Alternative Investments: The Right Expectations

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By Roger Nusbaum AdvisorShares ETF Strategist

Every year around this time we hear about the fiscal year investment results for the various college endowments and typically there is much written about the endowments and 2014 is no exception but this year most of the attention seems to be on the extent to which various forms of alternative investments have been a drag on endowment results after years of their having provided outsized gains.

The media and blogosphere are both picking up on the drag created by too much exposure to alternatives.

The Wall Street Journal had an article a few days ago titled Big Investors Missed Stock Rally that delves into the ever-expanding allocations to alternatives over the last ten years on the part of corporate pensions, public pensions and college endowments.  Jane Mendillo, the CEO of the Harvard Management recently announced she is stepping down due in some measure to the result of the endowment.

The Journal reports that the average endowment had 16% allocated to domestic stocks, 18% to foreign stocks and 53% to alternatives in the three years ending June  of 2013 (not a typo on my part, it said 2013). For the last three years equities, especially domestic equities, have put it fantastic returns which in hindsight reduced the need for alternative diversifiers.

Although in a way that really isn’t hindsight. Over long periods of time equities have been the best performing asset broadly speaking. There will always be home run hedge funds, private equity funds and the like no matter what is going on in the rest of the financial world but expecting to own that home run is not realistic.

Barry Ritholtz picked up the thread in a post titled The Shame of Alternative Investments that recaps some of the Journal article and Barry also offers some of his insight on the issue and the Above The Market Blog had a post asking Is The Yale Model Past It?

This is a topic I’ve been writing about for years in terms of why to use alternatives and how to use alternatives. The point is not to try to refute what anyone else does but instead to assess a more realistic use for individual investors and the typical RIA client.

Equities will be the thing that grows enough (or not) to let people get to their number and then will be the thing that allows the number to keep up with inflation during the withdrawal phase.

Other assets, including fixed income, are crucial for proper diversification both in terms of managing the behavior of the overall portfolio during adverse times. Things like alternatives tend to have a low correlation to equities or put differently they tend to not look like equities. If equities tend to be the best performing asset class then a lot of exposure to assets that tend to not look like equities, like 53% exposure in alternatives, strays away from sound diversification to being counterproductive.

The realistic hope for alternatives when used in moderation is that they will smooth out the ride in terms of reducing volatility at the times when clients most want their volatility reduced and reducing correlation to equities some but not too much which opens the door to delivering value in the form of risk adjusted returns.

In the past we’ve used the John Serrapere concept of 75/50 to quickly explain risk adjusted returns.  Serrapere used to write regularly about a portfolio that targeted 75% of the equity market’s upside with only 50% of the downside. A portfolio that pulls this off would outperform over the long term, outperform in down markets but of course lag during up markets.

Clients will of course like the idea of risk adjusted returns that can come along with market downturns but will grow impatient during years like 2013 which requires advisors to be ready to reeducate clients as the need arises.

There is obviously no guarantee that the next time things hit the fan for markets that all alternative strategies can work which is a reason to consider several unrelated vehicles as a small portion of the portfolio for the minority of the time that stocks go down. 

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