Over the past few years, one of the more popular categories of mutual funds has been so-called ‘alternative’ funds. Alternative investments, broadly defined, are strategies that seek returns that are uncorrelated from traditional investments like stocks and bonds.
While alternative investments were once largely confined to private partnerships, they are now popular in mutual funds, or what the industry refers to as ’40 Act Funds. Following the 2008 financial crisis, alternative mutual funds were heralded as the solution for low expected returns for stocks and bonds.
As it happened, stocks and bonds fared well, and alternatives suffered, but that didn’t stop a flood of new mutual funds tracking alternative strategies.
I don’t have a problem with alternative funds and have owned them in my account since the crisis to learn about them. As I’ve said before, my account often serves as an incubator for strategies, for better and for worse. In 2014, I outlined my relative lack of success over the years in this category, and things haven’t gotten a lot better since then.
One of the things that I’ve learned about alternatives is that you’ve got to get comfortable with several normally objectionable ideas if you want any of these strategies.
Here is a partial list:
- Derivatives: Not all derivatives are as bad as they sound. Farmers have been using them for centuries to protect their livelihood from unpredictable weather. Many funds, even conventional ones like the Vanguard 500, use derivatives to some extent, but alternative mutual funds take derivatives to a whole new level.
- Leverage: Like derivatives, leverage is just a tool. When you bought your first home, you probably used 4:1 leverage when you put 20 percent down and borrowed the remaining 80 percent from the bank. Most alternatives use leverage, and while it can be benign, it can bite pretty badly from time to time.
- Short-Selling: If you want to profit from a price decline, you’ve got to sell the assets short (or using derivatives). Shorting is sometimes viewed as un-American and is often banned during periods of crisis, including the US during the 2008 crisis. I like short-sellers because they often uncover fraud like Enron and provide liquidity to long investors like us.
- Illiquidity: The ability to sell an asset anytime without impacting the price is known as liquidity. One of the major sources of return for a lot of alternative investments is illiquidity. A bond that you can’t sell ought to yield more than one that you can unload instantly. This applies to all kinds of assets. There’s an old saying that liquidity is like oxygen – you take it for granted until you don’t have any.
If these big picture items don’t bother you, some of the more practical things might, like the lack of transparency and operational risk. Once you get over these factors, then you have to accept the high fees, which start at one percent and average closer to two percent.
As I said, I don’t have a problem with alternative funds despite all of the issues listed above. There are obviously plenty of risks, but earning returns that are independent of stocks and bonds is an attractive proposition.
I wonder whether investors who can get over all of the aforementioned risks can really live through the bad times when they come. Every strategy loses money at some point, including old-fashioned stocks and bonds.
One of our jobs is to make clients stay the course when the going gets tough and that’s hard enough with just stocks and bonds. I may be wrong, but I think that job is a lot harder when you’re explaining that the losses are related to derivatives, leverage, or short-selling.