Monday, June 2nd, 2014
raw material

If I tallied all of my words during the last year, a good percentage would concern the burgeoning retail alternatives businesstjb | This is the gateway to my sites (and you can find a link to my ebook there too). — and that hot area has shown up in my work with consulting clients and networking with investment decision makers at a variety of organizations.  Plus, it serves as a stellar example of the migration of ideas across what I call “the investment ecosystem” (more about that concept in coming weeks).

The alternatives meme has grown into a generalized and often ill-defined need for exposures that are “not bonds” and “not stocks.”  There are debates about how much to have in alternatives — as if “alternatives” were one thing — and whether a retail investor should have any exposures to them at all or quite a load.

Alternatives are most assuredly not one thing.  A range of strategies that have been available to individuals for years can now be found under one big conceptual umbrella with the white-hot “liquid alts” — funds issued under the 1940 Investment Company Act that utilize strategies previously unavailable in that format (which allows investors to purchase and redeem them easily).

The goal in using alternatives is — well, that’s a matter of some debate and quite a bit of confusion.   “Uncorrelated returns” is a common answer, but not all things alternative are necessarily uncorrelated with stocks and bonds (and yesterday’s correlations aren’t tomorrow’s anyway).  Some folks think that alternatives provide higher returns than traditional asset classes, others think that they lower risk, while some believe you can get both.  Being clear about your expectations is a good place to start.

Then, will these vehicles live up to your expectations?  Of course, don’t rely on historical return numbers (or correlations) for your proof, especially since many of the vehicles haven’t been around very long.  And make sure to read the footnotes, since the performance you see in promotional materials might be backtested rather than real.

When it comes to analyzing the investments themselves, I’d say start simply.  What is the raw material being used?  Commodities?  Private equity or debt?  Or the very same stocks and bonds that you’re trying to avoid?  Any and all of the above, among other things, might be the proper answer.

Yet individuals, advisors, and, yes, even institutional investors think about the performance stew in abstract terms rather than being very aware of the ingredients and how they interact.  The vehicles have become the numbers, just like with more plain vanilla strategies.

But they aren’t plain vanilla at all.  What is the raw material?  That’s what you have to work with and managers can only do so much with it.  Defining it up front helps you think about what happens next.  What alpha are you expecting the managers to provide?  How?  What is the role of leverage?

If you reduce a vehicle — to say nothing of a category — to some past performance characteristics or some vague expectations, you don’t have nearly as good a chance to understand what might go right and wrong in the future.

Somehow alternatives managers are expected to produce alpha when it seems like it’s nearly impossible for other managers to do it consistently.  And we expect them to apply leverage in a productive fashion and to capture the benefits from illiquid investments without suffering from the hazards of them.

That hoped-for expertise will have to offset the generally hefty fees and embedded transaction costs of the alternatives — or at least to produce a risk/return profile that can’t be created via some relatively simple and less expensive strategy.

But first things first.  The vehicles need to be demystified and to be taken apart and examined.  That’s certainly true for multistrategy funds, which are beyond the understanding of a very large percentage of the buyers and their advisors, but it’s also the case for more simple strategies.

An equity market-neutral fund is made up of equities.  Alternative fixed income is, well, fixed income.  The possibilities are bounded by the raw material that is used.  Start with a good understanding of that; then you’ll get a better sense of the alchemy that is being proposed.