Alternative Investments: Should You Invest in Them?
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By most measures, 2022 was a challenging year for investors. Stocks were down, bonds were down, interest rates spiked, and inflation remained high. The only safe haven was either cash under the mattress or what some refer to as alternative investments. Alternative investments or alts refer to pretty much everything except the three traditional asset classes.

Those being stocks, bonds, and cash. So asset classes like private equity, venture capital, hedge funds, managed futures, art, and commodities. Real estate, especially private non-traded real estate, is also often thrown into the alternative investment bucket.

Now, historically, alternative investments have been reserved for the ultra wealthy or institutional clients, along with needing to prove that you are an accredited investor. You also needed to know the right people and hang in the right circles in order to be able to participate in the quote best investments.

On top of that, you had to trust that the managers of those investments were going to be good stewards of your money because alternative investments are often illiquid and less regulated than traditional publicly traded asset classes.

And while much of the alternative investment world still operates this way, many of these strategies have now found their way to mom and pop investors through publicly traded mutual funds and exchange traded funds. Alternatives are often advertised and marketed as uncorrelated to traditional asset classes. In other words, when stocks and bonds zig, alternatives are supposed to zag. They

They're also sometimes touted as lower risk investments that have similar long-term returns to the riskier publicly traded securities.

Given how these investment solutions are often positioned, when traditional asset classes like stocks and bonds suffer, like we saw last year, alternative investments typically receive extra attention from investors. Lower risk coupled with uncorrelated healthy long-term returns sounds pretty compelling, especially coming off of a year where just about every traditional asset class in a portfolio was in negative territory.

But do alternatives live up to the hype? Do they in fact offer lower risk and comparable long-term returns to traditional asset classes? Do they belong in a diversified retirement portfolio? Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today I'm answering those questions. For the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 181.

In 2015, investors had allocated roughly $6.5 trillion to alternative investments. By the end of 2021, that number had skyrocketed to about $13 trillion. And according to Prequin Research, alternatives are now projected to cross $23 trillion in assets under management by 2026. Needless to say, alternatives have thrived in recent years, and it doesn't look like the momentum is slowing down anytime soon.

As I mentioned at the top of the show, alternative investments is a relatively broad term that attempts to capture dozens of different unique asset classes. But for the purposes of today's conversation, we're going to mostly zone in on hedge funds, specifically a basket of well-known hedge funds that have attracted billions of investor dollars over the years.

The study I'm referencing today was published on the CFA Institute website by Nicholas Rabiner. Like many of us, Nicholas was just curious to dig into the alternative space and he set out to see if adding alternatives to a plain vanilla 60% stock, 40% bond portfolio was a smart decision over the last 20 years.

As always, if we're going to add an asset class to a portfolio, we want it to serve a purpose. We want it to improve our long-term results somehow. And for what it's worth, improving results doesn't necessarily mean achieving higher returns.

For example, the theoretical purpose of adding alternatives to a portfolio of boring stocks and bonds, according to the article, is threefold. One, to improve diversification. Two, to improve risk-adjusted returns, i.e. achieve a similar or better return while taking less risk.

And three, to mitigate drawdowns or reduce the amount a portfolio could drop in value. So in short, the intended goal or purpose of adding alternatives is to create a smoother ride for the investor without sacrificing returns.

So to see if alternatives did in fact achieve their intended goal, the author of the study took each of the seven well-known hedge funds and ran a simulation to test the results of adding a 20% allocation of each one to a plain vanilla 60% stock, 40% bond portfolio. In other words, he ran seven different simulations. Each one of them was a 20% allocation of each one to a plain vanilla 60% stock, 40% bond portfolio.

Each simulation reduced the 60-40 stock bond allocation by a total of 20% to make room for a 20% allocation to one of the hedge funds he selected. He then compared each of those seven shiny new ultra diversified portfolios with a 20% allocation to alternatives to just a plain vanilla 60% stock, 40% bond portfolio.

Over the 20-year time period he tested ending in 2022, he found that adding alternatives to the boring 60-40 portfolio did not improve the portfolio's Sharpe ratio. The Sharpe ratio is a popular method for measuring risk-adjusted relative returns.

