A discussion of “Liquid Alternative” Investments

Throughout financial history, every bull market seems to be characterized by some new investment product or vehicle that captures investors’ fancy. Like housing bonds in the early 2000’s, mutual funds in the 1980’s, and junk bonds in the 1970’s, liquid alternative assets appear to be that vehicle of the current bull market.

Prior to 2008, alternative investments were primarily available to only endowments and institutional investors. However, in recent years, investment companies created mutual funds with the promise of bringing similar strategies to all investors. These funds have seen tremendous growth and broad acceptance as many investors and advisors have allocated to these liquid alternatives in an attempt to build more diversified, sophisticated and endowment-like portfolios. Unfortunately, performance of liquid alternatives funds over the last five years has broadly disappointed investors.

Alternative investments can be loosely described as investments designed to have differentiated returns versus traditional stocks or bonds. The asset class is comprised of a broad mix of investments and strategies structured to offer a low correlation to traditional assets, meaning that they can zig when stocks or bonds zag. The category itself is quite broad and includes a range of strategies from managed futures, to equity long/short funds, to arbitrage, to name a few. As one would expect, with such a range of investments, the strategies are complex and difficult for the average investor to analyze.

Nonetheless, liquid alternative asset strategies have grown rapidly over the past decade. Thanks to aggressive sales teams and promises of uncorrelated returns, assets invested in these strategies have grown by over 500% to $321 billion since 2006 1. Unfortunately, over this time period, most liquid alternative investments have reduced portfolio returns relative to a simple stock/bond mix.

What is the appeal of alternatives?

The overarching premise for investing in alternative asset classes is that simple stock/bond portfolios are flawed and that these portfolios of old lack diversification, sophistication and things like ‘exotic alpha’.  Advisors in particular are sensitive to being discarded as ‘old fashioned’.  Another big tailwind for alternatives has been the low interest rate environment.  With U.S. Treasury yields around 2.5%, alternative funds have a historically low hurdle rate to satisfy investors.

Investment companies have also been quick to develop new product types as the average fees for these funds are higher than most equity or bond funds, typically 1.5% or higher. Hence, sales forces have worked hard to pitch these new vehicles as an important part of a diversified portfolio despite a lack of compelling evidence.

Of course not all alternatives have performed poorly. The Yale endowment managed by David F. Swenson has achieved outstanding performance for the past decade, with a 1/3 allocation to alternatives. His success has encouraged two trends: First, fund managers aspire to bring Yale’s track record to all investors through the issuance of liquid alternative funds. Second, advisors look to emulate the ‘endowment model’, allocating large portions of portfolios to alternatives.

Alternative results

Recently, returns generated by alternative indexes have heavily underperformed a simple stock bond mix.  The green line on the chart below shows the risk/return profile an investor could expect from investing in a simple stock/bond mix over the past 5 years.  Any investment below this line underperformed, which includes all of the Liquid Alternative Indexes tracked by Goldman Sachs (LAI indexes).  Over 300 mutual funds are used to calculate the four indexes making them the best measure of average returns from liquid alternative funds.  The performance of these indexes has been miserable with 3 of 4 LAI indexes underperforming bonds with higher (some much higher) risk.  Also, pictured is the HRFI Index from Hedge Fund Research 2.  On average hedge funds have also produced poor results.

Chart source 3

Yale results are unobtainable

Unfortunately, running a $25 billion endowment is different than managing assets for individuals. Individual investors cannot meet minimums, which can exceed $5 million, pay taxes, have a greater need for liquidity and do not have access to the same managers. Perhaps most important is access. Yale is large enough to command a spot in any fund. Also, roughly 50% of Yale’s portfolio is illiquid, meaning that they could not readily sell their investments to raise cash 4.  Yale benefits from a premium in exchange for their willingness to sacrifice liquidity. Even when compared to other large endowments, Yale’s results are exceptional and nearly impossible to replicate 5.  Advisors who blindly follow endowment-like allocations have not fully understood the difference between running an endowment and managing taxable client portfolios.

