Following is an overview of several alternative investments that didn’t warrant their own posts:

Convertible Bonds.  These are bonds that are convertible into shares of stock. They are mostly traded by hedge funds using sophisticated arbitrage strategies.  We do not use these in portfolios as they aren’t different enough from stocks to make the diversification compelling.  They are equivalent to having a bond portfolio combined with call options on the related stocks.  Because of the call option the yield on the bonds are lower than they would otherwise be.

Preferred Stocks. Preferred stocks are mostly owned by corporations due to the special tax treatment (there is a dividend exclusion for companies). While preferred stocks are senior to common stock in the capital structure, they are junior to all debt.  This means in the event of bankruptcy, there is likely to be little, if any, recovery.  These stocks are not typically a compelling investment for individuals.  While they are technically stocks, they more closely resemble bonds in most cases.

Hedge Funds.  A hedge fund really isn’t an investment strategy, it’s a compensation method.  There are a wide variety of funds so it is difficult to paint with a broad brush, but in general:

• In the U.S. hedge funds are only available to accredited investors – those who have a net worth of over $1 million excluding their primary residence, or an income over $200,000 ($300,000 with spouse) for the last two years and expected for the current year.
• The fees are high (though worth it if in fact they are delivering alpha), and are most commonly “two and twenty” – two percent of the value plus twenty percent of any profits.
• They require minimum investments that preclude even relatively wealthy investors from owning enough of them to diversify properly.
• Hedge funds of funds solve the previous problem but at the cost of another layer of fees.
• It appears hedge fund outperformance may have existed when there were fewer of them, but it probably doesn’t exist any longer.
• To the extent there is (or was) outperformance it is (or was) concentrated in a very few funds that have such restricted access you (or I) are unlikely to be able to get in.  (Groucho Marx said, “I would not join any club that would have someone like me for a member.”  Similarly, you don’t want to invest in a hedge fund that would allow you to do so.)
• While ostensibly charging high fees for alpha (outperformance) it appears in practice they are delivering a great deal of beta (simple market performance) which should be nearly free.
• The strategies are opaque and illiquid.

We do not invest in hedge funds or encourage clients to do so either.

Master Limited Partnerships.

• These have historically been owned by investors in taxable accounts for the favorable tax treatment, but it comes with increased tax complexity (K-1s) that investors dislike.
• If the positions are large, it may cause the investor to have to file state income tax returns in states where the partnerships are located.
• If the positions are large and located in a retirement account, it could result in UBTI (Unrelated Business Taxable Income) which is taxed at trust (i.e. high) rates. Further, this does not create any basis in the account and thus will be taxed a second time when it is distributed to the owner.  This is very unfavorable.
• It would be difficult to diversify properly among individual MLPs given the very small weight it would have in even a relatively large portfolio.
• Recently Exchange Traded Notes (ETNs) and Exchange Traded Funds (ETFs) have been created that remove some of the favorable tax treatment (particularly with the ETF), but offer diversification and 1099 treatment.
• Like REITs, I think the best metric is the current yield.  Past total returns should probably be given little weight.
• They have very low correlation to stocks; higher than commodities, but less than high yield bonds, and high yield is also the asset class to which they have the highest correlation.
• MLPs should actually go up with inflation.

The returns on MLPs can be attractive relative to high yield and offer additional diversification.

High Yield Bonds.  These are also known as “junk bonds” or “non-investment grade bonds.”

• These are somewhat like covered call writing on an equity portfolio, and should produce high returns in moderate periods, little extra upside potential in good times, all the downside in bad times. In other words, the distribution has negative skew.

• These can be very good for “muddle through” markets. If the economy booms, stocks win. If the economy tanks, investment grade bonds (particularly treasuries) win.  But in a slow growth environment where companies are neither doing extremely well nor going out of business, high yield can do relatively well.

• Some analysts believe these are unnecessary in a portfolio of stocks and bonds as they are merely a hybrid of those two. I find a significant idiosyncratic element that leads to improved portfolios because of the increased diversification.

