Alternative Thinking vs. Alternative Assets
If you’ve sat in on any presentations on alternative assets, or picked up any of the marketing materials, you will have heard all the reasons why financial advisers and portfolio managers should own alternatives.
The checklist of potential roles that alternatives play in a portfolio goes something like this:
- Low correlations, which lead to better diversification
- Great inflation hedge
- Capital protection in down markets
- Pure alpha (i.e., great return potential)
- Strategic allocations — a dedicated “slice”
Sound familiar? Slow down, says Peter Chiappinelli, CFA, CAIA, a member of GMO’s asset allocation team. It’s not about alternative assets, per se, it’s about alternative thinking.
In a recent presentation at CFA Society Philadelphia’s high net worth and family wealth conference, Chiappinelli systemically shot down these five reasons, laying out GMO’s “alternative thinking” on each point. (If you are wondering why investors pay heed to what GMO says, it’s because as of 30 September 2013 GMO managed $112 billion in client assets, and Jeremy Grantham, GMO’s cofounder and chief investment strategist, has made many prescient market calls, including cautioning investors during the Japanese bubble, the dotcom frenzy, and the US subprime crisis. And lest you think GMO is skeptical of alternative assets, Chiappinelli, who is founding president of the CAIA Boston chapter, points out that alternative assets are completely legitimate, but that “investors need to apply a critical eye to every dollar they put to work on their clients’ behalf.”)
Here’s a summary of the main arguments and counterarguments, as GMO sees it:
Alternative assets offer low correlations. The conventional thinking is that rising correlations are a problem. But Chiappinelli noted that on GMO’s long list of risks to worry about, rising correlations are so far down as to be “barely a consideration.” The risk GMO does obsess about for portfolio construction, however, is overpaying for assets. “You want to do permanent damage to your client?” he asked delegates. “Buy an expensive asset. It’s the surest way to do it.”
To bolster his case for why rising correlations don’t matter, Chiappinelli referenced GMO’s ten-year forecast from 31 December 2001. Back then, the asset class that looked the cheapest (and thus the most attractive) was emerging equities. How cheap? So cheap that GMO forecast that emerging equities were poised for compound growth of 9.4% over the coming decade.
At the bottom of the list, the asset GMO thought was the most expensive was the S&P 500. So expensive that for the next 10 years, GMO believed that the index would make no money.
So what has this got to do with correlations?
“On the day we made that forecast, the correlation between the S&P 500 and emerging stood at 0.71. Nothing to sneeze at, that’s pretty high, these things are moving together,” Chiappinelli said. “What happened during the next 10 years is that correlations got worse. By the end of that 10-year period, correlations had risen to almost 0.9. That is hand in glove; they are zigging and zagging completely together. That is what everyone was freaking out about. GMO’s reaction is: So what? Who cares?”
If you look at the returns of these two highly correlated assets during that 10-year time frame of rising correlations, the S&P 500 returned 0.4% (real) and emerging (MSCI EMI) returned 11.4% (real), Chiappinelli noted. That’s 11% more, per year, for 10 years.
“If you didn’t own emerging because you were so spooked by rising correlations, if that drove portfolio construction for you, you missed out on one of the best investment opportunities of your lifetime,” he added. “Do not let correlations drive the bus. And yet correlations are one of the main arguments that the alternative camp is trying to sell you on. They don’t matter.”
Alternative assets are an inflation hedge. Have you heard the China-India story? The one about the emerging middle class in China? And how the changing diet of the Chinese household — moving from rice to meat — will reverberate throughout commodities markets? Think about the knock-on effect on the price of cattle, on the price of corn to feed the cattle, on the price of potassium or fertilizer to grow the corn to feed the cattle. Sounds like a no-brainer, right?
Or how about Tata Motors, which can now profitably produce a car in India for $2,000. “Think about it. What does that mean for the price of steel? What does that mean for the price of oil? What does that mean for all the metals that go into catalytic converters? Again, it’s a no-brainer trade. That’s the argument,” he said.
This all might be true. “But what about current valuations? Is it possible that that story is already baked into the price?” Chiappinelli said. “If it is, then maybe it’s not a good deal. Maybe it’s even gotten ahead of itself. If it’s an expensive asset class, maybe it’s going to be a lousy inflation hedge going forward.”
Then there’s this not-so-insignificant situation in futures markets in which futures prices are above the expected future spot prices. “This is the situation today. It’s been this way for five years,” Chiappinelli said. “The industry has a term for it, it’s called contango. We have a term for it at GMO. It’s called: you lose.” (For more on contango, see “It Takes Two to Contango . . .“)
Alternative assets offer pure alpha/great return potential. After 2008, “the mantra was ‘Whew! Those beta markets can be nasty.’ That’s what we heard in the institutional space. ‘I am done with beta,’” said Chiappinelli. “‘But I’ve still got liabilities to pay, so I am very interested in pure alpha solutions, absolute return type solutions.’”
Alpha is just another way of saying skill, and the hedge fund community has done “an amazing job” of convincing people that they have been able to hire the best and the brightest, he added.
