Updated: Jan 7
"Complexity gives a comforting impression of control, while simplicity is hard to distinguish from cluelessness." - Morgan Housel, The Collaborative Fund
As financial markets flare up, the drumbeat for alternative strategies gets louder. We wrote about the big push into alternatives by Wall Street last May (see Hedge Fund Hold Up). A few highlights:
According to a Barron's survey from 2017, the average recommended allocation by wealth managers to alternative strategies is 17% (I would bet it's higher now).
The majority of financial advisors believe alternatives reduce volatility and provide diversification benefits.
Alternative strategies fall outside of traditional investments like stocks, bonds, and cash. Some examples of alternative investments include private equity, hedge funds, managed futures and commodities.
The case for alternative assets sounds quite compelling. The advisor pitch would go something like this...
"Stock markets are overvalued and bond yields are low. Alternative investments will help generate uncorrelated returns and reduce risk."
The problem is that the above narrative is an opinion. It's the financial equivalent of proclaiming the Earth is flat.
Even if alternative mutual funds performed as intended, their ridiculous expense ratios would wipe away any benefit.
The above graphic shows the most expensive alternative mutual funds on the market. These funds are almost always sold by advisors. The above figures do not include the advisor fee of ~1% (hard not to be suspicious of any advisor who allocates to the garbage above- may be an indication of other value destroying behaviors). Can you imagine trying to achieve a 5% return per year just to break even?
Not all alternative mutual funds charge 4%+. Let's look at popular strategies by assets under management. The below funds charge between 0.45% - 2.01% per year (depending on the fund and share class).
The above highlighted funds are the biggest alternative strategies by assets under management.
Let's see how the biggest alternative funds have held up versus fixed income over the past 12 months.
The above graph shows a boring US Aggregate Bond ETF (AGG, purple line), which costs next to nothing to own vs. the largest alternative mutual fund strategies. The bond index crushes the complex (and expensive) alternative funds.
What about alternatives versus Gold?
The above graph shows a gold ETF (SGOL, purple line) vs. the largest alternative mutual fund strategies. A picture is worth a thousand words.
How well do alternative funds hedge against equity risk?
The above graphic shows the S&P 500 (purple line) against the same basket of alternative funds. The results are a bit more mixed. Alternatives did retreat less than equities, but three out of the four alternative funds were still down over 5% at the end of last year.
If you see managed futures, long/short, market neutral, arbitrage, dynamic, systematic in the name of your mutual fund, run to the nearest exit. Stick to what works. Cash, high quality bonds, and gold are a great way to hedge equity risk. Unfortunately, that's too boring for Wall Street. The only thing alternatives are good for is lining the pockets of your broker and harvesting losses at the end of the year.