Alternative Investments

By Bob Marshalla

April 9, 2003

Is There Anything Else?

With the stock market having declined three years in a row, and most pundits anticipating that bonds and real estate will have a hard time repeating their recent run of success, it is reasonable for investors to ask, is there anything else? In other words, are there any other types of investments or investment strategies that might enhance the risk-return performance of our investment portfolios?

This is a good question, and it is one I have been pondering ever since starting work in the investment advisory business. Over the years I have gone down numerous interesting avenues in search of alternative investments, but to date have come up short of finding anything I want to invest my money in or my clients’. Keep in mind; to actually make an investment, we have to find both a worthwhile investment class and a worthwhile investment product by which to access the asset class.

One class of alternative investments that I have been studying pretty carefully for the past year-plus is hedge funds or “absolute return strategies”. I have some optimism that I will eventually be able to find a good entry vehicle for our client portfolios. If so, clients will need to understand and feel comfortable with such a new investment class, and in fact, the purpose of this article is to begin the educational process about it.

But before getting into hedge funds specifically, some more general background is advisable. Why should we be interested in looking for alternative investments in the first place?  What kinds of alternative investments are available? And, what kinds of problems keep investors like us on the sidelines even when the investment classes themselves may look interesting? After addressing these questions, I will shift gears and focus specifically on hedge funds, first describing their investment rationale and defining characteristics, and then summarizing the status of my own search for specific investment vehicles for our portfolios.

The Rationale for Alternative Investments

First of all, why bother with alternative investments of any kind? Are they potentially the antidote for lousy recent stock market returns?  With perfect hindsight, I’m sure we could have found some kinds of alternative investments that would have bettered the stock market’s dreadful run of the past few years. But the relevant question is, do alternative investments offer the expectation of higher returns in the future than traditional equity market investments? And the answer to that is “probably not”, at least not without taking inordinate risks.

If alternative investments are not the savior, then why bother with them? The real reason has to do with their potential effects on the risk-return profiles of our overall investment portfolios. If the new investment class has very low (or God help us, even negative) correlations to our more conventional investments, then we can construct a new portfolio that has less risk or higher expected return, or some combination of the two, than our original portfolio.  In other words, we could decrease the year-to-year volatility of the portfolio with no sacrifice in long term compound annual returns. Or, we could increase our portfolio’s expected returns while maintaining its original level of risk.

It may not be obvious at first, but the possibility of increasing the portfolio’s returns does not depend on the alternative investment class itself having higher expected returns than equities or of the original portfolio at large. The higher portfolio returns would result from the ability to increase our allocation to higher yielding, more volatile investments, like stocks, at the expense of the lower yielding, more stable investments. The increase in portfolio volatility owing to this move alone would be compensated for by the addition of the lowly correlated alternative investments, thereby keeping the portfolio volatility constant.[1] In investment science jargon, we would be moving the efficient frontier for investments upward and to the left, as illustrated in Figure 1.

To summarize all of this in simpler terms, the key to achieving benefits is finding positive returning alternative investments that tend to “zig” when our other investments “zag”. The benefit will be a portfolio with a smoother ride, or higher returns, or a combination of both.

Types of Alternative Investments
What do we mean by alternative investments? While we tend to focus our attention on conventional equities, bonds and real estate, there are many other kinds of investments. Some of them include the following:

   Commodities and managed futures

   Gold and precious metals

   Collectibles and art

   Direct real estate ownership

   Private equity and venture capital

   Oil and gas royalty trusts

   Partnerships that own hard assets like transportation equipment

   Hedge funds or absolute return strategies

The last of these, as I said, is the leading topic of this article, and it is worth pointing out in advance that the hedge funds classification refers to a long and diverse list of sub-strategies that will be summarized later in this article.

The Problems With Alternative Investments

While some of these investments look interesting in theory, the available investment products or vehicles are generally beset by at least some of the following serious problems:

   High investment minimums

   Low diversification (sometimes a product of the high investment minimums)

   Very high investment costs (relative to typical mutual fund fees)

   Meager long run expected returns[2]

   Lack of liquidity

   Opaque investment approaches (managers are not always required to explain exactly what they are doing, even to their own investors)

   A need for unreasonably large amounts of due diligence and subsequent oversight

   Unverifiable manager track records and ethical standards

   Difficulty in measuring and/or verifying investment returns, volatility and other sorts of inherent risks[3]

   Low or no regulatory safeguards or oversight

Unfortunately, for investors like us, these sorts of problems tend to overwhelm the potential benefits for most alternative investment classes.

