News, Vision & Voice for the Advisory Community
A decade on, the investment industry is fast destroying a promising asset class
January 27, 2015 — 6:19 PM UTC by Guest Columnist Rob Isbitts
Brooke’s Note: From my perspective, it just comes across as a license to steal. Call your product an alternative investment. When they’re on their best game, alts, as they are known, are elegant investments masterfully crafted to ensure either unusually steady, healthy returns or to have an unusually high chance of hitting it out of the park. If only it were so. Too often it just seems to be an excuse to charge high fees, provide lousy liquidity and to offer low visibility about inner workings. I wondered if other people besides me felt that way. When I talked to Rob Isbitts, he assured me that he was my man for this topic.
As the alts industry continues to expand, morph and (I assume) eventually consolidate, just keep in mind that some of your clients can’t afford to not have the money they need, when they need it.
• Daniel Thibeault, a portfolio manager at the GL Beyond Income Fund, faces civil charges from the SEC and criminal charges from the FBI for allegedly stealing $16 million (about 40% of the total) in assets from fund he managed, the GL Beyond Income Fund, of which he was portfolio manager. This “hedge” fund invested in consumer loans.
• In the summer of 2014, Nick Schorsch of American Realty Capital (ARC) is hailed by Forbes as “Alternative Investing’s Slick New King” and is described by brokers as “the Messiah of High Yield.” Two months later, an ARC board member recommends publicly that investors should have 30% of their assets in “alternative investments.” Two months after that, it is revealed that the company concealed accounting errors, causing widespread distress for holders and advisors involved in its private REIT investments. This is the latest hiccup in private REIT business since the financial crisis jarred such products due in part to their limited liquidity. See: Nicholas Schorsch explains why buying Cetera makes him a white-hat magnate in a black-hat world.
• F-Squared, a successful RIA that grew to over $27 billion in assets as of last September through the management of ETF managed portfolios, discloses at that time that it had overstated portfolio performance from 2001 through 2008. The misleading disclosure was one thing, but the fact that advisors and their clients flocked to F-Squared based largely on that performance track record (which was allegedly based on live accounts, but was not, alleges the SEC) was another. In fact, at the time of the news, F-Squared was managing over 1/4 of all ETF managed portfolio assets. So, do you think people make decisions based on past performance? Appears so. See: Big brokers take action on F-Squared funds and Virtus shares reel as SEC actions sink in.
And the beat goes on … or should I say, the beating up of advisors and their clients by this labyrinth our industry has created called “alternative investments.”
Liquid, illiquid and other
This article came about because RIABiz founder Brooke Southall called me to blow off steam. Not at me, but at the constant barrage of solicitations he receives via e-mail and otherwise from alternatives providers. RIABiz was an early follower of what used to a be simpler investment category to understand. And I was an early practitioner in the “liquid alternatives” area, having been a long-short investor since the late 1990s and managing two long-short funds when very few people knew what alternative mutual funds were. See: The top 10 alternatives to alternative investments.
By now, nearly every advisor has heard of alternative investments, whether liquid, illiquid or in-between.
But here’s the rub: How do you figure out what the heck to do amidst the piles of material and pitches stuffing your inbox and mailbox while alts product providers mount their soap box, one after another, trying to convince you that their way is the right way to complement or replace your tired old stock/bond portfolio mix?
Always bursting bubbles
Alts are now a huge industry, but it was not always that way. The first “alternative investments” were private-equity funds and hedge funds back in the 1940s. For the latter type, the goal was simple: reduce volatility and correlation to the broad stock market but still have stock market exposure. And instead of using bonds to create a “balanced portfolio,” sell short stocks you don’t like. To me, this is still the purest form of alternative investing. It can be complex to succeed, but it can be explained to clients in a very straightforward manner. See: A more liquid alternative to alternative investments catches on.
Oh, if it were only that simple today! Commodity trading funds, private real estate, oil and gas wells, low volatility funds, alternative beta, market neutral, long-short, high yield, hedge fund of funds, EM debt, merger arbitrage, credit arbitrage, currency management, private equity, structured products…did I forget any? Sure I did, the list is endless!
And if you try to navigate through all of the nuances, risk disclosures, opaqueness (even in the 1940 Act-Registered Funds!) and of course the scandals and misdeeds in some segments of this industry, it reads like an RIA’s version of the old Billy Joel hit song, “We Didn’t Start the Fire.” I suspect the chorus would go something like this:
We didn’t start the bubble
It was never-ending government spending.
We didn’t start the bubble
But the Alt investing led to some arresting.
You see, the reason Brooke’s and my days (and likely yours) are filled with alternatives to traditional investment strategies boils down to this: opportunists trying to capitalize on the still-palpable investor skittishness in the wake of the financial crisis and Great Recession.
Back to basics
Now, there are many, many credible and successful players in this field.But just as if something that seems is too good to be true probably is, if something is so ubiquitous that you can’t get away from it, it must be handled with great scrutiny (by you).
In the case of alt investing, what started as a great concept went the way that so many overhyped asset classes do: the field gets so crowded, its gets that much harder to spot the ones that make sense for your clients. Note that I said “make sense” not “the best” because what is best for you, your practice and your clients is what you get paid to determine. See: Top 10 alternatives to alternative investments for RIAs: 2013 edition.
