Mini-Course Series - Alternative Investments (Part 1)

MINI-COURSE SERIES ALTERNATIVE INVESTMENTS Part I

Copyright © 2012 by Institute of Business & Finance. All rights reserved.

ALTERNATIVE INVESTMENTS

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THE PORTFOLIO The taxability of every investment plays a role in whether or not an asset is included in a portfolio and where. Indeed, certain assets have modest returns but are tax advantaged (e.g., municipal bonds and fixed-rate annuities). Investments that are tax inefficient, such as taxable bonds and commodities, should generally go into sheltered accounts (e.g., retirement accounts, annuities, and certain whole life insurance products). Tax-efficient investments, such as stocks and low-dividend REITs, can be used in nonsheltered as well as sheltered accounts.

Alternatives and the Portfolio This alternative investments course covers arbitrage strategies, leveraged funds, hedge funds, commodities, futures, private equity, buyouts, mezzanine debt, distressed debt, credit derivatives, and real estate. Most alternative investments are not tax efficient.

The objective of portfolio construction is to provide the client with a series of asset classes that, when combined, offer a risk-adjusted return that is acceptable to the client for the time period specified. Most portfolios include enough marketability and/or liquidity to satisfy any emergency or client concern. Furthermore, properly positioning assets in sheltered and nonsheltered accounts should result in a portfolio that is highly tax efficient. Legendary investor Ben Graham pointed out “the essence of portfolio management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.”

Dalbar Time-Weighted Return Study Flip through the mutual fund section of your local newspaper, or look at any website to find the performance of a favored mutual fund. The result you see is a timeweighted return of the fund. This is an internal rate of return (IRR) number that assumes no cash flows into or out of the fund. It is used strictly for comparing the return of the fund to the return of an appropriate index.

Time-weighted returns assume $100 is invested in a fund at the beginning of a period and remains invested throughout the period. The calculation is the same regardless of the time period. It does not matter if the returns are year-to-date, one year, five years, or 25 years.

A fund’s time-weighted return rarely reflects the actual return of an individual investor because it does not account for the money investors add to the fund or deduct from the fund. Over time, these additions and withdrawals from a fund create real dollar profits and losses for investors. These real profits and losses are known as dollar-weighted returns.

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The shortfall in return caused by tactical asset allocation is a timing gap that can be measured by comparing mutual fund cash flows to the subsequent performance of sectors and markets. A negative return from timing occurs when money is shifted out of a poorly performing asset class that subsequently outperforms or flows into an asset class that underperforms.

Early attempts to measure the timing gap began in 1994 with Dalbar, Inc. The firm was commissioned by the active mutual fund industry to investigate the differences in holding times between load funds and no-load funds. The theory put forth by the fund companies was that investors stayed invested longer in load funds than they did in no-load funds, thus giving the load fund investor higher returns. The fund companies hoped to use this information to counter the criticism they were receiving for selling funds with high sales commissions.

The Dalbar study did show that load fund investors held onto funds longer than no-load investors, but this finding was not what made this study famous. Dalbar revealed huge timing gaps for both load fund investors and no-load fund investors. These gaps were so large they astonished the investment industry (note: these “gaps” refer to the difference in annualized returns of actual equity fund investors vs. what equity funds returned).

Dalbar found a nearly 500-basis point gap annually between equity funds and fund investors, and a 600-basis point gap per year between bond funds and fund investors. These are extremely large shortfalls for investors. Are individual investors and advisors really that bad at timing the markets? The data compiled to date suggests they are.

According to Dalbar’s 2011 report, over the most recent 20-year period, equity investors earned 3.8% per year, while the S&P 500 averaged 9% annually. Fixed income investors averaged just 1% annually, while the aggregate bond index returned 6.9% a year. Dalbar also measures how long the typical equity fund investor stays with the fund. The average holding period for 2010 was 3.3 years.

THE TRADITIONAL PORTFOLIO A number of advisors may mock the traditional 60/40 (stock/bond) portfolio for its simplicity, but the reality is this mix has fared well historically. The weightings gained tremendous popularity among pension plans looking for a somewhat reliable equity-oriented return, while continuously paying out money to retirees. What is rarely described is the type of risks the 60/40 portfolio is exposed to: 85% of the entire risk comes from the equity portion; only 15% of the entire risk comes from the bond portion referred to as term/credit risk.

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The Strong Impact of Stocks Many things in a person’s life are tied to the stock market, which is closely linked to the economy: [1] when a company’s stock does well, it is more likely to give promotions, raises, and hire more people; [2] when net worth increases, people go out and spend more; [3] when stocks are up, most retirement accounts are also up; [4] when people are making money, they tend to be happier; and [5] multiply all of this by two if there is also a working spouse.

The reverse, a declining stock market, has a similar (but likely greater) impact: [1] people have less confidence and spend less, [2] job security becomes uncertain, [3] company benefits may be reduced, [4] both spousal jobs may be at risk, and [5] employees are more concerned with keeping a job even at a reduced salary. In many ways, the 60/40 portfolio acts too much like a stock portfolio and not enough like a stock + bond portfolio. Over the past 10+ years, the mix for the typical pension plan has been more like 50/50 or 40/60.

