Swedroe: Beware Alternative Investments

November 10, 2014

Correlation Problems

This fits with traditional economic theory, which states that the only free lunch should be diversification. The study showed that alternatives don’t seem to provide either that free lunch or much, if any, true diversification because their returns are well explained by common risk factors.

Another problem with alternative investments in general is that they are often touted in their marketing literature as having low correlation with equity portfolios, and thus are a good tool to reduce overall portfolio risk. There are two problems with this assertion.

First, as we just discussed, the supposedly low correlation rose once adjusted for common factors and the serial correlation problem. Second, while some alternatives might have a low correlation with equities and bonds, their correlations can turn high at just the wrong time.

For example, as the Yale endowment fund discovered in the financial crisis of 2008, when things go wrong with the stock market, they also tend to go wrong with many alternatives. The reason is that falling stock prices are often accompanied by flights to quality, resulting in a widening of credit spreads and falling liquidity.

Since the strategy of many alternatives is to invest in distressed and highly illiquid assets, they will be negatively impacted by such flights to quality. Therefore, the reality is that many alternatives really don’t combine well with equities in a portfolio.

Cheaper Alternatives Than ‘Alternatives’

The takeaway, demonstrated by Pedersen, Page and He, is that in general, alternative investments are really not much more than repackaged factor exposures. And factor exposures can be obtained far less expensively, and in a more diversified way, in publicly available securities. In other words, alternative investments in most cases are products meant to be sold and better not bought.

 


 

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


 

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