Alternative investments are shining as old-school investments seem to be losing their luster. Short-run bonds are stuck with negative after-inflation yields. Long-run bonds may be even worse as they promise both low yields and big future inflation risk. Stocks priced at today's Shiller cyclically adjusted price per earnings (CAPE) ratio of nearly 25 have returned about 2% after inflation over the subsequent decade. Investors looking for yield are looking for new alternatives. Are alts the answer?
There's definitely a place for non-traditional financial assets in modern portfolio theory. In fact, MPT says that the optimal risky portfolio consists of all capital assets including alts. So an advisor following MPT will want to include assets such as commodities or private equity in a well diversified portfolio. Many of us know how to find the right equity fund, but alts are a different animal and finding the right species often requires a good DNA test.
The alt story goes something like this. All assets are priced based on risk. Stocks and bonds are sold on competitive markets that are often strong-form efficient with many expert traders who keep prices fair. Other markets may not be quite so efficient. Warren Buffett spent years locating private business owners whose firms weren't quite large enough to lure an investment banker into taking them public. By buying these smaller private firms, Buffett essentially turned Berkshire Hathaway into a publicly traded asset that gave investors access to untapped alternative investments.
If alternative assets are infrequently traded, then they might generate excess returns. Berkshire Hathaway has done pretty well buying private business assets. So have many venture capitalists. Their low correlation with stocks and bonds may also provide significant potential portfolio benefits. In a perfect world, alternative investments have a lot to offer.
Hedge That Bet
Bear in mind that the world isn't perfect. The SEC exists because markets work better when investors have full information and legal protections. We know that investors don't do well in countries where information can be hidden from investors and where shareholder rights are violated. Operating in a slightly murkier marketplace often means information is more opaque and investors are vulnerable to bad behavior.
Hedge funds are a great example. Freed from the shackles of the SEC's Investment Company Act that constrain mutual fund managers, hedge funds can identify attractive markets, exploit mispricing opportunities, and take advantage of new opportunities to capitalize on factors providing excess returns. Since there is evidence that more active mutual fund managers tend to outperform, even greater freedom may lead to even higher performance.
But hedge funds can choose what information about returns and assets under management they disclose, and this can drive academic researchers trying to analyze performance up the wall. Spotty reporting means that there's a lot of disagreement about whether hedge funds are a valuable asset class or a remarkably effective way to turn dollars from institutions and rich investors into Picassos and oceanfront estates owned by a few fund managers. Efficient market types are the most passionate critics of hedge funds.
What's the problem with hedge funds? The first is their fees. The traditional 2% of assets and 20% of gains make even the most expensive mutual fund seem like a bargain. The second is that rewarding fund managers for achieving gains while not punishing them for losses looks suspiciously like giving them a free call option. If the value of their portfolio goes up, they cash in. If it goes down, they write nice letters to investors explaining how unusual market conditions foiled their excellent plan, and then collect 2%. If all else fails, the manager can always just close down the fund, return cash to investors, and start a new one.
This all sounds like a pretty sweet deal for hedge fund managers. Which makes the seemingly unending flow of assets into hedge funds over the last decade a mystery to many economists—particularly those at academic institutions that increased the share of hedge funds in endowments from less than 5% in 2000 to over 20% by the end of the decade.
Professors Bill Fung of the London Business School and David Hsieh of Duke have worked to collect the most complete data on hedge fund returns and have come to some interesting conclusions. First, a lot of funds don't report returns. In a 2013 article published with Daniel Edelman of Alternative Investment Solutions, they found that the share of hedge fund assets invested in firms that do not report information to public data sources increased to more than 38% by 2010. They also found that small hedge funds and very large ones tend to have the best performance. And the great recession killed hedge fund performance, driving alphas for all categories to insignificance between 2002 and 2010.