Hedge Funds – An Emerging Possibility

Until recently, hedge funds were no exception. They suffered from all of these problems to varying degrees. But alternatives have now begun to emerge that may (and I stress “may”) provide us with suitable entry vehicles for this class of investments. As a result, I will provide some basic information about hedge funds, and conclude by summarizing the status of my research into finding suitable investment vehicles for our own portfolios.

Hedge funds are limited investment partnerships that are largely unregulated by the SEC. Like conventional mutual funds, they typically hold stocks, bonds and related securities, but unlike conventional funds, the managers are allowed enormous freedom to pursue the investment strategies and trading tactics of their choice. While these strategies are varied, they have come to be grouped under the common label of “absolute return strategies”, which means, in theory, their returns should be judged on an absolute basis, and not relative to the returns of common stock or bond markets.   

Hedge funds may be largely unregulated, but they are no “fly by night” investment scheme. There currently exist more than seven thousand hedge funds, controlling $650 billion in investor assets, and these numbers are growing rapidly. Hedge funds have heretofore been the province of very wealthy individual and institutional investors. In fact, I suspect a good part of their appeal lies with the cachet of being included in an insiders club with the rich and famous. Investment minimums have typically been in the $1 to $5 million dollar range, and in fact, most hedge funds are limited by law to accepting only a limited number of “accredited” (i.e., wealthy) investors. In addition, money managers love and aspire to run hedge funds because they offer the managers far more flexibility, less regulation and, most importantly, much higher fees than they can earn than with traditional investment vehicles.

At least two factors have converged in the past couple of years to greatly increase the appeal and promotion of hedge funds, particularly to a somewhat less affluent crowd than their traditional clientele. One is the poor recent performance of equity markets world wide, which has caused investors to search for alternative investments. By one benchmark, hedge funds on average have produced positive single digit annual returns over the past three years[4], while the S&P 500 has suffered losses averaging 14% per year. The other factor giving rise to hedge funds increased popularity is the advent of new types with investment minimums as low as $25,000 to $50,000, which has made them more accessible to the “semi-affluent” investor class.[5]   Furthermore, these new low investment minimum products tend to be “funds of funds” products, rather than individual hedge funds. This means the investor buys into a collection of hedge funds, selected and monitored by the product’s sponsor, rather than just one at a time. And finally, a few of these new products (about a dozen at last count) have been registered as closed-end funds under the Investment Company Act of 1940, which at least subjects them to some regulatory standards. Thus, three of the alternative investment problems in the list above, high minimums, low diversification and no regulatory standards, have now been at least been partially addressed by the hedge fund industry.

What Do Hedge Funds Do?

As an investment class, hedge funds cover such a broad range of strategies and purposes, that it is hard to define them succinctly. While they are usually based on stocks and bonds and related securities (like convertibles), they employ unconventional trading strategies such as shorting, arbitrage, use of derivatives and leverage. Further, they may invest in distressed securities that most mutual fund managers would not touch. This may sound scary, and for some of the more aggressive hedge funds it is[6]. In fact, we might divide the hedge fund world into two types by objective: return enhancers and portfolio diversifiers. Return enhancers are the kind that are focused on making huge returns regardless of the risks involved. In contrast, portfolio diversifiers are designed to provide a hedge against the volatility inherent in conventional investments. For these funds, the word “hedge” really is the operative word. Used judiciously as part of a diversified portfolio, they should in fact dampen, not amplify, your overall portfolio volatility. These are the only kind of hedge funds that I am considering for our portfolios.

Such funds have the following goals:

1.      Attractive absolute returns (variously stated as “more than T-bills”, on up to “approximate equivalence to long run equity market returns”)

2.      Low volatility (typically no more than general bond funds’ volatilities)

3.      Very low correlation to equity and bond markets (ideally, near zero)

The third of these goals is the most important, since it is the necessary condition for these investments to improve our portfolio’s risk-return profiles.

