The previous post focused on ‘conventional’ savings instruments – bank accounts, bonds, stocks, real estate. Most of what I’ve read on other blogs/books/websites stays on these topics. In fact, even the CFA curriculum stays pretty safe on these topics: Alternative Investments are kept at mostly a conceptual level. That probably makes sense, as most people won’t go for alternatives; they’re kinda ‘new’ relative to stocks and bonds.
As I wrote in a previous post, I’m always looking for more portfolio diversification: investments which perform at different times (and/or in different ways) than conventional stocks and bonds. Here is my list of alternative investment vehicles, ranked by my view of increasing risk/complexity:
- Most hedge fund strategies: in days of yore, hedge funds used to be high-octane, high-risk performance vehicles. As the investor base for hedge funds has shifted towards risk-averse institutions, most hedge funds have lowered their risk; often risk is lower than equities. This bucket includes Long/short equity, merger arbitrage, event-driven, convertible arbitrage, fund of funds… most strategies. Most individuals can’t access the ‘flagship fund’ (i.e. the fund charging full 2 and 20 fees), unless they’ve a financial advisor who usually charges additional fees on top. More affordable alternatives include alternative beta mutual funds (e.g. AQR) or ETFs (e.g. GURU). These funds tend to provide the least diversification to conventional equities, so up to you whether you include.
- Macro/managed futures/CTAs: both discretionary and systematic macro or managed futures strategies fit here. For the icons, think George Soros or Paul Tudor Jones: big calls on macroeconomic themes. From a statistics perspective, these funds are based around momentum trading: buying when prices rise, and selling when prices fall. For a conventional long equity/bond portfolio, the best bang-for-the-buck diversification comes from this strategy; they were the only guys making money during 2008. Same with #1, flagship funds typically charge 2 and 20 or more; affordable options are managed futures mutual funds (see earlier post on fees) or ETFs.
- Master Limited Partnerships (MLPs): the US has a tax-efficient structure (similar to a REIT, covered in last post) for infrastructure investments. Think natural gas pipelines, cell phone towers, etc. These are traded on exchange, so pretty liquid. Dividend yields can be pretty attractive as well, provided they’re sustainable. MLPs had a very tough 2008-2009, so diversification against equity is good in the good times, but bad in the bad times.
- Private equity funds: in particular, I mean buyout funds. The idea is pretty simple: buy a company with a ‘mortgage’ – e.g. borrow a large portion of the purchase price from lenders. The interest cost is tax-deductible for the target company, so the tax savings alone sometimes makes this a worthwhile investment thesis. Buyout funds are similar to hedge funds in lack of liquidity (flagship buyout funds frequently lock up capital for 3-5 years) and high fees (buyout funds typically charge 2 and 20, as well). Affordable alternatives, to me, are buying the shares of listed buyout firms like Blackstone or Apollo.
- Venture capital funds: let’s find the next Facebook, shall we? The business plan for these funds is like a baseball player who always swings for the fences: some investments return zero; some break even; and a small proportion return so much, they pay for all the failures and then some. Similar terms to buyout funds, and diversification benefits versus public equities is up for debate. Big firms like Blackstone have venture funds; otherwise you may be out of luck getting into these ‘sophisticated’ investment funds.
- Volatility arbitrage: getting into the more exotic realm here. The idea is that implied volatility (of options) is almost always overpriced relative to actual volatility (of underlying assets). This is a prime example of ‘it works until it doesn’t’: many of these funds lost 50-75% of capital when markets crashed in 2008. Those that survived have made most of it back, I think. How do you feel about keeping invested in a fund that’s lost 75% of your initial investment? Anyway, most funds are small, expensive, and near-impossible to access.
What did I miss? Derivatives! It’s a bit outside a 101 course. I’ll cover basics next time.