They say all the world loves a clown. That may be true, but one thing I know that is even truer is that all the world currently hates alternative investments.
We have been using alternative investments—securities that don’t fit neatly as either stocks or bonds—for the last seven or eight years. Over most of that period, the returns aren’t bad. They’ve generally been better than the bond market, but certainly below the types of returns we expect. Lately, however, returns from alternative investments have been quite poor.
Add to this that these investments often come with high fees, are generally tax-inefficient, may be liquidity constrained, and many of the strategies are difficult to understand. That’s a recipe for unhappy clients (ask me how I know).
Yet, despite recent performance, these investments continue to make a lot of sense.
First, they offer a tremendous diversification benefit. The correlation of returns between stocks and alternative investments is quite low, which means their returns move in different patterns. So, if stocks rise or fall, it doesn’t necessarily mean that alternative investment returns will do the same. A couple of the funds we use can be defensive when the stock market falls, but most of the funds offer returns that are largely independent of the stock market.
Also, the expected returns, which cannot necessarily be inferred from the returns of the last couple of years, are quite attractive. Many of these investments offer long-run expected returns in the high single-digit range. Some, like our private real estate investments, have done even better. While returns generally should be below that of the stock market, they should be well in excess of the bond market. With the 10-year Treasury bond yielding less than 3%, the outlook for bond returns is not great. Alternative investments offer a compelling way to control the risk of the stock market, but with long-run returns that should exceed that of bonds.
As for recent performance, I’ll point you to the nearby article on risk and reward (“Should I Stay or Should I Go”). Every investment, even bonds, has the ability to lose value over certain periods. High-quality bonds lost almost 13% from July 1979 through February 1980. That was followed up by a loss of 9% between June 1980 and September 1981. They subsequently went on to earn very significant returns over the next five years, during the Paul Volcker era at the Fed.
With any investment, there is a chance that you will lose money over shorter time periods. However, all the strategies in our alternative portfolio have been well researched, and have long histories of positive returns over time.
It may be hollow succor, but it isn’t just us. The entire alternative investment industry has experienced unsatisfactory returns the last couple of years. In fact, the returns for the HFRI Fund Weighted Composite Index were down more than 4% in 2018. That isn’t a great benchmark for how we are investing, but it is an industry-standard way of measuring alternative investment returns.
There’s an old saying that the markets can remain irrational longer than you can stay solvent. We don’t take the types of risks that will result in insolvency, but the point is that we can’t tell you when the returns will improve for our alternative funds. We’re hopeful that the environment is changing currently, but no one knows what the future holds in the capital markets. Despite what the near-term future may hold, we still believe strongly in the diversification benefits and long-term return potential of an allocation to alternative investments.
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