Alternative investments
From time to time alternative investments come to the fore as potentially better places to invest than the equity, bond or property markets and arguments are put forward that "smart" investors, in the spirit of diversification, should be looking at "alternative" asset classes.
While there is no argument that diversification is a key investment principle, many investor’s idea of what constitutes an "asset class" is rather open-ended.
Recently the media has espoused the attractions of managed fund futures, commodity derivatives, foreign exchange speculation, stamp and wine collecting.
Some people get lucky betting on currencies, commodities or horses, but in our view this is speculation, not investment. That is because the relationship between risk and return in these areas is hazy at best.
Commodities, for example, were being promoted as the asset class du jour, a chance to ride the so-called "commodity super cycle" driven by the rapid emergence of China and India in the global economy.
At first sight, commodity investments seem to have some interesting investment characteristics. However, they are totally reliant, in terms of price performance, on what the next man will pay for them. There may be a risk premium embedded in them, but it is far from clear as to what extent this has evaporated with the rush of money into the “asset class”.
That is to say that the delicate balance between hedgers and speculators can be easily unbalanced, and hot money chasing risk premium, in this case, can cause the risk premium to no longer exist.
Analysis in 2004 1 found the average excess return from commodities is not reliably different to zero. There is also little evidence to support commodities' reputation as a diversifier and inflation hedge.
Likewise, there is little argument among academics that betting on currencies is not an optimal way to produce asset growth. Currencies provide no future cash flows and do not generate any underlying earnings.
There are also substantial risks in speculating in foreign exchange, a market that is extremely volatile and highly unpredictable. Even the venerable former chairman of the US Federal Reserve, Alan Greenspan2, has described the task of predicting currency movements as no better than a coin toss.
Among the other alternatives currently in vogue are managed futures. These are instruments that create an opportunity to speculate on "trending" markets, those exhibiting signs of upward or downward momentum.
The trick for these fund managers is to pick the turning of the trend. Naturally, they all claim to have a reliable proprietary model for doing so, but if it is so easy to time the market, why isn't everyone doing it?
Collectables such as wine, antiques or rare stamps are often seen as attractive alternatives, but success here usually requires an encyclopaedic knowledge, passion and patience far beyond the capacity of most of us.
Collectables are also extremely illiquid, generate no income, are expensive to trade and are subject to fickle fashion. That is not to deny that there is innate pleasure in pursuing these hobbies. We would just argue that there is no case for building a long-term investment strategy around them.
In Australia, regulators3 have warned investors about the dangers of investing in so-called "alternative" assets, particularly those that are irregularly priced, illiquid or where returns bear little relationship to the risks undertaken.
The Australian Prudential Regulation Authority sees a risk of a "race to the bottom" as investors chase limited opportunities in alternative assets, where there is an "inappropriate level of reward for the risk taken".
This is the primary point for anyone considering a so-called alternative investment. What risks are you taking and to what extent are the risks commensurate with the rewards?
Absolute Return Funds
Hedge funds and Absolute return funds are not an “asset class” they are a compensation structure. Managers attempt to beat the market by exercising their “skill” and charge a higher fee as compensation for their “skill”.
As investors, we all want to believe that we are investing in an “above average fund manager”. This reminds me of Estelle Morris UK Education Secretary saying that “she wanted ALL children to have an above average reading age” or both myself and Brian O’Driscoll have an average of 50 caps for Ireland etc.
Absolute return funds appeal to investors who want to make money when stocks go down.
We would argue that when we are investing in stocks, we are doing so over an investing lifetime 30 years+. Over those periods stocks go up, considerably and we can show statistically that over very long timescales stocks outperform risk free assets. There is no need to short the market or seek to avoid risk.
If, as an investor, you are not willing to bear the risks associated with stocks, or by virtue of your investment timescale, you do not have an investment lifetime, then you need to make a risk return trade off. This means allocating more of your capital to risk free assets and less to stocks.
You don’t need to pay a fund manager a high fee for trying to guess when stocks are going down or which asset class might outperform from year to year.
Given the recent volatility in global markets many commentators are proclaiming that "buy and hold" is dead as an investment strategy and that funds that focus on absolute returns are the most suitable course for investors.
Our view is that long-term buy and hold from a diversifed mutl-asset class portfolio has worked just fine through recent years and that any attempt to actively manage a portfolio will inevitably add costs.
Furthermore, there is no evidence in the academic literature that fund managers posess sufficient skill to attempt to time the markets or excercise a tactical asset allocation strategy. It is therefore our belief that a low cost diversified portfolio will tend to outperform an Absolute Return fund over the longer term.
Obviously there will be periods where the absolute return strategy will do well, but we believe that these periods will tend to be no more than we would expect by pure random chance.
To test this hypothesis, we created a simulated Global Absolute Return fund from a range of assets randomly selected by my 10 month old son.Matthew does not excercise any tactical asset allocation decisions for his portfolio and we simply rebalance every 6 months back to the original starting allocations.
For a comparison of the performance of this portfolio with the Standard Life Global Absolute Return fund, please click on the image below:
1'Commodity Futures in Portfolios', Truman A. Clark, Dimensional, December 2004
2'Greenspan Sees No Rise Soon for the Dollar', New York Times, November 20, 2004
3’APRA Alternative Warning', Money Management, March 23, 2007