, we had a rule: don’t buy mortgages on operating properties like hotels, marinas, casinos, theaters, etc. When you do that, you cease to be a lender, because the underlying cash flows of the property are not stable enough to support a loan. If you do such a loan, you have a smaller loan that is real, and the rest is an equity investment.  In a bear market, that “equity investment” could prove worthless.

People will find out this same thing with durable income products, they will prove far more risky than ordinary fixed income investments in the next bear market because they are running a levered lending business. And in the few cases where the business is not levered, the riskiness of the investments is higher than what would commonly expect.

And thus my counsel is focus on the return of your money, rather than the return on your money. Play it safe with your fixed-income investments.

Making Systematic Risk Disappear, Not Really