Alternative investments bandwagon not worth the price of the ride

New products with short track records hard to judge

 
Illustration of a man looking at a half-golden egg
(Tomasz Walenta)

Alternative investments are among finance’s fastest-growing segments. A McKinsey & Co. report last summer found these vehicles—hedge funds, private equity, commodities, real estate and infrastructure—now account for nearly 30% of the asset management industry’s revenues; it also predicted that portion will hit 40% by 2020.

That’s the industry’s cut, mind you, coming from just 15% of assets under management. But it’s clear that as mainstream stock and bond markets around the world move more and more in unison, there’s growing demand for the non-correlated, market-beating returns that alternatives promise. According to consultants Mercer LLC, 40% of Canadian pension funds are dabbling in alternative assets, up from 25% just a few years ago. The fund industry is creating products designed to give retail investors more access to the alternative world too, such as mutual funds and exchange-traded funds (ETFs) that mimic the strategies of hedge funds. Still, there are some good reasons not to hop aboard this bandwagon.

Proponents pitch alternatives as the ultimate portfolio diversifier. The old rule of thumb that investors should place about 60% of their holdings in equities and 40% in bonds no longer applies, argues Ron Lloyd, executive vice-president at Westcourt Capital, which advises clients on alternative strategies. To reduce volatility and avoid the risk of years of below-target performance in your portfolio, you need to add other asset classes.

The thing is, those other asset classes have had little to crow about lately. The HFRI Equity Hedge (Total) Index, which tracks funds that employ long and short equity and derivative strategies, has returned 62.7% since the bottom of the market in March 2009 to the end of September 2014. Compare that to a 201% return for the S&P 500 over the same period. Some observers reason that the proliferation of hedge funds in recent years has diluted the pool of management talent, hurting industry-wide returns.

“A lot of institutional investors have had limited or disappointing experiences with alternatives,” says Dan Hallett, a vice-president at HighView Financial Group. Case in point is the California Public Employees’ Retirement System (CalPERS). In September, the fund said it would divest its US$4.5-billion investment in hedge funds, citing (in a roundabout way) their high fees and lacklustre returns. Cal­PERS is one of the largest pension funds in the world, and its move is likely to cause other funds to reassess their holdings.

If anything, retail investors are in a worse position to assess alternative asset managers’ complex and often opaque strategies. “We’ve done a lot of work in the hedge fund area, but we’ve never been too enamoured of them,” says Steven Belchetz, president and chief investment officer at T.E. Investment Counsel, whose clientele includes high-net-worth individuals. “We only invest in things we understand.” Many of the products are relatively new and don’t have reliable track records. “A lot of the suppliers will be flogging simulated performance and things like that, but you have to be careful,” he says. “They’re hard to evaluate and can be biased.”

There are good alternative asset managers, of course, but they can be hard to find. Ted Rechtshaffen, president at TriDelta Financial, says his team looks for managers who have been in the business for a long time in order to assess their performance over multiple market cycles. “We find there are a lot of one-trick ponies,” he says. “We’re looking for someone who can shift styles and sectors depending on where the market is.”

There are mutual funds and ETFs that attempt to emulate alternative strategies, but Hallett advises caution. “By the time you really count the all-in costs and layer on the complexity and risk of using these things, I’m highly skeptical there’s any real long-term value,” he says. If leverage is involved, the fees will be higher in order to cover the interest costs. Management fees and performance bonuses also scale up accordingly, sometimes into double digits, Hallett says, which is a steep performance benchmark to surpass consistently.

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Buying one alternative product isn’t necessarily going to provide much diversification on its own, either. Institutional investors might allot 10% to 20% of their portfolios to alternatives, but will diversify within that space—giving a portion to hedge funds, some to mortgage pools and a sliver to venture capital. This is neither practical nor cost-effective for ordinary investors.

In Canada, many financial planners use private mortgage investment pools as an alternative allocation. These represent bundles of either residential or commercial mortgages that earn interest income and pay it out to investors. “Sometimes people think these are like GICs, but they’re really not,” Rechtshaffen says. The risk is higher, which explains why some mortgage funds offer a 10% return, and they’re not as liquid as other investments. During the 2008 financial crisis, for example, many mortgage funds suspended redemptions. A fund that holds a large number of mortgages to distribute risk is a safer bet, and shorter-term mortgages are generally preferable because they will be paid down sooner. If you’re not up for the attendant risks, you’re probably better off just buying a REIT.

The same could be said of a lot of alternative investments, in fact. Another way of looking at the McKinsey numbers is that the asset management industry’s margins are inching down on stocks and bonds, as low-fee innovations such as discount brokerage accounts and ETFs grab market share. It’s easy to see why investment professionals want to steer us into higher-fee vehicles. It’s less easy to see why we’d go along for the ride.

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