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[ref]Source Morningstar as of September 2016 includes Alternative and Commodity funds and ETFs[/ref]. 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.
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[ref]HRFI Index is the Hedge Fund Research, Inc. Fund Weighted Composite through 9/30/16[/ref]. On average hedge funds have also produced poor results.
Chart source[ref]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[/ref]
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[ref]Yale Endowment 2015 annual report[/ref]. 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[ref]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.[/ref]. 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.
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.
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.
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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