Alternative investments can both reduce risk and boost returns in a well-constructed portfolio, particularly at a time when traditional investments like stocks and bonds are expensive and priced to deliver disappointing returns.
But the key word here is can. Alternative investments can deliver that holy grail of higher risk-adjusted returns if chosen carefully and in prudent allocations. But if done poorly, alternative investments can just as easily take a wrecking ball to a portfolio and destroy years’ worth of gains.
As a case in point, consider the story of the Dallas Police & Fire Pension System (DPFP).
Dallas cops are in a dangerous line of work, a point that was made clear by the sniper attack this summer that tragically claimed the lives of five officers. But in exchange for the risks they take in keeping the rest of us safe, cops get certain perks, such as retirement at age 55 with a traditional pension plan. Well, today, those benefits are under serious threat.
After making a series of questionable investments during the go-go years of the real estate bubble, the DPFP took massive losses that effectively bankrupted the plan that over 9,000 current and former police officers, firefighters and their families depend on. Before the dust settles, Dallas taxpayers will probably have to shell out $600 million or more to keep the plan afloat, and the police and firefighters may be forced to work longer or accept benefit cuts. No matter what the final deal looks like, it will likely be a raw one for the police and firefighters… and for the taxpayers they serve and protect. And all of this is due to the incompetence of an investment manager.
Well, it made sense at the time…
Following the 1990s tech bubble and bust, the plan’s managers wanted to diversify outside of the risky stock market. But in order to make the targeted 8.5% return, bonds weren’t going to cut it. So the fund diversified into the wild, wild west of alternatives.
Hey, I get it. What was true in the early 2000s is even more true today. Stocks are expensive and looking wobbly, and bonds yield so little as to be unworthy of consideration for many investors. But what the fund’s managers did next is remarkable for its lack of basic prudence and common sense.
At one point, the fund had over half of its investments in alternatives. Now, in a vacuum, that’s not necessarily a bad thing. The Harvard University endowment fund has famously kept about half of its portfolio in alternatives for years. It’s the particular choices of assets that the DPFP held that should have been a major red flag. Among other questionable assets, the fund owned interests in the American Idol production company, luxury homes in Hawaii, a Napa vineyard and Uruguayan timberland.
I think there might have been some oceanfront property in Arizona in the mix too.
Not All Alternative Investments Are Created Equal
Apart from sheer strangeness (Uruguayan timber?), the alternative investments owned by the Dallas police pension had some other aspects in common. To start, all were extremely illiquid. Now, illiquidity is not necessarily a deal breaker. I’m comfortable with an asset being somewhat hard to sell so long as it is relatively safe and throws off consistent income. For example, the Dallas police would have probably been perfectly fine owning a diversified portfolio of rent-producing apartments or warehouses… but instead their managers bought them glitzy luxury properties and raw land held for speculation.
Along the same lines, the assets they owned, in general, did not have observable prices. Now, again, that is not necessarily a deal breaker by itself. It’s silly and cost prohibitive to get real estate appraised every month, and appraisals might not be accurate in the absence of reliable comps. And investments in private equity or private individual businesses also lack observable prices. But this is why you keep investments like these as a small piece of your portfolio and, again, make sure that they throw off a reliable stream of current income.
Doing It Better
So, how can we avoid falling into the same traps that ensnared the Dallas police and firefighters? After all, with stock and bond prices still very elevated, the case for alternatives is stronger than ever. So how can we avoid investing in alternatives that blow up?
To start, use the same common sense you would use in a traditional stock portfolio and keep your position sizes reasonable. What is “reasonable” may be subjective, of course, but common sense applies. Putting 10%-20% of your portfolio in a single alternative fund may be completely reasonable if that fund is itself very well diversified and liquid. Putting 10%-20% of your portfolio into a single property or into an operating business in which you are a passive investor with no operational control is probably not reasonable.
When I put together an alternative portfolio, I generally like to see four conditions in place:
- The alternative investments should be uncorrelated to both the stock market and to the other alternative investments in the portfolio.