High yield bond funds can have a place in client portfolios, but in small proportions and as part of the stock (i.e. “risky”) portion of the allocation rather than the fixed income portion.

Directly-owned real estate is a popular alternative investment.  While there is no right answer for every situation and different people will weigh the factors differently, here are some items to keep in mind (in no particular order):

• People like real estate emotionally. The fact that it is tangible and substantive, gives them comfort.  The danger is, however, that these emotions will get in the way of an objective decision.

• Behavioral finance research has demonstrated that people tend to overweight recent data. Long-term returns on real estate (longer than the past few decades) have been just above inflation (0.4% above inflation according to one study), though this ignores income or expenses of the real estate.  Income-producing investments can have very high returns (similar to stocks) if unleveraged (no debt) and potentially even higher if levered (debt financed), but flipping is probably not a successful long-term strategy.

• Real estate is a good inflation hedge particularly when financed with a long-term, fixed-rate mortgage. Thus it can be a risk-reducing part of a prudent financial plan, though it is difficult to get proper diversification due to limited personal resources except for the very wealthy.  Also, people typically don’t diversify because of comfort with “known” types of real estate and the local area (e.g. they tend to buy single-family residential rentals in their area rather than warehouses in another part of the country).

• High leverage (debt) frequently used exacerbates cash flow issues if properties are vacant temporarily. (This is ameliorated of course by not using leverage.)

• There are some tax advantages to real estate as an investment.

• It can be more work than people realize, and they rarely factor the value of their time into their basis when computing their returns. It is also generally illiquid, and transaction costs are generally high.  Because of these factors, publicly traded REITs may be a more appropriate alternative.

• It is a relatively inefficient market (i.e. mispricing can happen and can be large); so there is opportunity to outperform based on skill. Even assuming skill exists however, it is difficult to have the requisite number of transactions for it to evidence itself.  See the detailed explanation of this below.

• The riskiness of real estate is frequently not recognized due to artificial smoothing of prices reducing the standard deviation of the data as mentioned below.

I would like to dilate further on the last two points because they are important in areas other than real estate as well.

It is not enough to have skill; there must be adequate opportunities to evidence that skill.  This is one of the primary problems with attempting market timing with traditional investments – even assuming some people have skill, they don’t get to exercise it often enough.  To illustrate, suppose I have a coin that has a 60% chance of coming up heads and a 40% chance of coming up tails.  Would you bet $1,000,000 on one coin flip that it would be heads?

If the flip comes up tails you pay $1,000,000 and if it comes up heads you get $1,000,000.  The expected return is $1,000,000 x 0.6 – $1,000,000 x 0.4 = $200,000.  Few people would be willing to make that wager, even though on average you would win $200,000.  However, you would almost certainly be willing to bet $1 on that coin flip and do so 1,000,000 times, even though the expected return is the same.  The difference is the outcome becomes practically guaranteed because of the volume of wagers.  You will almost certainly have a profit of close to $200,000 at the end (99% of the time you would be between $197,476 and $202,524).  In real estate, even presupposing superior skill, many transactions are necessary to eliminate bad luck and evidence that skill with high certainty.

Real estate may look less volatile than it actually is for two reasons:  First, properties don’t trade every day, so prices between trades are estimated.  These estimates tend to be based on the last transaction and/or the last estimate, which tends to smooth the volatility (hedge funds with illiquid holdings have this same artificial reduction of volatility).  Second, when prices “decline,” many people exhibit typical loss aversion, and pull the property from the market until it recovers rather than selling.  Thus, while the true price is a loss, volumes simply slow dramatically rather than showing up as a loss in the data.

On a related note, we occasionally have people ask about purchasing real estate in their IRAs (individual properties, not REITs).  We wouldn’t recommend buying real estate in an IRA for the following reasons:

• The fact that someone is using an IRA for the investment generally would indicate they don’t have the financial resources to buy it without using retirement funds. Since frequently the vast majority of an individual’s non-retirement assets are tied up in their primary residence (i.e. real estate), investing retirement funds in a similar asset in most cases would mean they are very undiversified (and possibly leveraged).

