News, Vision & Voice for the Advisory Community
Our alts maven gives his thumbs-up and thumbs-down on products and strategies and offers ways to cultivate a taste for off-the-menu offerings in clients
July 15, 2013 — 4:15 PM UTC by Guest Columnist Rob Isbitts
Way back in November 2009, I wrote an article for RIABiz about how I thought advisors should approach alternative investments. See: The top 10 alternatives to alternative investments. This was also around the time when alternative products were bursting onto the scene, and you couldn’t swing a dead cat without hitting a wholesaler carrying some new, sexy product that wasn’t exactly stocks and wasn’t exactly bonds (apologies to any wholesalers who were offended by that!)
The financial crisis of late 2007 through early 2009 had both advisors and their clients clamoring for something that stood a chance to do well when the stock market fell hard. And, although the damage had already been done in the market, we know that when investors are fearful and alleged solutions come flying at them, they are vulnerable — sort of like the trusting apartment dwellers in the classic “Saturday Night Live” skit “Land Shark.” See: Five scary investment scenarios.
It is my strong opinion — to the extent that I run my advisory firm on the premise — that while alternative investing can be outsourced, it doesn’t have to be. Furthermore, I think you can deliver an “alternative” way to solve your clients’ true concern (big losses in value and volatility that scares them into emotional decisions) without giving up total control of the investment process. The real kicker is that if you line up what it costs to do this, you can likely lower the client’s overall cost and raise your fee within that cost at the same time. See: The 10 most likely contributors to the next market panic.
Everybody wins! ... except for the sponsors of the alternative products you don’t buy. If you can somehow make this approach work (and I think many reading this can), you will likely be seen in a different, even more professional, light by your clients. Why? Because you will be giving them what you they want — having you in charge of their ultimate financial outcome.
Explaining it to clients
I think that RIABiz chose now to update my thoughts in this area because of the historical anomaly that currently faces investors. Many major stock market indexes are at all time highs, and the bond market is too, in that yields are near generational lows. Just thinking about it simply: What goes up often comes down, and without making any market forecasts here, it is prudent to have a strategy for your clients now to defend against one or both major asset classes declining in value.
In the case of bonds, this is potentially the start of a decade or more of tough investment climate, and your clients want to know that you are thinking about answers now to the questions they will have months or years from now. See: Five steps to get your clients out of bonds and into alternative, low-volatility investments.
My guess is that the majority of people reading this article will blow off this advice. They will talk about how for decades a balanced strategy of U.S. stocks and bonds did quite well, and that bodes well for its future. They will insist that the bond bubble bursting is OK, because their maturities are short-term. They will say that active management is inferior to indexing, ignoring that success in indexing is due to more to the presence of a bull market than anything else. Every advisor has an investment philosophy, and regardless of what yours is, this is a moment when you need to 1) be able to explain it clearly to clients and 2) make sure you invest consistently with that philosophy. See: 5 entrenched ruts in which advisors are idling — and how to shift gears to peel out of them.
Above the din
Judging by the ads, booths at industry shows and the attention paid to them, alternative investments are more pervasive today than ever before. I recently attended the Morningstar, Inc. Investment Conference in Chicago and the agenda was packed with sessions on alts. As the former manager of one of the earlier alternative open-end mutual funds (all the way back in 2008) and designer of alternative-separate-account strategies since the late 1990s, it was amazing to see how far this field has come. And yet, I wonder if it’s already gone the way of too many advisory industry trends: Overkill!
When our industry gets oversaturated with solicitations about a concept such as alternative investing, we naturally start to tune out, remember what we learned initially, and forget about why we listened in the first place. This is human nature, no different than a client complaining that his or her account is not up as much as the market this year, even though their objectives led to a very conservative portfolio setup. We naturally get caught up in the excitement and lose track of the big picture. I see evidence in my interactions with advisors that this is taking place now. It leads to a neutered understanding about alternative investing, a commoditization of what they are and what they do. This is not a good thing in any business.
Whether we are talking about private REITs, commodity investments, private equity, hedge funds, alternative mutual funds or anything else that meets your definition of alternative investing, this is a great time to take stock (pun intended) of how you can approach this dazzling, yet potentially very simple, area of your obligation to provide your best thinking to your clients.
In that 2009 article, I suggested 10 alternative styles for you to consider and noted that while all were available as private placements, they were all available in open-end mutual fund form as well. I am more convinced than ever that you do not have to give up liquidity and transparency to pursue nontraditional investment approaches for your clients.
And as for cost, in an industry obsessed with expense ratios, management fees and trading costs, it is curious to me that many alternative products get a free pass when it comes to their cost. So alongside my firm belief that you can deliver lower market correlation and something fresh and responsive to your concerned clients and do so in a liquid and transparent manner, I also believe you can do it at a lower cost to you and thus to your clients, than you might think. See: How CONCERT is leveraging a full-service alternatives platform to boost its carriage trade clientele.
