Understanding Alternative Investments

Besides the exploration of alternative investments and how they move in waves, Understanding Alternative Investments reviews how occurrences in nature, such as waves, can be used in finance. That is, the study of waves can be used for additional knowledge about investing in alternative investments. Ocean waves are generated by wind energy: “Wind energy is imparted to the sea surface through friction and pressure, causing waves. As the wind gains strength, the surface develops gradually from flat and smooth through growing levels of roughness. First, ripples form, then larger waves, called shop. The waves continue to build, their maximum size depending on three factors: wind speed, wind duration, and the area over which the wind is blowing, called the fetch.”¹ Years ago, I was vacationing in Avalon, New Jersey, for the summer. Sitting on the beach, staring out at the ocean, I pondered how waves never stopped rolling in; they are incessant. Moreover, they could change direction, speed, and height in an instant. They were also influenced by the weather and other events. No wave is ever the same, but they share similarities. For example, I noticed the curve of a wave was not too different from any of the shells at my feet. Surfers love this curve, called the “barrel.” While it seemed far-fetched at the time, I wondered if these patterns or cycles could be broken down into mathematical equations. I thought of how these waves were calm but could suddenly turn into rogue waves, not too different from the storms on Wall Street, otherwise known as recessions or depressions. I was convinced that nature might teach us something about investing.

A lot has changed in finance since the Great Recession, but the vast majority of financial advisors and wealth managers appear to not understand alternative investments and yet recommend them to clients. Buyer, beware! A study based on surveys amongst 1,643 retail investment advisors called “2011 Advisor Brandscape” that was done by Cambridge, Mass.-based Cogent Research showed that 78 percent of all retail advisors (primarily independent advisors) now allocate an average of 11 percent of their book to alternatives.¹ Investors that receive recommendations from advisors with little training or knowledge about alternative investments is a case of the blind leading the blind. In my opinion, such ignorance amongst financial advisors presents a moral hazard. If a consultant or financial advisor appears to know little about alternative investments, a red flag should go up. My advice is to not walk. Run. At the very minimum, ask how many years’ experience they have with alternative investments, which ones they have worked with, and what professional training or degrees they have had to make them an expert. I would not take lessons from someone claiming to be a surf instructor who has never surfed before. Also, ask if they ever bought alternative investments themselves. A cook that refuses to taste their own cooking is not a cook.

Alternative investments are not generic products to procure or mass market to investors. A prudent investor will know the nuances between sellers. Sellers are not all the same. Figure 3.1 is a chart showing where an investor can find alternative investments through another party (as opposed to finding alternatives investments themselves).

Financial mergers happen all the time. Some companies have even created businesses out of all these financial mergers and acquisitions such as Sandler O’Neill + Partners, “a full-service investment banking firm specializing in financial services companies.”¹ There is a need for such firms considering that many financial mergers do not work out too well. Many have been colossal disasters and painful, like putting a dog to sleep. US Trust’s acquisition by the discount broker, Schwab, in 2000 was doomed from the start: “The union of the two firms kicked off a clash between the populist Schwab and white-glove U.S. Trust. It also exposed long-term problems in U.S. Trust’s business, notably the outdated state of its technology and its failure to serve investors’ increasingly sophisticated demands.”² Founded in 1853, US Trust’s clients are high net worth, white glove, and somewhat demanding clientele, which is different from low-fee, self-serve, discount-paying Schwab clients. Merging a discount brokerage with a private wealth management platform was beyond mismatched. US Trust was then sold to Bank of America which appears to have been in better match.

Based on a Morningstar poll (912 responses; poll taken November 10, 2009), “More Advisors Are Reporting that 76–100% of their Client Groups are Using Alternative Investments than Last Year,”¹ both finance experts and investors clearly see the merits of diversifying with alternative investments. In Smart Money’s “Own More ‘Alternatives,’” “The financial crisis did more than just shred the mystique of the buy-and-hold era; it also left many investors skeptical of the idea that stocks, bonds and cash were enough to see them through to the finish line. After all, stocks and bonds both took huge tumbles simultaneously, and low interest rates during the recovery made most people’s cash holdings about as profitable as a pet rock. Those trends are fueling demand for a wider array of assets—from long-short funds, which can improve their returns by betting against stocks, to commodities, which tend to rise when stocks fall.”²

Large pensions have done quite well by adding alternative investments to equity and fixed income; big public pension funds with a total market value greater than $5 billion did well using alternative investments. Figure 6.1 is a performance chart of alternative investments (real estate, hedge funds, and private equity), equity, and fixed income, with annualized returns over ten years ended December 31, 2012. Over the past decade, the “Smart Money” increased returns with alternative investments. Pension plans continue to find merit with alternative investments and have increased allocations. Table 6.1 shows the top 200 pension plans in 2011 and how much they increased their exposure to alternative investments.