• Individually owned real estate (the buildings, not the land) can be depreciated for current tax savings and capital gains (above depreciation recapture) get a special (low) tax rate. Neither of these benefits are available within an IRA.

• Investors should avoid using leverage on IRA investments because it creates UBTI (Unrelated Business Taxable Income) which is taxed at trust (i.e. high) rates in the IRA. Further, this taxed income does not create any basis in the IRA and thus will be taxed a second time when it is distributed from the IRA to the owner.  This is very unfavorable.

• Investors cannot use any “sweat equity.” Doing work on the property is an IRA contribution and prohibited since IRA contributions may only be made in cash.

• Using the property personally constitutes an IRA distribution and is taxable.

• Enough liquidity must be maintained within the IRA for unexpected expenses. Because the investor needs to avoid debt and thus UBTI and because they can’t just arbitrarily contribute extra funds to an IRA when needed, an adequate cushion of liquidity must be maintained.

• A similar need for liquidity exists in retirement when RMDs (Required Minimum Distributions) must be taken. There must be enough cash or other investments to make the distribution, or the taxpayer has to distribute a portion of the property.  For example, suppose a house is worth $548,000 and the taxpayer turns 70 ½.  There is a 3.65% RMD so $20,000 of the house is distributed from the IRA and put into different (individual) ownership.  Every cash flow is now split 96.35% and 3.65% between the two entities.  Needless to say, this creates a great deal of complexity.

• Related to the previous point, since RMDs are based on the value of the IRA, each year a qualified appraisal will have to be done each year to determine the current value.

For most people Real Estate Investment Trusts (REITs) would be a better investment option.  Here I am discussing equity REITs as opposed to mortgage REITS or hybrid REITs:

• REITs invest in a variety of commercial real estate ventures and the correlation between commercial real estate and residential property (which many investors already are overexposed to through their residence) is trivial.

• REITs are most highly correlated with small value stocks and also somewhat correlated with high yield bonds.

• The tax-efficient REIT structure is now available in enough other countries for international REIT funds to exist.

• In theory, REITs should serve as a reasonable inflation hedge as they own real property and the duration of the tenant’s leases should be shorter than the duration of the mortgages giving them the ability to raise rents faster than financing costs increase.

REITs are among the most popular alternative investments but they are actually not strong alternative candidates.  Nonetheless, given their widely accepted position and the ability to invest in international REITs (which should give a great deal of diversification) they may have a place in portfolios.

There are three types of investments in commodities, investing in the physical commodity itself, investing in a derivative instrument, and investing in natural resources stocks.  First, we have the physical asset:

• The expected return on the physical asset is roughly inflation, but the historical return on the spot price is actually slightly less than inflation because technological improvements in growing, processing, refining, extracting, etc. have trumped increased scarcity and increased demand over time.

• With the exception of precious metals, it is extremely difficult and/or costly, if not impossible to hold the actual commodity.

• The volatility is extremely high.

• They aren’t a particularly good inflation hedge.

Most investors do not invest directly however, but rather invest in a commodities futures fund:

• Investing in derivatives is a zero sum game.  For every winner there must be a loser, and it is irrational to expect to be on the winning side more often than not.  On average, the return to all investors will be the return on the collateral (typically Treasury bills).

• The historical out-performance of commodities futures is due to the short history of the relevant indexes, the fortuitous extreme over-weighting of energy in those indexes, and a supply/demand imbalance that caused normal backwardation of the contracts.  Currently contango is the norm, turning what has been a historical tailwind for long investors into a current headwind.  (I apologize for the technical terminology, but in the interest of brevity the explanation of normal backwardation and contango is outside the scope of this paper.)

• The volatility is about a third higher than the volatility of stocks.

Occasionally investors buy stock in natural resources companies as a proxy for the commodities themselves, but they are a very imperfect proxy because:

• Wise managers of such a company should attempt to reduce their exposure to the commodity with hedging contracts.  They seek to profit from skill in their business rather than the vagaries of current market prices.

• Business issues and factors can account for a great deal of their performance (competition, prices of things they need such as supplies and personnel, etc.).