I will explain as we go on, but I will summarize it this way: in an industry still mesmerized by prize-winning investment allocation theories from the 1950s, it is amazing to me that the original alternative investment method is largely ignored by most of that same industry. When A.W. Jones (no relation to A&W root beer) had the vision to create the first hedge fund in the 1940s, it was not designed to generate hefty fees by owning private placements or real estate that could not be valued every day. It was simple and, in my opinion, the purest form of alternative investment mankind has ever seen. It simply bought stocks the manager liked and shorted stocks the manager didn’t like. Isn’t that a lot easier to describe to your clients than what is inside the typical private placement memorandum?
Top 10 reconsidered
With that tip of the hat to alternative investing history, let’s proceed to my updated list of alternatives to alternative investments, with an emphasis on how they can be used within the context of a portfolio you can run yourself or with a moderate amount of assistance. What is even more valuable than looking at them individually is allocating among them.
As in 2009, I am convinced that liquid alternative investing approaches are, pound for pound, superior to those that suffer from opacity. Back in 2009, coming off the financial crisis, I wrote mostly about the appeal of open-end mutual funds to accomplish what you want for your clients. My guess is that versus 2009, many more people reading this article will know what these strategies are. That tells you how far alternative investing has come along.
My own approach has evolved since 2009. Whereas mutual funds used to be the central part of the strategy (and I managed a mutual fund comprising primarily other mutual funds), individual stocks now take a lead role alongside ETFs. See: Startup firm bets its ETF research technology can cut out the middle man for advisors. I can count on one hand the number of mutual funds I still feel are the best choice for the core portion of a portfolio whose value is at least $200,000. With that new personal bias in mind, here is an updated list of alternatives to alternative investments.
I think that the combination of being “long individual stocks” and “long inverse ETFs” (which effectively act as a short position) is a winning strategy for today’s advisor-investor environment.)
Clients understand what stocks are, and if you have a discipline and methodology for using them, some resourcefulness about how you identify ideas, and sell discipline that can limit damage, that is a lot easier to explain to them than asset allocation in an environment of historically low interest rates. See: 8 reasons why the hedge fund industry deserves a second look in 2013 and why RIAs are so well positioned to capitalize.
In fact, I think it’s an ideal way for a fiduciary to be a fiduciary. Your clients know what companies do and they know what stocks are. They may never understand what midcap, core, ACWI and fundamental indexing are. Even ETFs are going to take a long time to seep into the mainstream. See: The basic ETF trading practices that can save your clients money.
My approach today is a combination of individual stocks and ETFs on the long side and the purchase of inverse ETFs (singles, not the poisonous 2x, 3x, etc.) on the short side. I find this approach to be clean, crisp and very straightforward to explain to clients. I rely on equity research from Morningstar and other independent sources, and sync that with my strategic views, which are developed from applying my experience to the interpretation of macro news, data and trends and sentiment. I am convinced that many advisors can do this, and can put their own personal touch on it. I am equally convinced that many other advisors (the type that prefer planning and marketing over investing) should collaborate with an investment-focused advisor. These matches have the potential to boost each advisor’s fortunes and quality of life immensely.
In an industry obsessed with containing investment costs, the good news on individual stocks is that they have no expense ratios. Yes, there are trading costs, but they are quite minimal at the RIA custodians. And how about comparing your cost of operating a long-short style portfolio with that of a fancy hedge fund? The proverbial 2% fee plus 20% of the profits is significantly above what you would charge for a similar approach as I describe it. See: In search of alternative income solutions in the current low-yield environment.
And versus the mutual fund oriented approach? While it depends on what funds you are using, what the client pays to the fund companies can be rerouted to some ETF replacements and the costs of research and support of your process, leaving you around the same cost or lower than currently. But your importance in your client’s life just went up by a factor of many, and their respect for you as a handler of their wealth went up with it.
Think long-short, but with an emphasis on keeping the longs and shorts close to even. This strategy is as valid as it ever was, but tougher than a traditional long-short approach to generate enough “oomph” on the upside. Hedge funds use leverage on this low-volatility approach to try to overcome this. I strongly suggest that you don’t. Still, individual stocks can be a focus of a market-neutral strategy. It just helps to seek lower-volatility stocks and ETFs, and to be prepared to be liberal with your use of hedging techniques such as the aforementioned inverse ETFs.
This is the long-short approach applied to a “Chicken Little” investor — one who prefers to see little movement in his or her account value from month to month, but for whom CDs and bonds are no longer an attractive option. One of the portfolios I manage has a target beta to the broad stock market of 0.25%. That’s a quarter of the stock market. This is not unlike the experience of many limited-term=bond portfolios, but with upside potential and yield levels that such bond portfolios can no longer achieve as easily as in the past. Their free lunch is over, and the market environment and huge number of conservative investors needs a different strategy to consider.
When handled prudently, arbitrage is a wonderful thing. Consider this a specialized subset of market-neutral investing focused on companies involved in merger transactions. One gets the opportunity for consistent upside, but with built-in protection, since most deals a fund participates in involve both a long and short position (e.g., playing both sides of a merger event). Four years later, it appears the mutual funds in this space still do a pretty good job of what had until recently been primarily a hedge fund industry approach. Some ETFs are off the ground in this area, but they are still fairly new and I wonder if trying this without active management applied is a ticket to success.
