Introduction
Debt and equity are the
two essential building blocks for all portfolios. With the current dichotomy
between equity and debt indicators that were hinted at in last week’s post
there appears to be more risk of capital loss in many alternative funds than
investors perceive.
Surge in Introducing New
Alternative Funds
As with most “new”
ideas, nothing is rarely new, but a reworked old idea in new clothes, often the
famed emperor’s new clothes. Early British Trusts as well as US vehicles were
primary concerned with the preservation of capital for multiple generations; an
idea that appeals to me and many of my investment accounts. The adopted
solution used in many cases were the selection of investments that often move
in inverse directions avoiding chances of complete destruction from a single
event, think of Lloyd's Shipping syndicates. As these investment vehicles grew
an additional defensive mechanism was added, diversification. Thus, in the US
many of the first funds were balanced funds that held diversified bond and
stock holdings. Still today many bank trust accounts as well as other
institutional investors compare their investment performances to the Lipper
Balanced Fund Index found in the Wall Street Journal and currently produced by
my old firm. However, the traditional Balanced fund has been replaced by a
whole category of Mixed Asset funds with current net assets of $2.2 Trillion or
roughly equal to the total US hedge funds and in the same region of US listed
ETFs (Exchange Traded Funds). In Canada Balanced funds are the single most
popular fund type.
From this base many new
funds were launched with the same desire; that is to offer to investors a less
risky way to achieve good upside performance with controlled downside risk of
loss. Right now there are approximately 500 of these products on offer in the
US. Recent trips to Canada and Europe revealed that alternative funds have
become a hot sales item. Almost all of the newer versions of Balanced funds in
addition to stocks and bonds of various types include derivatives, private
equity, venture capital, use of leverage, and selling short. In the past, there
have been a handful of experts that have produced very worthwhile results individually
with these types of investments.
There are two types of
risks in these funds, the management company created risks and the inherent
investment risk in the asset class. Many of these vehicles are being produced
and sold by investment groups that have hungry indirect and direct sales forces
for new products after several years of lackluster performance from their
historic book of business. They either try to develop portfolio management
talent internally or hire past winners in smaller shops with significant
incentive contracts. Considering many of these firms past history to me either
approach adds to the risk in their vehicles.
As we not only invest for clients and ourselves in many mutual funds, we
also invest in many of the world’s publicly traded management company stocks.
Thus we measure results from different vantage points. This is similar to a
comment in the recent The Economist on celebrating the 100 anniversary of Einstein’s
10 equations where they said “What you measure depends on your vantage point.”
To us the long term profitability of the management company contributes to the attractiveness
of some of its investments, particularly in markets that are crowded with good
competitors.
The inherent investment
risk in most Alternative Investments is based on the structures of interest
rates and credit conditions. Granting a huge assumption that the specific
portfolio is not at risk as to what looks like significant changes coming,
other portfolios will be at risk and that will cause prices and flows to
change, perhaps in an unpredictable fashion.
Fixed Income Indicators
of Investment Risks
The market speaks often
in numbers and price movements not providing full explanations. For example:
Last week Barron’s
measure of “Best Grade” bond yields declined 3 basis points to 3.75%.
indicating an increase in popularity for high quality. In the same week its
measure of yields for intermediate credits rose 6 basis points to 5.12% measuring
some uneasiness about intermediate credits. (One might look at these
relationships and postulate that the stock market is not in danger of losing
assets to bonds until short-term rates run up to 3.75% to 5.12%. I have always believed that the Bond
Market is a better analyst than the stock market, as it has to be, for it has a
lower upside potential.)
Last week one of the
credit agencies noted that since there has already been 99 defaults this year,
we will soon be in a triple digit period which is likely to grow. Considering in general the relatively low
revenue growth of non-energy companies, the odds favor more defaults and are
the reason for the increasing of the yield spread on “junk bonds.” Stock funds
including ETFs had inflows of $2.9 Billion and Bond Funds had net outflows of
$2.8 Billion in the week ending before Thanksgiving.
By nature I am
uncomfortable with crowded markets because the participants often accelerate
their price/volume actions to get out of the crowd as fast as they can. Thus, I
found of interest that Bank of America/Merrill Lynch produced a list of the
four most crowded markets in the eyes of hedge funds:
1. Long US Dollar
2. Short Commodity Stocks
3. Short Emerging Market Stocks
4. Long
US Tech Stocks
If I had long-term risk
capital, my instinct would be to take the opposite views of these hedge funds for
the first three and possibly the fourth bet.
The three Alternative
investment objective classification averages on a year to date basis are minimally
above or below the average of US Diversified Equity funds and well below the
average Large Cap Growth fund and other funds that own the “FANG” Group = Facebook,
Amazon, Netflix, and Google or a slightly larger group known as the “Nifty Nine,”
including the first four plus Priceline, eBay, Starbucks, Microsoft, and
Salesforce. Both groups are up 60%.
Perhaps, the most
salient point of analysis is that because of the other somewhat dour coverage
I did not see the need to go over to the Mall at Short Hills to report “good,
but not great” Black Friday. I will be interested to see how the merchants
handle their inventory liquidation.
Question of the week:
How much risk do you perceive in your bond holdings?
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A. Michael Lipper, C.F.A.,
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Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
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