We do not invest in commodities because while it is not “wrong” (particularly in the extremely small doses that are generally used) it is unlikely to be helpful.

While gold is a type of commodity it is popular enough to merit its own details:

• While today’s prices have risen considerably from the recent prices, gold hit $850 per ounce in 1980.  If you had purchased gold as an investment at that time, your average annual return since then would have been about 1.23% (source data here).  Inflation over that period has been 3.14% (source data here). So an investor would have experienced (so far) 36 years of negative real return.  Due to volatility, picking different time periods can give wildly different figures.

• Today, if you are concerned about inflation risk, investing in TIPS (Treasury Inflation-Protected Securities) is a much better option.  TIPS are government bonds that pay returns plus inflation.  Generally (though not as I write this), the yield on 10-year TIPS is between one and three percent plus whatever inflation occurs.

• In times of financial crisis, gold is less correlated to the market, but so are short-term treasuries.  During the 2007-2009 financial crisis, gold was essentially uncorrelated with the stock market, but so were investment-grade bonds, and short term treasuries were negatively correlated, which is actually better.

• Some believe in gold investments as a hedge against some sort of Armageddon scenario.  If we have a worst case scenario with no functioning economy, gold will probably be relatively useless as it has little utilitarian value.  In other words, if you can’t eat it, wear it, or live in it, why would anyone want it?  The best investment for that situation is probably ammunition.

• If we don’t have a financial meltdown, the best gold investment is probably jewelry for someone special in your life.  This will probably have a higher rate of return (albeit not a financial one) than buying bullion.

• Finally, some tax trivia.  Most folks don’t realize that gold is considered a collectible by the IRS and thus has a maximum tax rate of 28% rather than the capital gains rate of 15% most people would pay – and this is true of investments in ETFs that hold the physical bullion as well.

We do not use gold in portfolios as the low expected return is more detrimental than the diversification potential is helpful.

In my last post I discussed the primary asset classes (stocks and bonds) and their various subdivisions.  In this post I will give an overview of some “alternative” investments.  First we should define what an alternative investment actually is.  There isn’t a precise definition, but broadly speaking it is an investment that is not one of the ones mentioned above (stocks and bonds).  As noted previously, common stocks can be large-cap, mid-cap, small-cap, or micro-cap; growth or value or blend; domestic or international; and represent companies located in developed countries or emerging markets; nonetheless those would all generally be considered traditional investments.  Similarly, investment grade bonds can be short term or long term; inflation adjusted or not; callable, putable, or neither; and taxable or non-taxable (i.e. municipals or “munis”) with none of those categories considered “alternative.”

A number of alternative investments are illiquid and don’t trade regularly so the prices are merely estimates.  This leads to two statistical artifacts of note.  First, the standard deviation (volatility) appears lower than it really is, and second, the correlation with other investments (generally the correlation being reported is with stocks) appears lower than it really is.  The investments that are prone to having this issue (and having salespeople present what is in fact bad data as a purported advantage to the investment) include many types of hedge funds, non-traded REITs, timber investments, and directly owned real estate.

Another difference between traditional investments in stocks or bonds and alternative investments is the source of returns.  Companies sell products or services and most of the time make a profit which investors then receive as a dividend, interest, or growth (in the case of government bonds, taxes pay the interest).  Many alternative investments don’t have that tailwind, but rather depend on three things.  First, that some investments are mispriced by enough to yield risk-adjusted excess returns even after transaction costs, search costs (the cost of finding the mispricing), overhead, etc.  Second, that the manager can identify those mispriced securities in advance.  Third, that the market will then recognize the “true” value of the investment and move it to that value over a reasonable period of time.

In addition, these types of investments frequently come with high risk, high correlations with stocks, and a great deal of illiquidity – though none of these may become apparent until there is market stress.  Further, the distributions of returns are typically leptokurtic (extreme events happen more frequently than you would expect) and negatively skewed (those extreme events tend to be the bad ones, not the good ones).

With that out of the way, over the next few posts I will review various alternatives.

