Alternative investments #1: what, why, when and how?
This first in a series looks at how individual investors, whether self-guided or as clients of private banks or financial advisers, should form an overview of the role of ‘alternative investments’ in their wealth management. The big picture needs two perspectives: a no-nonsense view of the industry’s sales pitch and practical awareness of how individuals with different wealth levels can get their exposure. Later items will look at the different kinds of opportunity one by one.
Following this trail will lead to some quite challenging conclusions: there is a lot of nonsense talked about alternatives but for wealthy investors with insights into the nature of the bets and who are also clear about their different goals for different elements of their wealth, they can be useful at times – though their use at all times is greatly (and sometimes maliciously) exaggerated.
True ‘alternatives’ are most usefully defined first at a ‘high level’, as bets that are entrepreneurial rather than systematic: they rely on the serial outcomes of a manager’s individual and independent bets as opposed to a set of ‘system’ risks and returns that can be reasonably predicted, fully diversified and cheaply purchased (the exposure to equity market systems that tracker funds give, for instance). Once this distinction has been grasped it is simple to locate different alternatives on a notional spectrum from ‘largely systematic’ to ‘purely entrepreneurial’. This in turn makes it easier to get behind the sales pitch and assess their use for individual investors.
This distinction between entrepreneurial investing and systematic investing, which is rooted in asset allocation practice, is not all that familiar but I made it an overarching simplification in No Monkey Business. Not being familiar, it is all too easily confused with some half-baked popular notions about a difference between ‘absolute return investing’ and ‘relative return investing’.
For portfolios that hold conventional asset classes, these are not mutually exclusive and professionals who pretend they are simply feed popular misunderstandings. ‘Absolute return’ measures the expected or actual system return, derived from ‘being there’: by having money exposed to an asset class or market. ‘Relative return’ measures the deviation explained by active management: how you choose to get the exposure. For alternatives that do not give exposure to any systematic asset class return, absolute return is the only meaningful measure of the payoffs of the bets made and relative return is simply comparative: differences between the absolute returns earned. Investors who claim only to be interested in absolute returns do not consciously wish to give up the returns earned from being exposed to an asset class with systematic payoffs, any more than a sailor would give up using the power of the tide. What they are more likely to be expressing is a risk utility function: something about their intolerance of loss. This is common to any portfolio, whether largely exposed to asset classes or largely exposed to independent bets. So let’s park absolute return investing on one side and focus on the more useful entrepreneurial distinction.
The ‘alternative spectrum’
After the event, it proves to be difficult when holding so-called alternative investments to avoid some systematic return exposure, be it to bonds or equities. The outcomes from private equity and venture capital, for instance, depend significantly on the exit route and exit values provided by public equity markets. Similarly, returns to portfolios that hold highly concentrated positions in individual equities or properties may look entrepreneurial and may even be managed just like a business but still pick up some underlying asset class payoffs.
There is effectively a spectrum of alternatives running from some combination of systematic and entrepreneurial payoffs to pure entrepreneurial payoffs. At the pure end I place two bets: certain types of hedge fund strategy and commodities. The two overlap in the form of ‘managed futures’. Less pure are private equity and VCTs. Clustered even closer to the equity asset class are AIM and Ofex stocks and ‘focused’ funds. Low-grade bonds, though often treated as alternative investments, are also clustered close to nominal fixed income, itself a risky asset class. What these combination of entrepreneurial and systematic bets possibly have in common is that they may not share the same return distribution as the host asset, as they may be subject (as we shall see) to higher than normal downside risks.
In this analysis, emerging market exposure is not an alternative investment. The long histories of developed markets, such as the US and UK, which take in early economic development, suggest that the underlying trends of real sustainable return, and even the nature of the variance in the returns for different holding periods, are fundamentally the same as for developed markets.
Similarly, in this analysis diversified exposure to property is mainly asset class exposure, albeit with some product-specific features, and is not an entrepreneurial investment.
Some features of alternative investments can also be replicated by combining conventional asset class exposure with derivatives. Indeed, this is what some hedge funds do, such as by selling the market return and retaining only the relative return (a ‘market neutral’ equity strategy). So the standalone alternatives are not the only entrepreneurial opportunities and may not be the only forms of existing exposure an individual has to entrepreneurial bets.
