In a momentous decision this week, CALPERS (the California Public Employee Retirement System) announced that it would shed all of its hedge fund holdings. This was the Absolute Return portion of its portfolios and it cited cost and complexity as the leading reasons to get rid of these portfolio constituents.
The amazing thing is that this comes as my email is cluttered daily with articles about how retail advisors are planning to adopt more alternative investments (i.e. hedge fund and absolute return strategies) in their practice going forward. There are hundreds of new mutual funds touting themselves as alternatives, mostly with much higher fees than ordinary funds and ETFs.
Who is right, CALPERS or retail advisors (if we believe that they are really adopting these strategies)? The allure of these funds is simple-they are trying to produce investment returns that are not highly correlated to the stock or bond markets. That is why they are referred to as absolute returns-they seek to make you money in either up or down markets. Generally, these strategies rely on expertise in order to produce these returns rather than market movement. Trend following is a simple example of a strategy. For instance, if a manager believed that monthly market movement of more than 5% (up or down) was a good forecaster of the following three months of market movement and generally went in the same direction as the short term movement, they would place their trades based on that fact as the market either up or down by 5%.
CALPERS stepping back from these fees seems to me to be sound judgement. Hedge funds often charge 2% a year plus 20% of profits versus small fractions of a per cent in many other investments. That is a very steep hill to overcome and make these good investments. It is always about what you get to keep at the end of the day. With hedge fund managers taking so much, can you possibly end up with enough return for the risk to make this a good investment? CALPERS says no.
The flip side of this is that portfolio diversification works. Avoiding big losses is very important in succeeding as an investor. Bonds have helped achieve this goal for the last 30 years. With yields at an all-time low, it is difficult to see them working as well in coming years. Are there investments that are not highly correlated to stocks and bonds and can therefore offer some diversification? To me, the answer is yes. Rob Arnott of Research Affiliates refers to these as the Third Pillar of investments. In particular, he sees these as being effective in inflationary times and in times when returns are low in stocks and bonds. We believe it is worth including these diversifiers in your portfolio.
So, we believe you should look for diversifiers for your stocks and bonds but keep a very jaundiced eye on who you invest with. Alternatives tend to have high expenses (some mutual funds may cost 2-5% per year!) and short track records. You need to understand who you are investing with, why their strategy is worthwhile, how much they are charging you, and what your net total expected return on investment will be. There are many charlatans with back tested data vying for your investment dollars and a few experts with proven track records, sound thinking, and reasonable fee structures. A mattress may be a better place to stick your money than rolling the dice in the alternatives world unless you know what you are doing and why.
By Ted Schwartz, CFP©