Economics

Outsourcing Alternatives

Alternative Investments are nearly Mainstream. It took a couple decades, but there are more ways to access hedge funds and strategies like Managed Futures than ever before. They are so mainstream, in fact, that there’s a bit of a movement among some family offices to internalize some of these alternative investment strategies (especially private equity). Here’s Ben Carlson of A Wealth of Common Sense quipping about the phenomenon:

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Who wouldn’t want to earn double-digit returns without having to pay large fees to an outside money manager? That’s part of the allure of the family office.

Yes, there are more ways to access alternative investment return streams these days, including, it seems – just doing it yourself via a couple of private equity guys or girls in the corner of your shop (or building your own algos). But access doesn’t mean success, much like the way the Cheesecake Factory’s 1000s of item menu doesn’t equal culinary greatness.  Here’s Carlson again explaining why this may be problematic in his post highlighting the issues Family Offices face when investing in Alternative Investments:

The problem here is that most family offices are woefully understaffed for this type of strategy. If the average operation has just three investment staffers, with just two to oversee internal private equity efforts, that’s inadequate for all but the very best private investors in the world.

Private equity is not a strategy you can run passively. It takes a massive amount of work. Plus you have to know your competition. The biggest private equity firms look at thousands of deals a year. They have specialists who handle deal sourcing, banking, financing, operations and more. Cutting out these firms and their huge fees does sound appealing until you realize how hard it can be to beat them at their own game. The competition in this space has never been greater.

Not only do you have to gain access to, and choose, the right deals, but you also have to monitor and help improve these companies once you buy them. This is operationally inefficient, to say the least.

The due diligence is just the first step. Implementation and monitoring can be even more time consuming and confusing for those who aren’t experts in the field.

We’re insanely biased in this regard, of course, as our business revolves around assisting investors just like the family offices mentioned by Carlson in accessing alternative investment managers that fit their risk/reward profiles and mandates.  But we couldn’t agree more when it comes to our specific slice of the alternative investment space – managed futures and global macro investments. As Carlson says, are you really staffed up enough to do this type of due diligence? Can people on your team see the VIX future curve in their head, as we joke about on in our new VIX Trading Infographic? Do you have risk systems, attribution reporting, backtesting software? Execution algorithms? Who will you benchmark against?

All of this is to say nothing of the technology, compliance, and built-in biases with running your own strategy (won’t it be harder to fire those two guys in the corner?).

There’s surely family offices, fund of funds, and other institutional investors well versed in many sides of managed futures and global macros (sides like these and intricacies like these) – but they are few and far between. And what if you have special needs? A desire for machine learning programs, or day trading commodity managers, or volatility hedges?  It takes a special kind of shop to have the bandwidth and enterprise-wide knowledge to know what they are looking at when evaluating talent across such a broad swatch of strategy types.  Yes, there’s smart people out there who can quickly get up to speed. But at what opportunity cost?  Does it make sense to spend 50% of your time learning about something which will be 10% of your portfolio? Probably not.

And the real kicker… a group like RCM doesn’t charge anything for this expertise, instead earning their keep from the futures clearing and manager fees you pay anyway.

So go ahead and do what you will with Private Equity. But managed futures or global macro? Outsource that S^&$. It will be more efficient, and more cost effective in the long run.