Finally, gearing does not alter the underlying identity of the investment or its location on the spectrum, whether it is a fund that does the borrowing (or levers the portfolio using derivatives) or the investor borrows or uses derivatives to lever his or her own investments.
How should we judge alternatives?
All of these strategies have a similar purpose or similar effect: to alter the risk/return tradeoffs achievable from conventional assets alone. They are not intrinsically good or bad and it is the utility for an individual that needs to be judged. Judging utility requires that the bets be properly understood by someone, either the owner or the owner’s adviser. It also makes some version of the personal context critical to the assessment, whether the context is a set of separate tasks assigned to an individual’s money, each with their own risk tolerance, or some ‘risk/return personality’ common to an individual whatever the task.
Whatever they do for people’s personal risk/return tradeoffs, it is true to say that they are not necessary. Desired clarity and control of uncertain outcomes, consistent with some personal utility function, can be achieved with a combination of a risk-free asset and systematic, well-diversified equity exposure. ‘Alternatives’ in that sense risk being misunderstood because they complement but cannot substitute for a portfolio strategy based on asset class risk and returns, rather than on pure bets.
Judging the sales pitch
Altering portfolio risk/return tradeoffs means alternatives appear to fit into the industry convention of describing both individual investments and portfolio strategies in terms of expected return and standard deviation (or uncertainty) of expected return. This has a comforting effect as it places them within a familiar and respectable framework.
More than anything else, this simple fact explains the take-up of alternatives by US institutional investors, under the influence of a small, self-imitating community of investment consultants practising some very dodgy science. There are two fundamental flaws in the institutional sales pitch:
The approach fails to distinguish between the volatility of the path and the uncertainty of wealth outcomes
Partly because of the first, the quantitative inputs to the framework typically used are wildly mis-specified
These are pretty damning observations of some very clever people. But the fact is the framework of risk/return (or, as the industry commonly reverses it in its preferred jargon, ‘mean/variance’) trade-offs is much more familiar than it is understood. The professionals who best understand the limitations of estimating risk and return for individual investments and correlations between them are model builders, not model users. When you have to think about where these estimates are going to come from and how reliable they are, it tends to engender a healthy respect for uncertainty about the inputs and outputs.
Some of this can be built into the model’s structure and assumptions so that users do not exaggerate the significance of the outputs. The mean variance optimization processes, as mechanistic ways of making the trade-offs, that professionals have gradually come to rely on in the last 50 years do at least tend to enforce a high degree of diversification across a given opportunity set, as if the vehicle was known to be so unsafe it needed a lot of shock absorbers around it. But the implication of this is that interpretation of the outputs that implicitly requires precision may not be supported. Individual locations in risk and return space are fuzzy not fixed and calculations of risk adjusted returns, usually involving the division of one imprecise number by another often larger number (as in ‘Sharpe ratios’), are even fuzzier.
Why this is important for alternatives is that, by their very nature, the inputs that describe true entrepreneurial bets have to be empirical and cannot be theory-based. Empirical observations are restricted: there is not much history, only very specific history and not enough liquidity to measure true market prices at the same frequency as other assets. If the bets really are independent, a time series of payoffs is likely to be statistically meaningless.
In the absence of history for conventional asset classes, systematic features (or some theory about them that stands up to empirical tests) can fill in the gaps. For instance, how European equities will behave as a single market can be estimated from how equity markets have generally behaved in the past. How emerging markets will behave can be inferred from histories of markets that have already emerged. Without systematic features, the gaps can be filled by simulation or ‘stress testing’ but even this may not replicate the true uncertainty of the influences shaping manager returns or compensate for the limited information in the payoffs from a series of past independent bets.
