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Abandoning alternative investments at this point is based on twisted logic

Just because your house hasn't burned down yet doesn't mean you can skip insurance

Jun 17, 2015 @ 11:16 am

By Jeff Benjamin

As contraindicators go, things are starting to stack up in favor of alternative investment strategies.

After a half-dozen years of charging full speed ahead into the alternatives space with all manner of impressive-sounding products and strategies, a lot of investors, along with much of the asset management industry, are showing signs of exhaustion.

Last week, SkyBridge Capital announced it was launching plain-vanilla mutual funds rather than trying to export alternative strategies into a mutual fund format.

The main reason the firm gave was the “mixed performance” of existing "liquid alts" products.

Then there's the report due out next week from Invesco Consulting, which will encourage asset managers and advisers to take a fresh spin on alternatives. A key recommendation is using less industry jargon and more basic language that describes how each alternative investment is expected to perform under various market scenarios rather than exacerbates alts' complexity with nondescriptive buzzwords.

“Our research found that nearly eight in 10 investors would rather invest in alternative mutual funds bought and sold like any other fund than liquid alternatives, yet they are the same thing,” said Scott West, a managing director and the head of Invesco Consulting.

It's not that the products, generally described as liquid alternatives, haven't been catching on, it's just that the strategies have proven to be ahead of their time. For the asset management industry, this is often described in technical terms as a bloody nightmare.

Across seven subcategories tracked by Morningstar Inc., the liquid alts mutual fund universe has grown to 435 funds and nearly $320 billion under management. That compares to 163 funds and $73 billion in AUM at the end of 2009.

In the mutual fund arena, liquid alts have been the fastest-growing category throughout much of the bull market for stocks. The trouble is, as the liquid alts category has swelled, the stock market has refused to take a breather. It is during a bear market when alternative strategies would strut their stuff and prove to investors that the higher fees are worth it.

Even this year, an admittedly weak period for stocks that has seen the S&P 500 gain less than 3%, the best-performing alternative strategy mutual fund category, long-short equity, is up just 1.4%.

As a fund category, long-short equity lagged the S&P every year since the category was created by Morningstar in 2010.

Most years, the performance comparisons weren't even close. The category's best showing relative to the S&P was in 2013, when a 14.6% gain added up to almost half the S&P's 32.4% gain.

Last year the category gained 2.9%, compared to the S&P's 13.7%.

In response to performance comparisons such as those, the alternative investments industry will rightly point out that alternative strategies are doing exactly what they're supposed to be doing, which is reducing downside risk by acting as diversifying portfolio insurance.

But after six years, that insurance story is getting stale and investors are getting restless and skeptical, having gone this long without a chance to see the risk protection in action.

Even the so-called smart money represented by big pension funds is starting to lose faith, according to a story Wednesday in The Wall Street Journal.

Citing the relative underperformance of alternative investments in pension portfolios, Jim McKee, the head of hedge fund research at Callan Associates, described the last five years as “disappointing for pensions invested in hedge funds.”

The irony to all this is that we're talking about abandoning alternatives at a time when such portfolio insurance arguably makes more sense than it has at any time since the financial crisis.

We're closing in on four years since the last time the S&P 500 corrected by 10% or more, and it's been more than six years since the market corrected by 20% or more. The S&P did pull back by 19.4% in the middle of 2011.

It is easy and usually fun to pontificate about “new normals” or endless prosperity, but we usually get knocked back down to earth right about the time we start believing that stocks just go up and up.

The CFA Institute dumped cold water on the endless prosperity theory earlier this month with the results of a survey of financial professionals.

About a quarter of the respondents see a 50-50 chance of a global financial crisis unfolding within the next five years, and another 20% of respondents peg the odds at 75% or better.

In the context of the current market cycle, (and listening to the Federal Reserve, which continues to hint at its first interest rate hike in nine years), it just seems counterintuitive to abandon strategies that are designed to hedge risk.

It's really no different than arguing against having homeowners insurance because your house hasn't burned down since you bought it.

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