So the hedge fund pitch goes something like this: If you need alpha, you need the best and the brightest.
“Separating alpha from beta? We’ve got a fund that’s been doing that for years,” Chiappinelli said. “It’s a mutual fund. We’re not alone. There are lots of these things out there. A lot of the engineering techniques that hedge funds do, we can do.”
One straightforward technique is portable alpha. Chiappinelli said portable alpha asks a really simple question: “Is there a way to just get the good stuff, the stuff we want? Sure, it’s really easy: put $100 into a traditional, plain vanilla, actively managed, large-cap fund and simultaneously short the S&P by $100.” It’s a way to engineer a pure alpha solution, but within a traditional mutual fund structure.
Alternative assets are protection in down markets. “If you had rich clients, what were they saying after ’08? ‘Whoa, that was nasty. I worked my whole life to get rich, and 2008 almost wiped me out. I’m done. I just want to stay rich. Can you keep me rich?’” Chiappinelli said. “Hedge funds are tapping into that psyche and saying, ‘If you want to stay rich, we know how to protect you in down markets, we’ve got the unique legal structure and the skill set to protect you.’ That’s the pitch.”
And after the bubble burst in 2001, many investors started exploring hedge funds. But before they crossed the line, they had to get over the hurdle of what they called the three boogeymen of hedge funds: liquidity, transparency, and fees.
For the “privilege” of no liquidity and no transparency, hedge fund managers charge investors a 2% base management fee and keep 20% of any profits, Chiappinelli said.
“Who on earth would take a deal like that?” he said. “Turns out lots of people. Trillions of dollars flowed into these vehicles in the last decade. It’s now a $2 trillion industry. So the question isn’t who? It’s why?”
Chiappinelli believes 2001 was “so nasty, so disruptive” that everyone wanted to be hedged for when the next test came along.
As it happens, investors didn’t have to wait long. Fast forward to 2008. And here’s how it went: global equities (the MSCI ACWI Index) delivered a −42.2% return; the S&P 500 earned −37%; a 60/40 portfolio yielded −25.6%; and hedge funds (the HFRX Equal Weight) returned −21.9%.
“The hedge fund industry was down almost as much as the ‘naïve portfolio’,” said Chiappinelli, his label for the traditional 60/40 allocation. “The geniuses of Greenwich failed. They failed big time as it turns out. The hedge fund index was down 22%. It is now December 5, 2013, and that index is still under water. Hedge funds as an industry have not made their clients one dime in half a decade. If you gave them a dollar, they gave you back 85¢ five years later.”
Alternative assets are a small slice in a strategic allocation. One argument you will hear over and over, Chiappinelli said, is: take your 60/40 portfolio and just carve out a little slice — say 5% — for alternatives.
“If that little slice did everything the pamphlet said it was going to do, everything, perfectly, why bother with 5%? That’s problem one. Problem two: That little slice is complicated. Do all of you have the risk management systems to track all that stuff?”
Alternative assets offer absolute returns. “Hire us because we can deliver stock-like returns with bond-like volatility.” How many times have you heard that phrase? What about how performance-based fees align interests?
Emphasizing that this was his own opinion, not necessarily GMO’s, Chiappinelli said: “I believe performance-based fees are one of the best marketing gimmicks ever invented because you cannot dislike them. There is nothing not to like about performance-based fees.” The devil is in the details, and it’s called the high-water mark.
If you want stock-like returns with bond-like volatility. Chiappinelli said you need to find managers who break these rules:
- Rule #1: Break from the bonds of benchmarks.
- Rule #2: Think in absolute terms, not relative terms.
- Rule #3: Beware the dark side of performance-based fees.
- “There are lots of risks to worry about. Sweat the right ones. Rising correlations don’t matter. Expensive assets, poorly priced assets — that’s what matters.”
- “Strategic allocation frameworks (or as they are sometimes called ‘policy benchmarks’) are fundamentally flawed. They don’t move, and they don’t pay any attention to valuation.”
- “This is not about alternative assets versus traditional assets. Never fall in love with any asset class — if alternative assets are priced well, buy them. And if they’re not, don’t buy them. Fall in love with cheap assets.”
- “Be cautious of hedge funds — liquidity, transparency, and fees.”
- “Equity-like returns with bond-like volatility — without using hedge funds. Do not write off the boring old mutual fund; there is plenty of room to do some interesting things in a mutual fund.”
For more on this topic, see Chiappinelli’s October 2013 article: “An Alternative Take on Alternatives: Not Just Adding a Slice But Rethinking the Whole Pie.” And for more from GMO, James Montier’s December 2013 White Paper, “There Are No Silver Bullets in Investing, Just Old Snake Oil in New Bottles,” and “Jeremey Grantham’s Bullish Two-Year Outlook.” Also, Tom Brakke, CFA, who writes the Research Puzzle blog, has a good chart in a post entitled “Fees and Fees and Fees,” in which he notes, “The great rush into alternatives is built on the fees of investors who by and large are likely to be disappointed.”
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
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