Hedge funds with these goals are often called “absolute return strategies” because they seek to generate positive returns in all types of market conditions. The thesis is that the returns achieved should be judged on an absolute basis, and not relative to the equities or bonds markets’ prevailing returns.

Hedge Fund Sub-Strategies

Hedge funds comprise a long and diverse list of sub-strategies. These strategies range from very risky (such as using leverage or making big “global macro” bets) to very conservative (such as using covered call writing tactics). Some are potentially quite lucrative, while others are designed simply to eke out small, but nearly “sure thing” gains using arbitrage tactics. All tend to go in and out of fashion over time, but not necessarily in any relationship to how stock or bond returns go up and down. A list of some of these sub-strategies is the following:

 

   Long-Short and Market Neutral – Managers buy some stocks long, while shorting others. Returns depend largely on the relative performance of the longs versus the shorts, rather than on the direction of the market[7]. Market neutral is the pure form of long-short, in which longs and shorts are carefully balanced so that the fund’s beta to the stock market is as close to zero as possible.

   Event Arbitrage (Mergers) – Arbitrage applied to the occurrence or non-occurrence of some future event, most commonly corporate mergers and acquisitions. E.g., if a fund manager believes an announced or rumored merger will in fact be completed, he may go long on the stock of the company being acquired while simultaneously shorting the stock of the acquirer. Current stock prices seldom reflect the certainty of a merger, so if the managers’ judgments are correct, they reap an arbitrage gain when the merger succeeds.

   Security Arbitrage (Convertibles, Fixed Income) – Arbitrage strategies tied to the specific features of convertibles, bonds or other securities. E.g., a convertible is a security that initially pays interest like a bond, but which is convertible into common shares of the issuing company above a certain stock price. By monitoring for inefficiencies in the relative market prices of the convertible and the respective common stock, the investor can often earn a small arbitrage profits by going long on one security while shorting the other.

   Derivative Strategies – A broad collection of strategies related to use of calls, puts, futures and other derivative securities. A very conservative version is the writing (i.e., selling) of covered calls (i.e., calls on securities for which the manager already has long positions). This strategy increases investor returns in down or fairly level markets, at the cost of giving up big returns in up markets. This category also includes some extremely aggressive, high risk strategies, but these are not included in my search domain.

   Distressed Securities – Investing in the equity and debt of companies in severe financial distress, including bankruptcies and reorganizations. Sometimes the managers are big enough players to influence the proceedings themselves. These are the most inefficient of markets, wherein specific knowledge can really pay off -or mistakes backfire- big time! Distress investors are the ultimate value investors.

   Global Macro – An extreme top-down approach in which managers place big bets on anticipated global financial, economic or political trends or events. This can include plays on currencies, inflation or interest rates, as well as the economic recovery or collapse of certain countries or regions.

   Dedicated Short Bias - Strategies based entirely or primarily on short positions in stocks. Clearly such sub-strategies should have negative correlation to the overall equities markets, but will be no less volatile or risky in and of themselves. 

   Long-Only Leveraged Equity – Strategies based on buying equities long, much the same as a conventional mutual fund manger, only adding leverage (i.e., debt) to increase the exposure to the market per dollar invested. Clearly neither this nor the previous strategy would qualify in and of themselves as “absolute return strategies”, nor would they exhibit low volatility. But combined with other sub-strategies, a hedge fund manager can theoretically achieve both objectives for the overall fund.

Absolute Return Investments for MAM Portfolios

Absolute return strategies offer some intriguing possibilities for our own portfolios. But in addition to overcoming the more serious problems listed earlier, we must be sure they are truly structured for generating modest absolute returns, as opposed to the kind that are shooting for huge but speculative payoffs. As such, it is unlikely that the last three sub-strategies above, or the more aggressive of the derivative strategies, would be meaningfully represented in any choices we may make.

If we do decide to utilize absolute return strategies, I would classify them as a new top-level asset class, viewed at the same level as equities, real estate and fixed income. As such, I would envision initially allocating from 5% up to 15% of interested clients’ overall portfolio assets to this class. Again, this is not something I would do without first consulting with the client.