Crestwood’s Asset Class Process

At Crestwood, our asset class review practices are critical to our investment process. We apply the same discipline to evaluating liquid alternatives as any other investment with a goal of improving client portfolios by reducing risks and improving relative returns.

Return and Risk Review

The first step in our review process is to analyze historical returns. Importantly, any strategy needs a return history long enough to be evaluated through a complete market cycle. Additionally, while diversification helps, a history of success is critical. Investing in diseased cattle provides excellent diversification, but loses money. Examining performance during the market crash of 2008 is helpful in determining how a strategy might perform in a challenging market. As long as a fund strategy remains unchanged, history provides a useful guide of what to expect in a variety of market environments.

Role in Portfolio

The second step of reviewing an asset class is understanding how it interacts with assets already in the portfolio. Assessing the risk level and risk characteristics of an asset class are important. For example, if we look at a balanced portfolio, we see that the vast majority of risk has historically come from equities. A common mistake in today’s low yield environment is for investors to add high yield bonds to portfolios to increase yield. The unintended consequences is you are essentially doubling down on equity risk as high yield bonds behave very similar to stocks during times of crisis.

Vehicle Review

For every asset class, we screen the universe of managers to ensure we are buying a quality manager who gives us access at a reasonable additional cost. We interview all our active managers to understand their process and historical performance. When possible, we invest in low cost index funds, particularly in asset classes historically hard for managers to outperform. We view fees as a headwind for performance and minimizing fees is a cornerstone of our investment process. Another important consideration as we evaluate vehicles is tax efficiency and, where appropriate, we prefer low turnover strategies, tax-free income and deferred capital gains.

Expectations

It is impossible to predict stock market returns over short time periods and trying to do so often leaves investors vulnerable to behavioral pitfalls. When reviewing an asset class we consider valuation an important indicator of long term returns but recognize it can mean little in the short term. Although we can’t predict future returns we do try and take a practical approach to framing our long term expectations using a variety of scenarios and probability weighting them accordingly. For example, when the stock market falls, we expect quality bonds to perform well and provide diversification benefits.

Are there alternative strategies that meet our criteria?

Yes, while a few strategies which rise to the top of our screening, most do not. Many funds lack a sufficient performance history making them a challenge to analyze. We are especially cautious of ‘go anywhere’ funds that rely solely on manager skill, as a constantly changing portfolio and evolving makes returns unpredictable and, sometimes, less tax efficient. In our opinion, many alternative funds fall into the ‘diseased cattle’ bucket and have an unattractive track record. Finally, high fees are a major deterrent adding to the hurdle rate of finding an appropriate manager.

Conclusion

Successful portfolio construction requires rigorous analysis of all investable asset classes including new and often exotic ones. Often times, the decision not to invest in an asset class is as important as the decision to invest. We focus on employing our disciplined process to evaluate asset classes and always strive to improve the risk/return profile of our clients’ portfolios. We keep an open mind towards new investments but remain selective. The recent poor performance of many alternative funds, suggests many investors have not been well served by many of the options within the asset class.

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Notes:

  1. Source Morningstar as of September 2016 includes Alternative and Commodity funds and ETFs
  2. HRFI Index is the Hedge Fund Research, Inc. Fund Weighted Composite through 9/30/16
  3. Source for Annualized chart above: Crestwood Advisors, FactSset, Returns are from 9/30/11 to 9/30/15. U.S. Bonds is the Barclay U.S. Bond Aggregate, Hedge Funds is the HFRI Fund Weighted Composite (USD) index, LAI Equity Long/Short is the Goldman Sachs (GS) Liquid Alternative Index, LAI Event Driven is the GS Liquid Alternative Event Driven Index, LAI Relative Value is the GS Liquid Alternative Index Relative Value, LAI Tactical Macro is the GS Liquid Alternative Index Tactical Macro, stocks are 75% S&P 500 / 25% ACWI x USA
  4. Yale Endowment 2015 annual report
  5. Results for Yale endowment are for the past 10 years ending June 2015 and the risk level used is the expected risk level on the portfolio.  Historical risk is not disclosed.