The hole in diversification
Errors in assumptions that necessarily undermine the sales pitch arise in all three of the inputs to the framework:
Estimates of mean returns, which fail to distinguish between real and nominal returns and, the less systematic the bets, approach pure guesswork
Standard deviations, which fail to distinguish between holding periods and between more or less liquid and market-priced investments and may also assume normally distributed returns where extreme outcomes have a greater than normal occurrence
Correlations, which are quite different as between paths and outcomes
The commonest impact of these errors in a risk/return framework is to validate a strategy based on permanent diversification, or lasting exposure. This is what we can see happening in the US and which fortunately is so far being resisted (for whatever reason) in the UK. It arises because monthly standard deviations understate true long-holding period outcome uncertainty and because trade-offs made on long-holding period outcomes are much more sensitive to estimates of the correlations.
The idea of the alternatives spectrum can help to explain these without using complex science. It is commonsense that extreme outcomes for different strategies may coincide because in particular circumstances they share common economic influences, such as exposure to gearing. It is commonsense that VCT and private equity payoffs will depend on public market levels as this is what turns notional portfolio values into hard cash. It is commonsense that extreme systematic risks, such as a major bear market in property or equities, will impact entrepreneurial strategies like concentrated equity bets or buy-to-let bets. It is also well known to many older investors that the low observed short-period correlations between equities and property did not prevent the two assets moving together in past bear markets.
Bet like an entrepreneur
With weak diversification arguments, investors are pushed towards pure entrepreneurial bets. What I believe this implies for non-professional investors and professionals alike is the need for a completely different framework for risk management that focuses on exposure to extreme loss and its consequences and the compensating hope of exceptional profit, but with no false precision about the potential for either.
Risk in this case is managed very simply by proportional exposure. The easiest way to work out tolerable proportional exposure is a structure of different goals for individual or family wealth, prioritized and with distinct risk utility functions for each. For wealthy individuals, this typically manifests itself in pockets of money that do not require tight management of the risks because higher-priority tasks with such tight management secure all the goals that have more important consequences on household lifestyle or particular financial needs. It almost assumes the luxury of ‘surplus’ wealth.
In such a goal framework, the money available for entrepreneurial investing may take on a more opportunistic appearance, in which instincts about return over a particular time frame, probably explained largely by a view of current market conditions, dominate standard deviation and correlations. Indeed, it may be that the opportunistic goal does not need to be diversified at all.
This cuts across any likely goal structure for investors with less than say £250,000 to allocate to an opportunistic goal, and possibly poses practical problems for investors with more. By reference to a structure of prioritized goals, this may mean total financial asset exposure is likely to be several millions. For smaller investors, the means of entry is likely to be more diversified than the strategy’s logic dictates, such as being limited to fund of funds or tracking an alternative index (also the average of lots of funds). This is something I will return to when looking at individual alternatives.
What might an opportunistic approach yield today as candidates? Nothing much – unless my instincts about market conditions are misleading me. Some of these instincts rely on nothing more sophisticated than a deep mistrust of governments’ belief they have got the better of the business cycle and anxiety about the consequent build-up of stresses and strains below the surface. So this does not feel like a good time to be betting on business plans that are heavily geared and require stable income streams, as is normal in private equity. Entrepreneurial bets in residential and commercial property also look to have both unsustainable market prices and gearing stacked against them. Many hedge funds (and feelings about the sector as a whole) are highly sensitive to a reversal in several of the ‘easy-money’ strategies of recent years: short term interest rates well below long rates and yield spreads for poorer credit risk very low historically.
Equity-related strategies do not look as vulnerable as bonds and property, as expected long-term real returns appear fairly normal in both larger and smaller markets. But the argument about correlation of extreme outcomes puts a warning sign over entrepreneurial equity bets when bond and property strategies are poised for widespread regret in several major financial markets around the world.
For some hedge fund managers, the possibility of regret across conventional investment classes holds out the promise of both increasing volatility and opportunities to sell short, but the managers poised to profit are not easy to identify in advance and only become easier when momentum has been established for particular strategies. Shorting conventional asset classes and ‘buying volatility’ is also a strategy requiring focused exposure available only to wealthy investors.
The entrepreneurial investor should not be afraid to roll over cash balances in his or her opportunistic goal, preparing mentally for a time when alternatives are a dirty word. When this arises, there are more likely to be some routes in for smaller entrepreneurs too.