There are also ancillary considerations. When stocks are doing poorly, there is a greater likelihood the Fed will lower interest rates to try and stimulate buying and borrowing.

Lower rates mean new retirees, as well as those who reinvest income, will have less income. If the Fed is trying to stimulate the economy by increasing exports, the dollar may fall, resulting in higher oil prices. Still, people tend to embrace stocks because they realize real worth is created through ownership (and because we are greedy).

Over the past 80+ years, the S&P 500 has had a standard deviation of > 20% (~ 32% for small caps), while 20-year government bonds have had a standard deviation of < 10% (< 6% for five-year bonds). In order to have a portfolio whose risk level is truly balanced, the bond weighting would have to be twice as great as the amount devoted to stocks. However, a healthy weighting in equities is needed because of expected higher returns.

There are four possible ways to solve this problem: [1] leverage the stock portion (not usually a good idea unless money can be borrowed at a very low rate), [2] rely on active stock management (not a likely solution since for any given 20-year period, there is a 1in-7 chance for an active large cap portfolio to beat a passive large cap portfolio), [3] use riskier bonds to enhance yield (but high-yield bonds usually act more like stocks than bonds—and they are particularly vulnerable during severe market drops), or [4] consider alternative investments—low correlating assets whose expected returns are higher than bonds.

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Low Beta Stocks There are only a handful of “free lunches” in the world of investments: portfolio diversification, small cap value stocks, mid cap stocks, and low beta stocks. Unfortunately, there is no broadly diversified mutual fund or ETF specializing in low beta stocks—but there are low beta sector plays: iShares Global Consumer Staples (KXI), iShares Global Health Care (IXJ), and iShares Global Utilities (JXI) to name just a few.

There is also Berkshire Hathaway (BRK), a highly favored low beta stock somewhat tilted toward insurance holdings. Diversified low beta stocks might represent up to 10% of the portfolio’s equity portion.

Advanced 60/40 Portfolio foreign (mostly small cap and value) U.S. (mostly mid cap blend and small cap value) emerging markets low beta stocks aggregate bond index

ALPHA AND BETA One approach to asset management looks at the beta or alpha of the investment being considered for the portfolio. Beta investments are designed to replicate returns of an asset category, as measured by an index or a category average, such as mid cap growth funds. Alpha investments seek excess returns or added value (reducing portfolio’s overall risk level). After general allocations have been made (i.e., 15% real estate, 30% small cap value, etc.), alpha returns can be sought—by choosing active managers of an asset category and/or use of alternative investments. Portfolio management in this instance divides its holdings into two parts: beta assets and alpha assets.

For the most part, alternative investments are used for their alpha traits. Several asset categories that are included in the definition of alternatives are considered “alpha drivers.” These are investments whose returns tend to be less correlated to a traditional asset class that, in turn, often modestly reduces overall portfolio risk.

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Seeking alpha is either nonexistent or hindered by the typical institutional or individual portfolio that only considers traditional asset categories. Most of the time, seeking alpha is spent on finding active managers for a traditional category. This, in turn, gets us back to the ongoing debate of active versus passive (index) management. In short, the time and resources spent seeking alpha should be focused on what are considered less efficient categories: hedge funds, managed futures, etc.

HARVARD’S PORTFOLIO EVOLUTION The next table shows different weightings given to several asset categories for Harvard’s endowment fund (source: El-Erian).

Harvard’s Changing Portfolio [1980–2008] 1980

1991

1996

2000

2007

2008

66%

40%

36%

22%

12%

12%

foreign

—

18%

15%

15%

11%

12%

emerging markets

—

—

9%

9%

8%

10%

private equity

—

12%

15%

15%

13%

11%

66%

70%

75%

61%

44%

45%

U.S.

27%

15%

13%

10%

7%

5%

foreign

8%

5%

5%

4%

3%

3%

High-yield

—

2%

2%

3%

3%

1%

35%

22%

20%

17%

13%

9%

commodities

—

6%

3%

6%

16%

17%

Real estate

—

7%

7%

7%

10%

9%

TIPs

—

—

—

7%

5%

7%

—

13%

10%

20%

31%

33%

—

—

—

5%

17%

18%

-1%

-5%

-5%

-5%

-5%

-5%

100%

100%

100%

100%

100%

100%

Stocks U.S.

Total in stocks Bonds

Total in bonds Real Assets

Total in real assets special situations cash Total For Each Year

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According to a study by Buyuksahin, Haigh, and Robe (1991–2008), commodities can provide portfolio diversification—but such benefits have not materialized when diversification would have helped most (during a market crash).

THINGS TO DO  Your Practice List the five investment and planning topics you know most about as well as five you would like to know more about.  The Next Installment Your next installment, Part II, covers hedge funds. You will receive Part II in a few days.  Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.

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