An asset class is a group of investments that have similar behavior and characteristics. When selecting investments it is vitally important to have estimates of three statistics for each asset class:

1. Expected Return – the rate of return anticipated on average.
2. Standard Deviation – the variability likely in those returns.
3. Correlation Coefficient – the manner in which two classes move relative to each other.

Very safe investments tend to have very low returns and very low chances of much volatility in those returns. More speculative investments tend to have both higher average returns and a higher chance that actual experience will be vastly different from that average. The third factor, correlation, is extremely important but frequently overlooked. With investments that move in different directions from each other, the portfolio will have a lower standard deviation of returns than its components. This is the rare case of a free lunch – diversification works.

We believe there are only two primary asset classes – stocks (equity) and bonds (debt). There is overwhelming evidence that the primary determinant of gross portfolio performance will be the portfolio allocation between these two classes. Net performance can be greatly enhanced by accessing these classes efficiently, though this is not often done. Within these two main categories, a number of sub-classes, while they may be useful, are vastly less important than getting the “big picture” right. The precise sub-classes used and the level of use will vary by client. Following are some typical subdivisions:

Equities (Stocks). Some exposure to stocks is the only way most people can reach their financial goals. We believe the risk of a portfolio losing money in a given year is far less important than the risk that the portfolio won’t last as long its owner. The following are common ways to classify stocks:

• Geographic location: Domestic, Foreign, Emerging Markets, Frontier Markets. We believe foreign exposure may reduce portfolio volatility, but investors frequently prefer low exposures to foreign companies and are willing to endure potentially higher volatility to be more aligned with domestic markets.

• Market capitalization (size): Micro Cap, Small Cap, Mid Cap, Large Cap. Though it appears smaller companies may perform better than their larger brethren over long periods of time, the effect seems less pronounced now than it once was and may not exist at all after adjusting for the higher risk level. Because of the often high transaction costs with these smaller companies, it is important to get exposure to them as efficiently as possible.

• Valuation: Growth, Value. A fair amount of academic research indicates that value stocks have higher returns and lower volatility over time. This appears to be true because investors irrationally prefer growth stocks and therefore systematically misprice growth vs. value investments. This effect appears to be larger for smaller companies.  For this reason we tend to tilt portfolios toward value in general and small value in particular.

Fixed Income (Bonds). We believe the primary function of bonds in a portfolio is to reduce risk. For this reason we do not attempt to seek out incremental returns by adding risk in this area. We believe that if you need higher returns, the appropriate approach is increasing equity exposure rather than attempting to get higher returns from the fixed income portion of the portfolio.

• Duration: This sophisticated measure incorporates the magnitude, timing, and discounting of future cash flows to give a measure of volatility. It is related to, though not synonymous with, the more familiar “maturity.” Because we believe the purpose of the bond allocation is to reduce risk, we have a large bias toward short duration instruments. Long duration fixed- income investments have higher volatility levels but not commensurately higher returns. At the other extreme, the shortest duration is simply a cash equivalent.

• Taxability: Some fixed-income instruments (Municipal Bonds or “Muni’s”) are tax free. We tend not to use these investments much because 1) marginal rates appear to be in a long-term (not short-term) declining trend, 2) bonds are optimally held in tax-advantaged accounts, 3) Muni’s only make sense for taxpayers in the highest tax brackets, and 4) they are riskier than U.S. Government bonds.  However, for high tax bracket investors without the “room” in their tax-advantaged accounts to accommodate their fixed income holdings Munis can make sense as a portion of the fixed income holdings.

• Credit Quality: High Yield, Corporate, Agency, Treasury. We strongly advocate only investment grade bonds in the fixed income allocation of the portfolio and therefore consider High Yield (aka “junk”, “non-investment grade”, or “speculative bonds”) to be inappropriate.

• Inflation Protection: Treasury Inflation Protected Securities (TIPS) are a relatively recent innovation (1997) with no appreciable credit risk or inflation risk. We generally use these instruments in significant quantities.

This has been a much abbreviated and simplified overview of the two primary asset classes and some of the sub-classifications you will frequently see, but so-called “alternative” investments are becoming increasingly popular. My next post will delve into those areas.