Often the best time to invest is when it appears to be the worst time, when market conditions are deplorable. Smart Money typically has good timing. “The number of public pension plans investing in hedge funds has leapt 50% since 2007 to about 300, according to Preqin. State pension systems had $63 billion invested in hedge funds as of their fiscal 2010 and are expected to invest another $20 billion in hedge funds in the next two years, according to a recent report by consultant Cliffwater.”¹ Hedge funds became better not worse after the Great Recession, as so many mistakenly predicted. Hedge funds have become more attractive to investors, both on an institutional and on a retail level. The landscape for hedge funds has ultimately become more competitive. Hedge funds have even lowered their fees. “The overwhelmingly majority of investors interviewed, both large and small, are united in the belief that the industry’s 2 and 20 fee structure is not sustainable—and that a number of the practices in the alternative investment industry (such as gates, side-pockets, etc.) will not endure.”² One of the best-known hedge funds, Paul Tudor Jones, lowered fees. Hedge funds were also shown to add value, as evidenced by studies done on institutional investors in hedge funds. Returns also improved.

Gold moves in waves like other commodities. For example, gold went from a trough to a peak (April 20, 2001–September 5, 2011) and then from a peak to a trough (September 6, 2011–December 19, 2013). I call this Gold Wave VI since this was the sixth time that gold exhibited a clear cycle, pattern, or trend. Many self-proclaimed gold experts mistakenly forecasted that gold would surpass $2,000 per troy ounce. It did not happen. Any naysayers of Wave Theory were proven wrong again. Yet a reversion to the mean was inevitable. Amongst other dilemmas, the stock market collapsing from the tech bubble and then again from the real estate bubble drove scared investors to this precious metal. Gold looked like it was going straight into the sky. Eventually, however, a wave will reverse. Trees do not grow to the sky. Gold reached a nadir in August 2011 at $1,888.70. By April 2013, gold dropped to $1,361.10 per troy ounce. Gold plummeted to $1,195.00 by December 19, 2013 and lost -29 percent year-to-date. Hedge funds and other “smart money” investors began selling. Besides institutional investors, governments stockpiled the yellow metal for years, which also helped drive the price higher. As the United States and other economies recovered, investors turned to equities and focused less interest on gold. Recent sales occurred with gold ETFs during the first quarter of 2013. The reversal of the gold wave was not a surprise.

While venture capital appears to have not been affected as adversely as publicly traded stock markets, it is somewhat deceiving because venture capital is private and usually lags the stock market either on the way up or down. A healthy IPO market is essential to US venture capital. IPOs, like commodities, revolve around supply and demand. Bernie Marcus cofounded Home Depot during a recession back in 1978 and took the company public in 1981. The company prospered, growing into one of the largest in the United States. Home Depot created thousands of jobs. Even Google, which was one of the best companies to emerge from the last recession (though public now), had a precipitous drop in stock price. Yet Google’s stock price went back up with the market rather quickly. And how is Google doing? “Google has done quite well without its own social network. Its online search engine accounts for two-thirds of queries made in the U.S., and even more in parts of Europe. Its revenue is expected to surpass $36 billion this year.”¹ Google and other technology companies amassed massive amounts of cash. “Google, which has $39 billion in cash, and Apple, which holds $76 billion including long-term investments, don’t pay dividends.”²

Asset allocation is simply what you have invested in and the weightings an investor assigns to each asset class. “The goal of asset allocation is to get the best possible expected return/risk profile.”¹ The majority of professionals in the world of finance believe that asset allocation will affect returns. By diversifying your assets, an investor will presumably lower risk and increase returns. For example, hedge funds can be used to reduce risk and/or possibly increase returns with a foreign or domestic equity index (Table 10.1).

A number of institutional and individual clients that I helped over the years had heavy weightings to alternative investments. These clients either had alternative investments to begin with or wanted more of them to add to existing portfolios. Clients with alternative investments tended to outperform the portfolios of clients demanding all equities, fixed income, cash, or a combination of the three. A number of the largest endowments have heavy weightings to alternative investments. A larger allocation to alternative investments most likely explains why endowments had better performance compared to public pensions over the past ten years. According to the National Association of College and University Business Officers, “Endowments with assets over $1 billion generated the highest average return for all periods.”¹ “Big government-employee pensions reported median returns of 13.43 percent for the year. Funds with less than $1 billion in assets, which don’t invest as much in so-called alternatives like private equity, hedge funds and real estate, had median returns of 12.47 percent, according to Wilshire.”²

There are now two main styles of management for portfolios with alternative investments (active and passive). Given that investors can select alternative mutual funds, diversification has become easier to achieve. Mutual funds are quite common and owned by many investors, whether as part of a retirement plan or in a non-retirement account such as a wrap account or fee-based account. Mutual funds have plenty of attractive features. However, performance tends to vary, sometimes outperforming the indexes while other times failing to outperform them. Alternative mutual funds are no different. Persistence also is an issue. While one might have an initial aversion to investing in a leveraged buyout fund (private equity funds as they are frequently called), private equity or a leveraged buyout funds can be defined as: To briefly review the concept, in an LBO a small group of equity investors, usually including current management, acquires a firm in a transaction financed largely by borrowing. The debt is serviced with funds generated by the acquired company’s operations and, often, by the sale of some of its assets. Generally, the acquiring group plans to run the acquired company for a number of years, boosts its sales and profits, and then take it public again as a stronger company.¹