Don’t Be Distracted by Alternative Investments

Investing isn’t very complicated.  Most investors would be well served with a globally diversified portfolio of low-fee index funds or exchange-traded funds (ETFs) for their stock allocation and a fixed-income (bond) fund consisting primarily of short-term Treasuries. Your portfolio needs to be customized for your needs and tolerance for risk.

What about alternative investments?

What are they?  Why are they so popular?  Do you need them in your portfolio?

What Are Alternatives?

Alternatives are a broad category of investments that fall outside the traditional asset classes of stocks and bonds. They include private equity, hedge funds, real estate, commodities, and more.

Popularity of Alternatives

Alternatives have gained immense popularity over the last couple of decades. Several factors contribute to this phenomenon:

Diversification Appeal: One of the primary reasons investors are drawn to alternatives is the promise of diversification benefits. Alternatives often have low correlations with traditional assets, meaning they may perform differently under various market conditions.

Yield: Investors are constantly seeking higher returns. With their unique risk-return profiles, alternatives offer the potential for enhanced yield and returns compared with traditional investments like bonds.

Institutional Adoption: Many institutional investors, including endowment funds, pension funds, and sovereign wealth funds, have increasingly allocated a portion of their portfolios to alternatives. Their embrace of alternatives has generated interest among retail investors looking to mimic the strategies of successful institutional investors.

Market Hype: Media coverage and marketing efforts have contributed to the hype surrounding alternative investments. Stories of massive returns and success stories from high-net-worth individuals can make alternatives seem like the golden ticket to financial success.

What could possibly go wrong?

The Downsides of Alternatives

Here are some of the critical downsides associated with alternatives

Lack of Liquidity: Many alternative investments, like private equity and real estate, are illiquid. This means that once you invest your money, it can be challenging to access it before the investment's predetermined term expires. Stocks and bonds are highly liquid, allowing investors to buy and sell them quickly.

Lack of Transparency: Alternatives often lack the transparency of publicly traded securities. Investors may have limited visibility into the inner workings of the investment, making it difficult to assess risks and potential returns.

High Fees: Alternatives can come with hefty fees. For example, hedge funds typically charge management and performance fees, which can significantly affect your returns over time.

Complexity: Alternative investments can be complex. Understanding the intricacies of a hedge fund strategy or the nuances of a private equity deal requires expertise most individual investors lack.

Performance: Alternatives often don’t deliver the robust returns they often claim.

John Rekenthaler, Director of Research at Morningstar, analyzed all fund categories in Moringstar’s Alternatives Category group for the 15 years from February 2007 to January 2022.

Only one of the nine alternatives (real estate) outperformed a simple intermediate bond core fund.

Rekenthaler also found the diversification benefits were different from what was expected, with many alternatives registering a high correlation with the returns of a balanced portfolio of 60% stocks and 40% bonds.

What about endowments?  Should you follow their lead and invest in alternatives?

An exhaustive study found the average endowment underperformed a traditional 60/40 benchmark over several extended periods, including “the last 58 years.”  It also concluded the alternative investments in these endowments did not provide returns superior to  “liquid market options.”

Hedge funds and private equity are two popular alternative investments.

One study of hedge fund performance from the Credit Suisse Hedge Fund index looked at performance from January 1994 through June 2023.  Over that period, a simple S&P 500 index outperformed “every major hedge fund strategy” by more than 2.8 percentage points in annualized return.

The benefit of investing in private equity seems marginal, especially considering the illiquidity of these investments.  Studies show a modest outperformance over the S&P 500 index or, in the case of public pension funds, a slight underperformance for the ten years ending September 2020.

Do You Need Alternatives?

Given the downsides and generally unimpressive performance, do you need alternatives in your portfolio?

A well-diversified portfolio of stocks and bonds can provide significant diversification without the added complexity and fees associated with alternatives. This portfolio would typically hold thousands of stocks in developed and emerging markets.  For most investors, further diversification would be unnecessary.

It's difficult to justify holding alternatives when you consider questionable performance, poor liquidity, dubious transparency, and high fees.

At Daner Wealth, we keep investing simple, following sound academic principles.  We focus on what matters, like your asset allocation, keeping fees low, global diversification, tax efficiency, controlling investor behavior, and customizing portfolios to meet the requirements of our clients.