In general, a higher Sharpe ratio signals better risk-adjusted returns, and not one of the seven simulations had a higher Sharpe ratio. In fact, six out of the seven had lower Sharpe ratios, while one of them was identical to the boring 60-40 portfolio.

In addition to testing risk-adjusted returns, he also tested the maximum drawdown for each of the hypothetical portfolios during the 08-09 financial crisis. The boring 60% stock, 40% bond portfolio dropped 35% during this time period.

The extra diversified portfolios that had a 20% allocation to alternatives declined between 31% and 39%. And while losing 31% is certainly better than 35%, I'm not so sure that sort of double digit decline matched up with alternative investor expectations.

Even more interesting is that the alternative strategies that were added to the 60-40 portfolio all had low long-term historical correlations to stocks and bonds. In other words, over a long period of time, the alternative funds that were selected suggested that they would zig when stocks and bonds zagged. But that didn't appear to be the case during a catastrophic event like 08-09.

The conclusion was that correlations can be deceiving, and there are time periods where alternative strategies can become highly correlated to traditional asset classes. Now, to play devil's advocate here, we're only looking at a 20-year time period. We're only measuring one single catastrophic event, and we're only looking at seven different funds.

It's very possible that the alternatives being measured in this study behave more positively during the next catastrophic event and the next 20 years. And while the author attempted to choose seven funds that had low correlations to stocks and bonds and provided a good representation of the major alternative asset classes, it's certainly possible that a different set of alternatives might have produced better results over the same time period.

But unlike publicly traded stocks, we just don't have much historical data on alternatives, which puts constraints on studies like these. And yes, historical data certainly isn't a perfect indicator of what the future holds, but reliable, robust data can certainly help investors draw educated conclusions and make more informed decisions about how an asset class might behave and what they might choose to invest in for long periods of time.

That being said, one piece of very important data that we do have on alternative investments is their underlying costs. And because the underlying cost of an investment is one of the best predictors of future returns, we're still able to make an educated assumption about future performance of an alternative investment. In fact, we can see the impact of fees in the 20-year study that I've been referencing today.

For example, the seven hedge funds that were evaluated showed that they were able to achieve risk-adjusted returns that were similar to a low-cost 60-40 portfolio, even with their high fees. The author didn't expose the exact fees of the funds being measured, but traditional hedge funds often charge a management fee of 2% per year plus 20% of any profits. This is commonly referred to as 2 and 20.

And alternative mutual funds and ETFs, the funds that mom and pop investors can more easily invest in, aren't much more attractive. According to Morningstar, the average actively managed alternative mutual fund in 2021 had a management fee of 1.48% per year.

As I've stated dozens of times here on the podcast, hedge fund and alternative fund managers are crazy smart people and oftentimes very intelligent investors. But the fees they charge typically eat into any extra returns that they're able to deliver.

The fact that the high cost hedge funds measured in this study were able to keep up with a low cost 60-40 portfolio highlights both the skill set of the managers and the impact of fees on their net returns. As the author of the study concluded, alternatives are terrible at making money.

I've also mentioned here on the podcast that the high cost actively managed funds that have performed well over the last 10 plus years are not typically the funds that go on to continue performing well for the next 10 years. In other words, to have a successful investing experience with actively managed alternatives and hedge funds, you have to be able to identify the good ones before they even have a track record before they've shown positive results.

As you might imagine, it takes a unique skillset coupled with some or maybe a lot of luck to be able to identify a good manager before they're on the front page of magazines attracting billions of dollars. At the end of the day, while alternatives do tell a compelling story, and yes, some select alternative investments have proven that they can add value to a portfolio, the large majority of funds don't meet their stated expectations. When

When you look under the hood across the entire asset class, alternatives haven't yet proven to improve diversification or risk-adjusted returns, and they don't seem to be mitigating losses when you need them the most. In fact, many of them can do more harm than good, delivering lower returns than boring stocks and bonds with more risk.

Well, slightly off topic here, I do want to quickly touch on private and or non-traded alternative investments. For the most part, the alternatives discussed today were publicly traded or at least had publicly available performance information that could be properly evaluated. Unfortunately, the giant and complex world of alternatives and private investments isn't always that transparent.

A non-traded alternative investment doesn't need to reveal their actual day-to-day performance. It's not publicly traded like Apple stock or XYZ mutual fund. It's non-traded. It's private. The accounting rules are different and many of these funds are less regulated and held to different standards.

