Swedroe: Beware Alternative Investments

Alternatives may not be as exotic as most investors believe.

The sophisticated asset-pricing models we have today allow us to determine the underlying sources of returns to investments. Specifically, they permit us to identify the factors to which an investment has exposure.

However, a problem arises when employing current asset-pricing models to consider alternative, illiquid investments. The volatility of such assets is often understated.

This occurs because the data is often “smoothed” due to the lack of available daily pricing information. As a result, we can observe a serial correlation—the correlation of a variable with itself over successive time intervals—of returns that makes prices appear to be less volatile than they really are. The apparently “free lunch” provided through the diversification benefit, plus the lower volatility, tends to lead to an overallocation of such assets.

Key Research

Niels Pedersen, Sebastien Page and Fei He—authors of the study “Asset Allocation: Risk Models for Alternative Investments,” which appears in the May/June issue of the Financial Analysts Journal—attempted to solve the problem of understated volatility.

Using economic intuition and econometric techniques, they estimated the exposure of various alternative investments (such as private equity, venture capital, hedge funds, private real estate, infrastructure, farmland and timberland) to well-known risk factors that have been found to explain almost all of the differences in returns of diversified portfolios.

The risk factors they used included beta, size, value, liquidity, momentum, real interest rate duration, credit risk, industry exposure, leverage and the carry trade.

The Usual Suspects

The authors concluded risk-factor analysis reveals that alternative investments actually have exposure to the same factors that explain the returns and volatility of publicly available stocks and bonds.

They write: “Returns on alternative assets depend on changes in interest rates, as well as how investors view risky cash flows, as reflected in equity market valuations and credit spreads… Liquidity and other specialized factors also play a role… The risk factor-based approach generally generates higher correlations between alternative investments and their public counterparts, especially when their equity beta is high.”

The authors found that when their model was applied to portfolio construction, the allocation to alternative investments was reduced.

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.