Alternative investments are the 8 Minute Abs of the financial industry. Great results are touted, but few will actually experience them.
Historically US equities have produced a total annualized return ABOVE the rate of inflation of 6.4%, while non-US earned 4.3% (1900-2022)*. Why would anyone ever want an alternative to that?
Outside of securing known distribution needs from your portfolio in lower-risk investments such as bonds, cash, CDs, and treasuries do alternatives bring a portfolio any additional benefit?
The asset management industry preys on the fears investors have about equity investing (as do annuity salesman but we’ve covered them before), which is rooted in emotions and not reality.
This is why every past equity crisis looks like a grand buying opportunity in hindsight, while every current crisis seems like the end of times.
Here are the common pitches from alternative asset managers:
Temporary declines in equity prices are a feature of markets, not a flaw. Trying to eliminate short-term declines will in all likelihood harm your long-term expected returns.
The reality is that we don’t have much history of alternative investments being used by retail investors, and if they will work when needed. I searched a database (www.portfoliovisualizer.com) for funds that fall into the “Alternatives” category, there are 679 results produced.
How many are left when I screen for 15+ years of performance history in that group? Only 67.
The below image from Wes Crill of DFA shows the massive growth in these offerings after the 2008 market crash. The scars of the Great Financial Crisis market crash were still fresh, and the asset management industry saw an opportunity to lure people into alternatives at a time that happened to be a grand buying opportunity for equities. That coupled with very low interest rates on bonds, was a golden era to sell investors on alternatives.
You can find Crill’s full article here which goes on to show that liquid alternative funds as a group produced an average annualized return of 1.73% from 06/2006-06/2022, significantly lagging both equities and bonds.
Crill’s results in the DFA paper referenced above are consistent with an annual study produced by Morningstar called “Mind The Gap” which shows how investors underperform the very funds they are investing in. This happens from people buying, selling, and tweaking their portfolios at the wrong time.
This below image sums up their 2022 Mind The Gap study:
What stands out is that alternatives severely underperformed every other category even before accounting for the behavior gap. Below we see the performance of alternatives as a group in every calendar year from 2008 – 2021 compared to other asset classes.
Alternatives just barely outperformed taxable bonds in 2008, which was a year where diversification was desperately needed. What is apparent is that every year you see negative returns for US Equity or International Equity, you see negative returns for Alternatives.
To add insult to injury, the alternatives category on average has the highest fees of any category. Finance sketch artist, Carl Richards, came up with this beautiful illustration:
Morningstar’s 2021 Fund Fee Study showed the alternatives category had an equal weighted fee of 1.48%. For comparison, the equity portfolios created by Meredith Wealth Planning generally have expense ratios between 0.20% - 0.30%.
As an investor in alternatives it appears you are paying for a Picasso but receiving my 6-year-old’s macaroni art (no offense Sawyer).
Alternative asset managers will generally construct a “backtest” based on an alternative asset class (currencies, commodities, trend following etc.) or trading strategy, and show great returns on paper that no one (or few people) ever actually earned, then create a product to try and replicate the on-paper results. Time after time the real-world returns fail to live up to the on-paper results.
One example of this comes from AQR Capital Management, which is a highly prestigious quant-based asset management firm.
In 2014, AQR published a paper titled “A Century of Evidence on Trend Following Investing”. In the paper, they display the following hypothetical returns from a trend following managed futures strategy covering the period 1880 – 2013:
In column three, you will see the net of fee returns averaged 11.2% for the full period with close to zero correlation to both stocks and bonds.
AQR launched a retail mutual fund in January of 2010 with a very similar strategy outlined in the paper (AQMIX). How has that fund done since being launched?
From 02/2010 – 02/2023 AQMIX compounded at 2.93% annualized. Mind you, that’s after it earned an astounding 35% in 2022. At the end of 2021 it had only earned 0.91% annualized since inception. One has to wonder how many investors held on for the banner year in 2022.
Either AQR launched this fund at the worst time possible in the last 140+ years, or maybe the strategy doesn't produce real world results like it does on paper.
Although we already added the insult of high fees to the injury of poor performance, I’m afraid we will have to pile it on here as alternatives are terribly tax-inefficient in addition to their high fees and poor performance.
If we continue to use the AQR fund as an example, here is what we see since inception through 2022:
An investor who bought and held this fund may have appeared to earn 2.61% for the life of it. After taxes on distributions they’ve only netted 1.21% (assuming maximum federal tax rates).
That means AQR's expense ratio on the fund (1.25% annually) is higher than the buy and hold after-tax return to the investor.
While getting aggregated tax data for the entire alternative category is difficult, most alts tend to be tax-inefficient compared to equities.
I must throw Mr. Wimmer a bone in our spirited debate. Everything I’ve written here has shown alternatives in isolation and not in the context of how they impact an entire portfolio.
If there is an asset with little or no correlation to stocks and bonds, with a moderate degree of volatility, and a positive expected return, then there can be benefits to add it to a portfolio. I wrote a piece stating such a few years ago: How A Bad Investment Can Improve Your Portfolio (meredithwealth.com)
One must allocate a meaningful and possibly uncomfortable amount of their portfolio to an asset like this for it to truly have an impact, and doing that opens the door to behavioral risks.
When alts are appropriate for an investor, in many instances one would prefer to hold them in tax-deferred accounts.
*Source: Credit Suisse Global Investment Returns Yearbook 2023 Summary Edition.
Disclosures: This article is for informational purposes only and should not be considered a recommendation. Information contained in this article is obtained from third party resources that Meredith Wealth Planning deems to be reliable. Consult with a financial advisor before implementing any strategies. Past performance does not equal future results. Meredith Wealth Planning does not guarantee any minimum level of investment performance or the success of any index portfolio, index, mutual fund or investment strategy.
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