The most common example of this is in the non-traded REIT or real estate investment trust space. If you've ever purchased a non-traded REIT, you might recall that your monthly or quarterly statement doesn't show any losses. It appears as though your investment has remained stable month over month, year over year, while potentially paying you some nice dividends along the way.

But you might also recall when trying to liquidate or sell your non-traded investment and finding out that either one, you can't sell it because it's illiquid and there aren't any buyers or two, you're only able to sell it for a fraction of your original investment. In fact, we have a client right now that was unfortunately sold a basket of these by what seemed to be a reputable wealth management firm almost 10 years ago.

A few of these funds went straight to zero without any opportunity to liquidate. And a few of them we're still holding onto, hoping there's an opportunity for the client to at least get some percentage of his original investment back. It's a nightmare and an emotional rollercoaster for the client. And to be clear, I'm not against private investments completely. In fact, I think private non-traded investments have some very compelling benefits. Why?

One being that you're often locked out of selling your investment for an extended period of time, removing the emotional and behavioral challenges that come with investing. You can't just log into Vanguard or Fidelity and sell your investment because you were spooked by a headline.

You're forced to hold your investment for an extended period of time, sometimes 10 plus years, allowing the strategy to hopefully do what it's set out to do. Not all that different than Warren Buffett's strategy of buying good companies and holding them forever.

We are our own worst enemy as investors. So there is a clear benefit to not being able to make emotional and irrational changes to our portfolio every hour of the day. Lastly, before we wrap up one common rebuttal that I've heard more and more lately is something along the lines of, well, I'm glad I owned alternatives last year. Stocks and bonds were down double digits, but my managed futures alternative fund was up 30%.

While I can certainly understand the excitement about owning something that had sizable positive returns during a year like 2022, it's important to take note of how many years of underperformance an investor might've had to endure in order to finally see that investment outperform.

Yes, some managed futures funds were up 30 plus percent in 2022, but their 10 year average annual returns look like something closer to a low cost bond fund, but with more risk and more volatility without one or two home run years over that 10 year time period, a long-term managed futures investor would be underperforming boring low cost bonds while taking more risk.

And that's assuming the investor was able to stick with an underperforming investment for that long of a time period.

In other cases, an investor might have had some luck on their side. Perhaps they decided to add a managed futures fund to their portfolio at the very end of 2021 and immediately reap the benefits of this new hot asset class. Again, I can certainly understand the excitement, but now what? When do you sell? When do you buy again? Or do you hold it for the next 10 plus years, hoping that the fund does what the marketing material says it's going to do?

Getting lucky with an investment decision can be exciting and fruitful in the moment, but sometimes it makes future investing decisions even harder and more complex. When it comes to investing, the more systematic we can be about our decision-making process, the more likely we are to have a successful investing experience and avoid making costly mistakes.

In my retirement investing series that I did a couple of years ago, which I'll link to in the show notes, I shared the four drivers of investing returns and why they're widely accepted as the four drivers. In other words, what criteria did those drivers of returns need to meet in order to be agreed upon by most of the academic investing community?

As a recap, the criteria are as follows. It has to be sensible. It has to persist over long periods of time. It has to be pervasive across all markets and asset classes. It has to be cost effective and it has to be robust. For example, one of the four drivers of returns is company size. In short, smaller companies are expected to provide investors with higher rates of return than larger companies over long periods of time.

Is it sensible that a smaller, riskier company would produce higher returns than a larger, stable, less risky company? Yes. Does this outperformance persist across long periods of time according to the data? Yes.

Is it pervasive across all markets and asset classes, i.e. not just U.S. stocks, but also overseas? Yes. Is it cost effective? Well, thanks to low cost factor based funds, investing in small cap stocks is cost effective and getting more and more cost effective by the day. Lastly, is it robust, i.e. does it hold up to different measures used to determine company size? Yes, again.

So if this criteria seems reasonable, it might be worth using it to evaluate investments or asset classes like alternative investments that you might be considering adding to your portfolio. If it doesn't seem reasonable and you have a different philosophy, that's okay too. As David Booth once said, the important thing about an investment philosophy is that you have one that you can stick with.

Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 181. Thank you as always for listening, and I'll see you back here next week.