Look Before Jumping...Into Liquid Alternatives
In investing most people quietly favour following the crowd. There is comfort in the crowd which has resulted in the growth of mega funds with $5B and up to $20B+ in assets. With that comfort should also come tempered enthusiasm for returns that are differentiated from the average as doing the same as others rarely produces results differentiated from others. This trend may be shifting with a desire for enhanced returns or a lower risk appetite that has seen growth in liquid alternatives climb. Over $4B in assets have entered the category since the Alternative Mutual Fund rules were introduced in January 2019. While the word alternative is often not well described the promise of something different is resonating. The question is whether different is better. There are three main changes that have been introduced with the Alternative Mutual Fund rules which are the ability to (i) short sell securities (ii) use up to 3X leverage and (iii) concentrate up to 20% into a single security from the previous limit of 10%. The question is which are right for you, if any?
Short Sell Securities: It would be great to take advantage of the gains that come along with the stock market and avoid the losses. The appreciation you would see in your portfolio would put you on a path to financial security far quicker not to mention the reduction in anxiety you would experience from never having to see your portfolio deteriorate. The problem lies in timing the market correctly. There are many truths in investing and among the top you will find (i) stock outperform bonds (ii) invest when you have the money and (iii) you can’t time the market. Warren Buffet, John Templeton and almost any other successful investor will tell you that they don’t know when the market will go up or down but that doesn’t stop some from trying. For my own personal experience I would agree with the experts, here’s why. I got into the investment industry in 1994. Most people that were investing at that time do not remember what the Dow Jones was at back in 1994 but it closed on January 3rd at 3,756. As of September 26th, 2019 the Dow has surpassed 27,000 several times. That is an increase of over 7 times. The law of large numbers says that some have got it right once or maybe twice but rarely have you seen extended period of success from shorting the market or individual securities.
Use of Leverage: This one is likely the most easy to understand. By using leverage you will magnify the profits and losses you have achieved with your investments. Let’s use the example of a $10,000 investment that you leverage three times to achieve an investment of $40,000. In this example if you achieve a return of 25% you will have doubled your money. Conversely if you loose 25% your principle is wiped out. The average annual return of the S&P500 over the last 90 years has been approximately 9.8% with an average annual risk of 15.6%. That means that in any given year the return of the market will be 9.8% +/- 15.6% or a range of -5.8% and 25.4%. That is a pretty significant range. Now consider multiplying by a factor of 3. That may be manageable for some professionals who enjoy risk but not something most individual investors need to endure.
Security Concentration: If the risks of leverage are the most recognizable risk the ability to concentrate into a single position may be the most desirable addition to the rule changes. Extreme wealth has most often been the result of concentration especially more recently with the growth in technology stocks like Facebook, Apple, Netflix and Google. A $1,000 investment in Apple at its IPO in 1980 would be worth approximately $432,000 at the end of December 2018. For most having a one stock portfolio is to much for most to stomach but there is no firm consensus on the number of stocks you need to be properly diversified. The studies range from a low of 20-30 stocks to 50. If we are aggressive and take the lower range that would mean the average weighting per stock would be 5%. If we take the more diversified approach of 50 stocks that would result in a 2% weighting on average per position. The average will likely be different from the max or minimum weight of a stock in your portfolio based on preference as well as growth but to say that you would allow a position to increase to 20% or between 300% and 900% from your average would seem aggressive.
While the new Alternative Mutual Fund rules do open the door to strategy diversity for investors they don’t necessarily line up with client preferences or market tenants. Add to this the relative lack of experienced domestic manager talent with long term track records managing alternative mandates and the initial couple of years could be a challenge for investors. If you are adding liquid alternative strategies to your asset mix do your research on the benefits of liquid versus less liquid options and don’t give up potential benefits for the benefit of daily versus monthly or quarterly liquidity. Alternatives likely do not need to fit into your liquidity bucket as you likely have lots of other assets in your portfolio that can play that role far better.