But with so much choice out there, there is a core set of principles that I can suggest. These have guided me through a career which went from picking less-correlated SMAs in the 1990s (like convertibles and REITs), to managing portfolios made up of alt mutual funds, to running an alt mutual fund, to simplifying the whole darn thing for my clients by running long portfolios with individual stocks, combined with single-inverse ETFs to hedge (i.e. long-short). Through that winding path over the past 20 years, I think you can boil Alternative investing down to the pursuit of five things.
I use the baseball analogy to a “Five-Tool Player.” In baseball, if you find a guy who can hit for power, hit for average, run, field and throw at an exceptional level, you have a stud. Alex Rodriguez was one before his pharmaceuticals issues. In alternative investing, I suggest the Five Tools advisors and their clients seek are these:
1. Preserve capital by actively defending against big losses
2. Produce income that is sufficient, stable and growing
3. Grow over the long term
4. Reasonable total cost (this may not be the cheapest alternative available, but the one that has the best tradeoff with the potential merits of the investment)
5. Liquidity that is intraday or daily
In particular, liquidity is a big one that obviously has been underrated by investors before, during and since the financial crisis.
And while there are still plenty of choices for client capital, it seems to me that too many alt strategies that require giving up liquidity end up not being “all-that” when times get tough. See: How CONCERT is leveraging a full-service alternatives platform to boost its carriage trade clientele.
As the alts industry continues to expand, morph and (I assume) eventually consolidate, just keep in mind that some of your clients can’t afford to not have the money they need, when they need it. Liquidity used to be something you sacrificed to get a higher return or a more consistent income payout. From what I see, that is no longer needed.
Cost too is overrated, but probably the other way. Investors, and in turn advisors, have become so hyper-focused on keeping costs down, they often forget about the biggest investment cost. It’s the one that rears its ugly head when the S&P 500 and Barclays Aggregate Bond Index don’t go up for six years straight, as they have recently.
I am referring to the cost of very lousy, very negative performance, the type that can send retirees back to working for a living.
So when we look at the alts business today, it occurs to me that a strange and ironic shift is happening, in two parts:
• ETFs are replacing what many mutual funds used to do (act as core buy and hold portfolio holdings) See: How ETFs have been oversold when it comes to flexibility, lower costs and tax efficiency.
• Mutual funds are replacing hedge funds as firms try to tap the mass-affluent and baby boomer retail market by launching their hedge fund strategies with a ’40 Act wrapper. See: Criticism of ETFs is based on fear more than factual basis: columnist.
SEC and FINRA weigh in
That’s all well and good, but as Brooke, me and probably you just got the feeling that the whole thing was developing too fast, a couple of well-known industry participants chimed in. I am talking about the SEC and FINRA. I quick review of their supervisory history when it comes to liquid alts:
• In June of 2013, FINRA issued an alert on alternative mutual funds and warned of their complexity. In “Alternative Mutual Funds are Not Your Typical Mutual Funds,” the self-regulating body for broker-dealers stressed the importance of understanding how such funds work and how they fit into one’s overall portfolio. Of course, this is par for the course with RIAs, but unless you have a consistent process and core belief system about how your clients should use alts, you are whistling by the graveyard … on Halloween. See: Fidelity, Goldman Sachs and Morningstar call 16 top reporters to New York to define the RIA alts problem — and to explain how their Dream Team solves it.
• In April 2014, the SEC announces it’s taking exams of alternative mutual funds with particular interest in their use of leverage, derivatives and overall risk.
• In January of this year, FINRA strikes again, noting that their annual letter on examination priorities focuses on “key sales practice, financial and operational, and market integrity matters.” See: What the 8 pillars of a FINRA-replacing entity for RIA oversight look like and how personal accountability is key.
The regulator also cites five “key areas” where deficiencies occur frequently.
The alts discussion
In other words, when you are pursuing ideas like “smart beta” you had better make sure you don’t commit the same dumb mistakes that have damaged the advisory business in the past.
In response to the slew of products and assets chasing those products, some familiar and not so familiar sources have emerged to help advisors get a grip on the alternative landscape. Morningstar Advisor is one, and naturally the biggest investment firms are now adding perspective and research components behind their product arsenal. See: The 4 biggest investment performance myths — and how they can torpedo advisor-client trust.
That’s a good thing, even if it does nothing to clarify the sea of offerings for you. But at least if you can hone in on a few sources you trust and “go deep” with, you can gain sufficient confidence to determine if, how and how much you use these strategies. There are also some emerging consolidators of alt investing news, such as DailyAlts.com. See: Fidelity teams with Goldman Sachs as part of big push into alternative investments on behalf of RIAs.
We’ve come a long way in the alts business. So much so that I am far from the first to exclaim that “alts are now mainstream” in our industry.
And as a result, even if you have little or no interest in them, you had best gain at least a basic understanding. In the Internet economy, your clients will run into plenty of “advice” from product providers, media and others, so it makes sense to be ready to hold your own in the alts discussion. Brooke and I certainly hope that our frustration and crowded e-mail accounts that resulted from today’s alt-mania helps you focus your efforts.
_Rob Isbitts is a thought leader in the area of “hedged investing”...but he is not a hedge fund manager. Over the past three decades, he has managed daily liquid portfolios through a diverse market conditions. He has created several investment strategies, including the Sungarden Investment Research Hedged Dividend portfolio, an alternative approach to the pursuit of income, preservation and long-term growth. Rob has managed mutual funds and authored two books. He blogs regularly at sungardeninvestment.com. His most recent research papers are available at hedgedinvesting.com.
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