Over the past year and a half or so, I have been evaluating various ways for us to take advantage of absolute return strategies. In theory, the fund-of-funds concept should be the most attractive because of the diversification and extra layer of due diligence that it offers compared to investing in one fund at a time. However, these benefits come at a cost, which is a cost on top of the already high cost of the underlying individual hedge funds. Hedge fund managers typically charge clients 1% of assets, plus an incentive fee of 20% of the profits they generate[8]. In addition to these costs, the managers of the fund of funds tack on their own fees for assembling, monitoring and managing the collection of hedge funds. These extra fees may include an additional 1.0% to 1.5% of assets, plus another 10% of the profits. So overall the investor could be left paying on the order of 2% of assets plus 30% of gross profits. In such a fund, if the gross return earned was 12%, the fees would amount to 5% and investors would be left with only 7%! In fairness, some of these products are a little less expensive than this, and at least there is no incentive fee to pay in down years. Still, the overall expense level of these products is not to be taken lightly.

Another issue with the fund of funds products is the range of funds and sub-strategies they employ.  It seems to me the typical fund of funds includes too many hedge funds but not enough sub-strategies. Funds of funds are usually comprised of 15 to 50 individual hedge funds, which is probably more than necessary. On the other hand, some of them are limited to using only one or two of the sub-strategies discussed above. Unfortunately, products I examined from two of the more reputable management companies suffer from just this problem. They are basically a collection of long-short funds. The long-short strategy seems to be the favored strategy these days, but I’m not yet convinced we want to place all of our alternative investment dollars on just this one strategy. And to be worth the extra cost of having a fund of funds, I would like to have exposure to a number of different strategies.  

A third issue is the lack of transparency about the particular strategies employed by the managers, and about the long-term track records of the managers and funds themselves. An amazing feature of the hedge fund world is that the hedge fund managers do not have to disclose exactly what they are doing with their assets, even to the actual investors in the fund! As for track records, there is plenty of data out there, but due to the lack of regulation and disclosure requirements, it is not always very reliable. Much of it is self-published. There do exist various third party evaluation sources, but they seem to be geared to institutional and other large scale investment organizations. Taking advantage of some of them could be very time consuming and expensive for an independent investment advisor.

An alternative to a finding a ready made fund of funds is a “build our own” approach. Because of the investment minimums and high costs outlined above, assembling one’s own collection of actual hedge funds is probably not practical. But another intriguing possibility that I have been considering is assembling a set of conventionally registered mutual funds to the same effect. I have found that there exists a small number of special purpose mutual funds that pursue some of the same strategies pursued by hedge funds, at least to the extent their more stringent regulatory structures allow. And since these are registered mutual funds, they operate under all of the same disclosure requirements that conventional mutual funds must observe. They are regularly evaluated and reported upon by the usual third party evaluators like Morningstar and Value Line. Their costs, while on the high side relative to conventional mutual funds, are still much lower than we would pay in a fund of funds since there are no performance fees and no fund of funds manager fees involved.  Some of these (like the Merger Fund and Calamos Market Neutral) have even been in existence for over a decade. And a handful of them have generated very good results over their lifetimes.

The main drawback to the “build our own” approach is that the range of strategies and managers available to choose from is far smaller than in the hedge fund world. While there are over 7,000 hedge funds, there are only a couple dozen or so mutual funds that specialize in these strategies, and some of those are currently closed to new investors. There is also the added burden of the investment advisor (yours truly) having to fill the role of the fund of funds manager. While this does not create a direct cost for clients under MAM’s fee structure, it does entail the opportunity cost of using up some of the my research time.

In conclusion, there does not currently appear to be a dominant alternative for taking advantage of absolute return strategies, and none that I am comfortable enough with to recommend for investment at this time. But I am continuing the research, and I remain somewhat hopeful that I will come up with something eventually. The benefits of an enhanced risk-return profile for your investment portfolio could be well worth the effort. 

For anyone who is interested, I would be happy to discuss these topics in person and/or to provide references to other sources of information. Please, just give me a call.