As a follow up to my snarky reaction to Don Phillips’ editorial, I thought it might be helpful to share a few thoughts about what my experience tells me regarding just why people invest in alternatives.
First let me admit that I’m no psychiatrist and I don’t profess to understand the human condition any better than anyone else. But I will also say that I have been at this a long time, seen a lot of things, and read a pretty tall mountain of research about why people make the investment decisions they do.
As I mentioned in my previous post, alternatives are sold, not bought. What that means is that no one calls up an alternative investment firm and asks to buy their product. Instead, these strategies are sold by the investment community as essential pieces of a wealthy person’s diversified portfolio. And there are three very important words in that sentence.
Essential: when someone “knowledgeable” tells you something is essential, you believe them. Essential is a powerful word, and we all assume those using it have thought about whether it’s the right word or not. But instead of pushing back and asking just why alternatives are essential to have, folks take an investment professional at his/her word.
Wealthy: yes, I said it. It’s the wealthy (and the institutional investors like pension funds, endowments, etc.) who are vulnerable to getting sold alternatives. Not because they are any different on the human gullibility scale than anyone else, but because they are the only ones legally allowed to invest in them for now. To own alternatives you must meet certain wealth or asset requirements. Why? Because the regulators think more affluence equates to either an ability to do better due diligence, an ability to take more risk and suffer greater loss, or both.
Diversified: here’s the kicker for sales people. The real allure of alternatives is ostensibly their uncorrelated nature, and it’s this uncorrelated characteristic that makes them “essential” for a “diversified” portfolio. The argument is that if these investments are zigging when the rest of your portfolio is zagging, you’ll be better off. While that is solid investment advice for the most part, it’s been distorted by the sales people and used to sell all kinds of things, alternatives being probably the worst example.
So how can being more diversified be bad? It’s called di-worsification and I’ve spoken of it before. Yes, you want to combine assets that are lowly correlated to each other, but you know what asset class is lowly correlated with everything? Cash. Guess what kind of return cash gets you. Bubkus. Squat. Do you want to throw a bunch of that in a portfolio that is trying to grow? Of course not. So lowly correlated isn’t all that useful if it doesn’t offer growth characteristics, too. Ideally you find assets that are lowly correlated but both can generate growth for the portfolio. Unfortunately, many alternative strategies offer low correlation but not nearly the return characteristics ideal for an investment portfolio with any kind of a reasonable growth objective.
It happens all the time, subordinating growth to lowly correlated to such a point that the entire portfolio’s performance is dragged down. Alternatives generally fall into one of two types: lowly correlated to traditional asset classes but also low return and cash-like (think relatively safe) or variably correlated with returns all over the place (think risky). Most of the time, though, they are all sold as uncorrelated and diversifying, and to most it works.
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But with alternatives, the sales people don’t get into the details even though that’s where the devil is. If they did, they’d tell you their returns have been horrible, that their correlations tend to spike at the worst times (nullifying their main selling point), that they self-report returns which throws everything into question, that they come with high costs, greater manager risk, low or no liquidity, zero transparency, and for taxable investors – an extremely high tax footprint. Not to mention the difficulty of doing manager due diligence to figure out whether or not they can replicate performance or stay on the right side of the law (just Google SAC Capital, Raj Gajaratnam, or Bernie Madoff to see what I mean).
Getting back to the main question, though, why do people invest in alternatives?