- The returns should be consistent and, ideally, have a current yield component.
- The assets should be relatively liquid. I don’t have to have 24-hour instant liquidity, but I need to know that my clients can get their money out in a month or two if they need it.
- The investment should have observable prices or, at the very least, accurate financial statements that give me an indication of financial health.
In the interests of full disclosure, I co-manage a liquid alternative robo advisor specializing in risk parity strategies. So, I’m obviously a believer in alternative investments and make them a major part of my practice.
The pension crisis has led many Dallas police officers to retire early and request a full distribution of their pension out of legitimate fear that the plan will fail. If you’re one of those officers, give my office a call to see if our liquid alternatives might be the answer for your portfolio.
Charles Sizemore is the principal of Sizemore Capital Management, a registered investment advisor based in Dallas.
This piece first appeared on Forbes.
This article first appeared on Sizemore Insights as Alternative Investments Gone Wrong: The Story Of The Dallas Police Pension Plan
Photo credit: Sean Davis
Hedge funds don’t get a lot of love these days. They’ve underperformed for years, and their fees — the standard is 2% of assets and 20% of profits — make them a pariah in the age of indexing and low-cost robo advisors.
Hey, I get it. The high fees and lousy performance of competing hedge funds was a major reason that I started a liquid alternative robo advisor with my partner, Dr. Phillip Guerra. We run a suite of risk parity portfolios that hold their own against comparable hedge funds… and we do it at a fraction of their fees.
Yet let’s not throw out the baby with the bathwater. While many — perhaps most — hedge funds add no real value and certainly don’t justify their fees, there are plenty of hedge funds that absolutely do add value and deserve every last cent. But how do you separate the wheat from the chaff?
Ask yourself the following questions:
Does the fund do something unique that realistically cannot be replicated in a cheaper and more transparent vehicle, such as an ETF, mutual fund or managed account?
Really dig deep here. If the fund is a long-only large cap fund, you should be skeptical as to whether the hedge fund structure is necessary. If the fund employs sophisticated hedges that would be hard to implement in a smaller managed account, then the hedge fund structure is probably justified.
Does the fund deal in illiquid securities that would justify the lack of liquidity of the fund itself?
Years ago, a hedge fund in the DFW area made a fortune buying idled planes from the major airlines. Needless to say, that sort of thing would be impossible to replicate in a mutual fund, ETF or managed account. It’s virtually impossible (or at least impractical) to securitize an airplane. On a similar note, in the past I have placed accredited investor clients in a fund that finances medical accounts receivable that might take two years or more to pay off. It’s hard to see a strategy like that working in a mutual fund that promises daily liquidity.
Does the fund have a strategy that would be fundamentally undermined by investor redemptions?
Think about corporate raiders like Daniel Loeb or Carl Icahn. These guys are known for amassing massive stakes in companies and then using their clout to force change, including booting out management that is underperforming. That only works if you have a stable pool of capital. Imagine Loeb attempting to take over a company and then having to back away with his tail tucked between his legs because he had a wave of shareholder redemptions.
When your advisor pitches you a hedge fund, you shouldn’t necessarily recoil in horror. I regularly incorporate hedge funds into the portfolios of my accredited investor clients when they fill a specific niche I’m trying to fill. And to date (knock on wood), I have yet to have a major disappointment on this front. I’ve lost plenty of money for myself and clients in low-cost ETFs and mutual funds, though I’ve never lost money (again, knock on wood) investing in a good alternative manager or hedge fund. I probably will at some point. You know the drill, past performance is no guarantee of future results. But I can credibly say that it hasn’t happened yet.
Before you invest a single red cent in a hedge fund, ask yourself the questions above. Hedge funds are certainly not for everyone, but if utilized correctly they can reduce portfolio volatility without sacrificing returns.
Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.
This article first appeared on Sizemore Insights as In Defense of Hedge Funds…