Investors, advisors, fund companies and the rest of Wall Street are always looking for a silver bullet. Always. We just can’t help ourselves. We desperately need to believe that their is a better way to invest than our current strategy, regardless of our current strategy. Right now (September 2014) it is pretty easy for investors to be satisfied with a simple long-only index fund portfolio. The S&P 500 just broke 2000 and is up almost 300% from the low in early 2009. 300%! Those returns will placate us for a while, but it won’t last.
Already some investors are getting nervous about the S&P 500 setting new highs week after week. They think that the Fed is the only thing propping up markets (despite improving corporate profits, labor markets, housing prices, etc) and they “know” that a correction is in the making. Still feeling the emotional impact of the ’08-’09 bear market, these investors (and many of their advisors) are looking for riskless return. They are searching for some strategy that will give them stock-like returns with bond-like risk (despite knowing full well that such a thing is impossible).
And so money is flowing into “alternatives.” Long-short funds. Managed futures funds. Tactical asset allocation strategies. Buy-write and split-strike option strategies. “Absolute return” funds. Market neutral funds. Commodities funds. Merger-arbitrage funds. You name it, people want it. And they are buying it. Liquid alternative mutual funds held $96.3 billion in 2012, $140.8 billion in 2013 and are up to $157.5 billion through July 2014.
Unlike the rest of the investment marketplace where assets are flowing to simple, transparent and low-cost index funds and ETFs, the alternatives space is awash in high-fee products. Investors and their advisors seem to have little regard for the bite a fund company is taking from a portfolio as long as it is labeled “alternative.” Funds in Morningstar’s “Alternative” category carry average expenses of 1.36%, compared to the 0.10% – 0.20% investors can expect from most index funds. Unsurprisingly, investors are chasing hot hands as usual, as strategies who have struck it “big” and outperformed most of their peers. If history is any lesson, new investors to these funds will depart disappointed in a few short years.
More importantly, can these “alternative” managers live up to the hype? Can they deliver better risk-adjusted returns than a simple portfolio of index funds? It’s crucial to remember that there are only so many investable assets. Stocks, bonds, cash, currencies, commodities, real estate. As I’ve addressed elsewhere, some of these are likely not appropriate or profitable long-term investments. Alternative funds own these assets just like plain-vanilla index funds do. Usually they are jumping in and out of them, taking short positions or hedging with options, but in the end they own the same assets.
The end result of most of the strategies ends up being really expensive beta. Sure, they are less volatile than the broad stock market, but of course they generally produce lower returns. This is simply the nature of the markets. The same effect can be accomplished with a simple portfolio of stocks and bonds, but that is harder to justify a 1.3% fee. Many “alternative” strategies, such as long/short equity, absolute return and market neutral funds were down alongside the broad markets in 2008 and 2009 and have relatively high correlations to a traditional portfolio of stocks and bonds.
So when investors and advisor are pouring their invested dollars into expensive, complex “alternative” strategies, usually all they end up with is really expensive beta. In a marketplace where the cost of beta (market exposure) is rapidly approaching zero, expensive alternatives make very little sense.