Crestwood Perspectives: Trump’s Impact on Investment Markets

Yesterday’s unexpected election result causes investors to wonder what can be expected over the next few years from a Trump presidency and a divided country. This election has been highly emotional and personal, leaving many of us bleary-eyed and uncertain about the future. The high level of emotion in this election is reflected in global stock markets, which initially sold off on Wednesday following Trump’s victory only to recover strongly as the day progressed. At Crestwood we know that emotions and investing don’t mix well. We try to look past the rhetoric to analyze potential long term outcomes of the election.

Uncertainty

Markets don’t like uncertainty and global stock markets initially sold off in reaction to Trump’s surprise victory. Adding to investors’ unease has been Trump’s avalanche of eye-popping rhetoric throughout the campaign. Trump wants to fire Janet Yellen, Chair of the Board of Governors of the Federal Reserve, tear up the North American Free Trade Agreement (NAFTA) and even suggested renegotiating the U.S. debt obligations. These comments are a small sample of his suggested changes that concern investors. With all of these comments long on rhetoric and short on details we are left speculating, for the moment, on how a Trump presidency will affect the markets. Continue reading

Implications of Populism

Why the anger? It’s the economy

One of the many notable characteristics of this unconventional presidential race is the broad-base populist uprising from both the left and right.  Across the U.S., pockets of workers are fed up with dead-end jobs and stagnant wages.  This anti-trade theme has resonated across both parties and will likely force changes in government policy, no matter who wins the election.

The primary cause of frustration is that workers across the U.S., especially those younger and less skilled, have faced falling standards of living since the Great Recession.  A McKinsey report 1 estimates that 81% of the U.S. population experienced flat or falling incomes from 2005 to 2014.  The report shows similar results internationally with over 65% of households in 25 developed economies facing flat or decreased real income during the same time period. This equates to over 540 million people worldwide whose quality of life has not improved, many of whom are voicing their anger in elections.  As we see in the U.S., these concerns are being integrated into both parties’ platforms.  One only needs to look at Britain’s surprise Brexit vote to understand that these ‘new’ political forces should not be taken lightly. Continue reading

Notes:

  1. Poorer than their parents? A new perspective on income inequality
    By Richard Dobbs, Anu Madgavkar, James Manyika, Jonathan Woetzel, Jacques Bughin, Eric Labaye, and Pranav Kashyap, McKinsey Global Institute, July 2016

Investing Through Recessions

The U.S. economy has now grown for 69 straight months, making this the sixth-longest period of economic expansion since the 1850s. The stock market has climbed apace—albeit with plenty of volatility along the way.

Still, the law of gravity hasn’t been repealed. Economic growth and contraction have always alternated, and at some point we’ll experience a recession. That, of course, will impact stocks.

Recessions’ Toll on Stocks 

Recessions are defined as periods in which Gross Domestic Product—a measure of trade and industrial activity—shrinks for two successive quarters. Slowing economic activity typically coincides with lower corporate sales, earnings and profit margins, higher unemployment, as well as higher levels of bankruptcy. Typically, equity indexes will fall in advance of and during a recession. Often a bear market, a period when stock prices drop by at least 20%, and a recession, will overlap one another. Continue reading

Quality Bonds: an Underappreciated Role in Portfolios

Stock markets across the globe fell sharply during the first few weeks of 2016. After years of strong stock market performance, downturns like these remind investors of the importance of diversification and disciplined portfolio construction. Even though interest rates remain near historic lows, bonds remain an important part of this diversification as adding them to portfolios lowers volatility (i.e. risk). Historically, high quality bonds, that is those with lesser credit risk, proved an important source of diversification during periods of equity market stress, offering lower correlation while their lower quality brethren tend to have returns more highly correlated to stock market returns. Lower quality bonds imply greater credit risk, which is the risk of not getting paid because the issuer goes bankrupt.

Whenever the outlook for the stock market is threatened, investors will sell risky assets to buy safe investments. This ‘flight to quality’ behavior is a well-known herding reaction to bad news. Historically, owning high quality bonds provides a diversification boost during periods when portfolios need it most. At Crestwood, we include high quality bonds in portfolios to provide a ballast against equity risk which helps to offset periods of stock market stress.

