After a friend recently sold his share of a company, he interviewed investment advisors to get some help managing his new fortune. He was surprised when most recommended a traditional blend of 60% equities and 40% bonds. No one suggested allocating a nickel to alternative investments — not to hedge funds, not to private equity, not to real estate. They did not even advise that he consider liquid alternatives, that category of mutual funds that utilizes alternative investment strategies historically associated with hedge funds.
Career risk probably explains some of the reluctance. Even if a 60%–40% equity-bond portfolio loses money, there's comfort being part of the herd. Moreover, despite their 65-year history, alternatives still strike many investment advisors as esoteric. The level of expertise required can be daunting. For starters, when investing in alternatives, it's crucial that you pick the best managers. Performance dispersion can be much greater among alternative fund managers than among managers running long-only equity portfolios.
That makes sense. You don't want all your managers hugging the same index, or any index for that matter. You choose them for thinking independently and because they have the confidence to concentrate their positions.
It's also possible, of course, that all the managers interviewed by my friend concluded that traditional, long-only managers outperform alternative managers. And it's true that hedge funds haven't been tearing up the track during this bull market. Over the past five years ending Sept. 30, 2015, the average hedge fund had an average annualized total return of a mere 3.27%, according to Hedge Fund Research, while the S&P 500 annualized total return was up 15.6% over the same period.
Though these advisors might concede that the average hedge fund has bested the S&P so far this year, gaining an average 1.53% versus the S&P's 6.44% decline through the third quarter, they might also counter that it's too early to write this bull market's obit. If that's the case, they might argue, why pay higher fees to alternative fund managers just because they have the ability to go long and short? Who needs to hedge?
Let me offer one reason that hedging might be a good idea. I'm not a permabear, but I am intrigued by John Hussman's new way of taking the stock market's temperature. Hussman is the president of Hussman Strategic Advisors and an economist who gained recognition for correctly predicting the recessions of 2000 and 2007. He also freely owns up to incorrectly predicting a recession in 2011-2012. Indeed, his bearish outlook has cost him — his equity portfolio performance has been negative over the past five years ending Sept. 30, 2015. When he's wrong, it means he risks missing the rally. When he's right, though, his bearish outlook means he's better positioned to avoid huge losses.
