Monday, November 19, 2012

Betting on the Wrong Horse: Alternatives

Betting on the Wrong Horse: Alternatives

In recent years, a Chief Investment Officer of a pension plan or endowment wouldn’t dare to show up at investment conference if he couldn’t brag about his increased allocation to alternative investments.  After a decade’s worth of low returns in stocks coupled with bouts of massive volatility, CIOs are steering their investments toward private equity, real estate, and especially hedge funds.  They’re all saying the same thing: “we can achieve better returns with less risk by moving into alternative investments.”  Just spend a few minutes googling terms like “public pension,” “alternatives,” and/or “hedge funds,” and you’ll see that everyone is headed in the same direction.  The CIOs have impressive Power Point presentations to back up this decision.  They can demonstrate that alternatives have outperformed conventional investments in the last decade.  Even more impressively, they’ve got tables and charts that show that alternative investments are only loosely correlated to traditional stocks and bonds.   In theory, this means that the volatility (a measure of risk) of their portfolio should fall.  

Sales Channels (1999)

Let me take a minute to clarify the concept of correlation.  Imagine you own two assets, A and B, that rise and fall completely in synch with one another.  The combination of assets would act like a big wave, reinforcing the highs and lows because their gains and losses would occur at the same time.   A and B have a correlation of 1.  Now imagine that A and B rise and fall at exactly opposite times.  This represents a correlation of -1, an investment nirvana because the variability of A and B cancel each other out.  You’d get pure return without the hassle.  In the real world, most investment correlations range between 0 and 1.  Even so, as long as A and B have a correlation of less than 1, when mixed they will produce a portfolio that has lower risk than A or B alone.

Let’s return to the concerted shift by pension plans into alternatives.  There’s one huge problem with this strategy: it isn’t likely to work.  In fact, pension plans are likely to achieve lower returns and higher risk than they are anticipating.  While the data in those Power Point presentations is correct, the conclusions are wrong.  What’s missing from every one of these presentations is any analysis of what happens when everyone or almost everyone decides to do the same thing at the same time.

Suppose you were to do extensive analysis on all the horses in a race and conclude that Hedge Fund Henry is the horse to back.  If only a few punters have your keen insight, the odds on Hedge Fund Henry will remain attractive even after you make the bet.  However, what happens when the crowd starts to make the same wager?  The odds on Henry are going to get a lot less attractive.

The same phenomenon applies when pension plans make big changes in their asset allocations.  The historic data, which they so painstakingly analyzed, does not account for the impact of all the new money pouring into the new asset class and exiting the old one.  If a vast swath of pension plans commit capital to alternatives, the alternative managers will be awash in cash.  They will find it impossible to find attractive investments because prices for companies, real estate, emerging market debt, or distressed securities will be bid up.  And in several years time, when it is time to reduce alternative exposure, all those investors simultaneously heading for the exits will depress prices.  The favorable returns won’t materialize.

The historic data suggested that risk should fall if a plan commits to alternatives, as the correlation between alternatives and stocks and bonds has been low.  However, the historic data doesn’t include the effect of big institutional money flowing into and out of alternatives.  In other words, all those big pension plans are going to make alternatives more synchronized with one another and with the conventional markets.

I’ve seen this horse race over and over.  Public pension plans discovered international stocks as a source of higher returns and diversification in the 1980s.  Neither the returns nor the diversification fully materialized.  Then in the 1990s, they discovered emerging market equities with even higher returns and lower correlations than international stocks.  Once again, the returns evaporated and the correlations rose.  Convertible Arbitrage, Large Private Equity, Opportunistic Real Estate; I could go on and on listing “new” investment opportunities that promised higher returns at lower risk. 

Unless you have the courage to invest before every CIO shows up at an investment conference touting his strategic thrust into alternatives, you’re likely to be a loser in this derby.  Tomorrow we’ll look at why it’s so hard to resist the alternative bet.

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