Alternatives Becoming Mainstream: Good or Bad News?

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Expert Analysis and Commentary

Alternatives Becoming Mainstream: Good or Bad News?

Larry Swedroe Jun 25, 2015

Over the past couple of years, institutional and retail investors alike have dramatically increased their demand for alternative investments. This demand has been driven by a combination of record low interest rates, a so-called “lost decade” for equity markets, increased correlation among traditional public equity investments and heightened geopolitical and economic risks beginning with the financial crisis of 2008.

Last year, a report on the alternative fund industry from management consulting firm McKinsey & Co. revealed that total assets in alternatives had reached $7.2 trillion, up from $6.5 trillion two years earlier. The report found that, while assets continued to flow into alternatives, their rate of growth during the previous two years had slowed dramatically to about 5 percent. That was down from a more than 14 percent rate of growth over the prior seven years.

Retail alternatives, including those in mutual fund, closed-end fund and exchange-traded fund (ETF) formats, now have about $2 trillion in assets globally, with U.S. retail alternatives accounting for nearly $900 billion of the total.

The report predicted that alternatives marketed to mom-and-pop investors would remain red-hot, with new cash flows into these types of funds driving up to 50 percent of net new retail revenue collected by U.S. retail asset managers over the following five years.

A similar prediction appeared in McKinsey & Co.’s 2012 report on alternative investments. The report—titled “The Mainstreaming of Alternative Investments: Fueling the Next Wave of Growth in Asset Management” and co-authored by McKinsey principal Onur Erzan—found that, in the United States, institutional investors expected to have 28 percent of their portfolios allocated to alternative investments by the end of 2013, up from 26 percent in 2010.

This led Erzan to declare that alternatives are now “here to stay.” Indeed, all of the U.S. participants in the survey (which included institutional investors, asset managers, registered investment advisors and other investment professionals) said that they believed alternatives would grow faster than traditional assets. They further expected alternatives to earn more on these assets than traditional products.

A similar survey by Cerulli Associates, which appeared at about the same time in 2012, found that money managers expected the assets they held in alternative strategies to grow by at least 50 percent over the following three years, eventually coming to represent about 10 percent of mutual fund assets. That’s up from 2.8 percent of mutual fund assets at the time of the survey. In the 10 years following the survey, these money managers expected that figure to grow to 16 percent.

Whose Interests Do They Have at Heart?

Wall Street wants to see this increase in alternative investments because it can generate revenue several times larger than the revenue it earns from more traditional investments. In fact, the 2014 McKinsey & Co. report predicted that alternatives would command up to 40 percent of the asset management industry’s entire global revenue by 2020 while accounting for just 15 percent of its assets worldwide.

What continues to amaze me is that the rapid growth of alternatives to date has occurred despite the poor performance of most of these investments, especially over the very periods when investors expected them to provide a safe haven. Given their dubious results, I’ve found it helps to think of alternatives as investments that are “fraught with opportunity.” They provide lots of opportunities, opportunities for investors or advisors to make mistakes while chasing yield and performance. Here’s some evidence.

A recent New York Times article on the performance of pension plans reported plans that had from a third to more than half of their money in alternative investments posted returns more than a percentage point lower than returns posted by funds that largely avoided those assets. They also had paid nearly four times as much in fees.

Hedge funds seem to be an ever-popular type of alternative investment. But from 2005 through 2014, the HFRX Global Hedge Fund Index returned just 0.7 percent a year, underperforming every single major equity index as well as Treasury bonds, no matter which part of the yield curve you examine (that includes riskless one-month Treasury bills, which returned 1.4 percent per year).

My favorite example, however, relates to absolute return funds. Despite the term “absolute return” in its name, the HFRX Absolute Return Index lost 13.1 percent in 2008, lost 3.6 percent in 2009, lost 0.1 percent in 2010 and lost another 3.7 percent in 2011. The next year, 2012, broke that losing streak at four years, but just barely. The index returned a bare 0.9 percent. A great year for equities, 2013 was a bit better. But the index managed to return just 3.6 percent. And in 2014, another good year both for stocks and bonds, the index actually lost 0.8 percent.

As an example, one dollar invested in absolute return funds at the start of 2008 would have been worth about 84 cents at the end of 2014. By comparison, $1 invested in Vanguard’s 500 Index Fund (VFINX) would have been worth $1.63, and $1 invested in Vanguard’s Total Bond Market Fund (VBMFX) would be worth $1.38.

The only thing really absolute about absolute return funds is that they are absolutely awful.

And the evidence on another type of alternative investment, private equity funds, isn’t much better. They have underperformed similarly risky but publicly available small value stocks. For instance, a study covering the 20-year period from July 1986 through June 2005 found that, while private equity did manage to outperform the S&P 500 Index (13.8 percent versus 11.2 percent), it underperformed (by 2.2 percentage points per year) more similar risky public small value stocks, which returned 16.0 percent. And that’s not even taking into account the lack of liquidity in private equity, which should command a premium return.

Alternatives Worth Considering

There are two major exceptions I would make related to investing in the broad category of alternative investments. They are both backed by academic research supporting their consideration in portfolios. Real Estate Investment Trusts (REITs) and commodities are worth considering so long as the funds holding them are relatively low cost and are passively managed.

The Bottom Line

The bottom line is that most alternative investments being pushed by Wall Street are more likely to enrich their purveyors than you. And you simply don’t need them to construct well-diversified portfolios.

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