Despite these attractive qualities, concerns over lower expected returns and potential interest rate increases have reduced the appeal for quality bonds. Unfortunately, the near historically low current yields for bonds is suggestive of low future returns (see Perspectives 5/1/15). In addition, the Federal Reserve is on a path to reduce their aggressively stimulative policy of near-zero interest rates. In December 2015, they increased the federal funds rate for the first time since 2006. When interest rates rise, bond prices fall, because most bonds have fixed interest payments and higher rates make these fixed interest payments less valuable. So, not only are lower returns expected, but depending on the pace of future increases in interest rates, it is possible that returns for some bonds could be negative. Continue reading

Profiting from an Emotional Market

The human race’s evolutionary wiring is a marvel: it has enabled us to avoid predators, feed ourselves and thrive in even the least hospitable parts of the planet. Unfortunately, the same wiring has made humans struggle as investors. Following age-old impulses of fear and greed, our species consistently behaves in a manner that often reduces our investment returns.

Ironically, our tendency to commit behavioral errors provides opportunity for disciplined investors to perform better and helps to inform Crestwood’s investment process. Crestwood’s investment process seeks to outperform the market over a full market cycle – with less volatility – by understating, and avoiding, common behavioral errors in the market. Indeed, our investment approach is designed to take advantage of the predictable, self-defeating behaviors of so many market participants.

Behavioral Finance 

Let’s look at a small sampling of the many innate hurdles to successful investing that typical investors must contend with:

Overconfidence: Investors systemically overestimate their knowledge and their ability, and the results can be unpleasant. In 2014, the S&P 500 index returned 13.7%–but the average equity mutual fund investor earned just 5.5%, according to research firm Dalbar. The discrepancy is explained by investors’ well-documented tendency to sell low and buy high. Additionally, high rates of “turnover”—holding investments for a short time, and then dumping them to buy others—demonstrates overconfidence that one investor knows more than others, even though historically low-turnover portfolios have outperformed high-turnover portfolios.

Continue reading

The Case For Owning International Stocks

Recent headlines from overseas have been grim: Debt-wracked Greece is struggling to avoid economic collapse, while slowing growth and rampant speculation has triggered a plunge in China’s stock markets.

For many, the bad news will reinforce a perception that investing beyond our shores is to be avoided. The fact that the S&P 500 has beaten international stocks since bottom of the market in 2009 seems only to reinforce the argument for keeping one’s money home.

Annualized Stock Returns by Region
3/31/2009 to 06/30/15
S&P 500                             20.2%
International Developed       13.3%
Emerging Markets                13.9%
Source: Crestwood Advisors, FactSet, MSCI and Standard and Poor’s

Continue reading

Life in a Low-Return World

Many believe that we’re living in an environment of perpetually slower economic growth and potentially lower investment returns.

Due to a variety of factors, investment returns may be below what investors might have reasonably expected not long ago. However, investors’ desire for returns hasn’t changed and, as a result, many are grappling with how to achieve higher performance in more modest markets.

“Macro” factors

Investment returns are heavily influenced by “macro” factors, which are more universal than, say, the sales results of a particular company. These “macro” factors may help explain why we may be in an era of lower investment returns. Continue reading

Caution: Diverging Monetary Policies & Volatility Ahead

2014 Wrap up:

While the rapid decline in energy prices dominated headlines as 2014 ended, the U.S. stock market turned in a 6th consecutive year of positive returns with the S&P 500 up 13.7%, outperforming most major international benchmarks. Despite a third consecutive year of double digit returns, there was a defensive tone to U.S. equity returns, as the best performing sectors were utilities and health care, while cyclical sectors like consumer discretionary and industrials trailed. The energy sector was the only group posting negative returns for the year, declining 7.8%.

Driving U.S. equities higher was improving economic growth, something that’s been lacking for some time. U.S. GDP for the 3rd quarter grew 5%, the highest rate in 10 years, and revenue and earnings for the S&P 500 came in at 4% and 8%, respectively. We’ve also seen a meaningful decrease in unemployment, with close to 3 million jobs added last year, bringing unemployment below 6% for the first time since 2008. Continue reading