4. Convertible mutual funds
Convertibles, if chosen well, can provide the upside potential of the underlying stock, but with the “safety net” of a bond … since it is a bond until such time as it converts to the stock. The bond may carry an interest rate (“coupon”) or a company may issue a zero-coupon bond instead. Convertibles are a market dominated by hedge funds and there are some mutual funds that have built a business around this asset type. I don’t know of an ETF that does convertible arbitrage but I suspect it is only a matter of time. See: Performance envy strikes investors as a familiar pattern sets in.
5. High-yield bonds
Leaders have emerged in the business of ETF product-creation in the high-yield-bond asset class. Plenty of mutual funds still exist, but I find they often lack a desired level of purity. When yield spreads get tight, they venture into areas you hope they don’t go in search of yield. Regardless, high yield (f.k.a. “junk”) bonds are a more established asset class than four years ago. Somewhere, Michael Milken and Ivan Boesky must be smiling. I used high-yield mutual funds for a long time, but have made the switch to ETFs, now that this asset class has what I consider to be a sufficient array of choices.
6. Short equityI alluded to these earlier. They are the short portion of an overall long-short strategy. They are also called “bear funds,” and can be very useful as part of an overall portfolio. But whether you use Inverse ETFs or open-end mutual funds for this purpose, I suggest you do so with specific understanding of how and how much holding it will impact your client’s exposure to the stock market’s volatility because of its volatility, not “risk” (the permanent loss of capital) that to me is what clients really care about). Regardless of where your client is on the risk spectrum, bear funds have a role. I use them more rigorously in more conservative portfolios, but when a market decline appears to be going from mild to severe, I am likely to seek bear market protection via one or more inverse ETFs in our more growth-oriented strategy too. See:Three RIA adventures that led to dramatic asset growth.
7. Short fixed income
Four years ago, I talked about inflation threats being the motivator for using these vehicles (one lightly-levered ETF and a handful of other products in this area). But it is not inflation now so much as a strong overshoot in Treasury rates to the downside that stokes my long-term optimism here. Even if rates don’t rise dramatically, there is some catching up to do based on reversing some of the Fed’s quantitative-easing-induced market lifting.
8. Global macro
Frankly, this one is testing my patience. Macro investing, also known as global allocation, and by many other names, encompasses more-flexible strategies that allocate among many asset classes. The issue I see is that as opposed to 2009, when this was an emerging approach in investing, now it appears everyone is doing it. Misery loves company — I see a real possibility that the managers of these funds will be way too passive as the threat of rising rates grows. See: How capture ratios can help you prepare for the next downturn.
Do you have clients that talk about losing faith in the U.S. government’s leadership or who bemoan the debt we are handing down to our kids and grandkids? For these investors, diversifying their cash holdings into multiple currencies can be an attractive addition to a portfolio. Currency investing was the domain of Wall Street trading desks and hedge funds for many years, but several mutual funds are now available to U.S.-based investors to pursue growth of capital and income by owning bonds denominated in non-U.S.- dollar currencies.
There has also been an explosion in currency ETFs, including those that focus on a single currency and those that attempt to invest in a classic currency management pattern (such as the so-called “carry trade” in which lower yielding currencies are borrowed to fund investments in assets in higher-yielding currencies. I have found currency investing to be a more critical part of the lower-volatility strategies I manage, but as that market starts to loosen up following years of nearly zippo in interest from the investments held, currency management could appeal to the more growth-oriented investor as well. See: 13 for 2013: A baker’s dozen of issues you and your clients should really be focusing on this year.
Finally showing signs that the strong price gains in this asset class (publicly traded real estate investment trusts) are ready to take a breather, REITs in recent weeks have acted a lot more like corporate bonds — very interest-sensitive. If that continues, that will be a long-term issue here regardless of how strong earnings are. As with utilities, sometimes the market treats REITs like stocks and sometimes like bonds. This has left REITS collectively with yields that are a far cry from what they once were, just as with bonds. I suspect that they will again sell at good value based on their yields, but at this point, I find it hard to identify many that are priced reasonably.
As I said back in 2009, how you handle your communication and implementation of alternative investing for your clients will mean a lot to them. To you, that means more time serving clients, cultivating relationships, seeking referrals to build your practice, managing a staff and overseeing the other parts of your portfolio. You can participate in the portfolio-building process to the extent you choose. You are independent, but not alone.
Rob Isbitts (email@example.com), a 26-year industry veteran, is the founder and chief investment strategist of Sungarden Investment Research. Sungarden provides advisors with an investment process, portfolio design and model portfolios. Rob has written two investment books, created several portfolio strategies, and is a former chief investment officer and mutual fund manager. You can follow his blog and connect to Sungarden’s website at www.sungardenblog.com. He offers advisory services through Dynamic Wealth Advisors, a registered investment advisor.
Mentioned in this article:
Sungarden Investment Research
Asset Manager for RIAs
Top Executive: Rob Isbitts
Dynamic Wealth Advisors
Top Executive: Jim Cannon
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