Alternative Investments and Active Management: Why Their Similarities Matter

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Alternative investments have created a storm of controversy in recent years. While the intent of alternatives — investments that are not correlated to stocks or bonds, which, therefore, should temper volatility and improve returns while lowering risk — is valid, the execution has not always been stellar. By my observation as the founder of an investment research and management firm, the problem is that some of these products are either poorly conceived, not well-executed, or both. What’s more, many of them have high upfront fees. The combination of these factors can produce investor losses and, thus, has led to a string of negative headlines over the years. But there’s more to know about alternative investments — and their human counterparts, active managers.

What is an alternative investment?

In simple terms, such products involve companies raising capital to buy anything from an apartment complex to an oil pipeline, converting operating profits into dividends. Once the investment goes “full cycle,” the underlying asset is sold for a profit, which allows investors to get back their principal and a percentage of the gains. That’s the ideal scenario. Unfortunately, it doesn’t always work out like that.

Why do they have a bad reputation?

One of the most notorious examples of the negative headlines referenced above unfolded in 2014, when RCS Capital, a nontraded real estate investment trust (REIT) controlled by Nicholas Schorsch, started to crumble after one of its units engaged in massive accounting fraud. The fallout included jail time for a high-ranking company official and RCS Capital filing for bankruptcy.

There have been other missteps involving other alternative providers, but for the most part, I believe the RCS Capitals of the world are the exception, not the rule. Most product sponsors, in my experience, are meticulous, careful, and have a strong track record of putting together offerings that help investors achieve their financial goals.
While it’s true that alternative investments are not for everyone, they were never meant for everyone. Indeed, only a select few investors likely have the ability to tie up significant capital for extended periods to allow such investments to run their course. However, if we again consider what alternatives, in part, are supposed to do — offer access to assets that are inversely correlated to stocks — it’s mostly a risk-mitigation strategy, and I don’t feel there’s really anything controversial about that.

What do alternative investments and active managers have in common — and how can you use them responsibly?

Many of the active managers and risk mitigation strategies, such as alternative investments, have failed to produce outsized returns in an environment where the U.S. market has shown tremendous strength, according to both 2015 and 2018 reports from CNBC.

In part, I believe this explains why it seems an increasing number of financial firms and advisors across the country have gravitated toward passive investment strategies. Because they are less expensive than active funds, I’ve found that they are often deemed “safer” from a compliance perspective. In an era filled with cost-conscious fiduciary debates, the default position of many across financial services has become to do no harm, so the cheaper option often ends up winning the day.

As a result, many Americans now have very similar portfolios. In many ways, it mirrors other periods when investors piled into “one-decision” investments, including the Nifty Fifty craze, the dot-com frenzy, and the ongoing hold of modern portfolio theory. When this has happened previously, the outcome, while not uniformly disastrous, has been suboptimal. Think about anyone, for instance, who adhered to modern portfolio theory during the run-up in equities the New York Times reported over the last nine-plus years. A 60/40 mix of stocks and bonds during that time would have lagged, perhaps significantly, any portfolio that had shed even its fixed-income holdings as interest rates reported by the Federal Reserve Bank remained historically low.

Active managers are almost always defined by whether they outperform indexes or one another, much like alternative investments. That’s often framed as having an uncanny ability to spot value where others cannot. But just as important to the value of an active manager is the ability to reduce exposure to depressed asset classes, whether markets are flying high or floundering. In other words, much of their inherent value is in how they mitigate risk — which, again, is not controversial.

However, I don’t believe that anyone should suggest investors go all active all the time. Passive investments have a place in nearly every portfolio. They just shouldn’t make up the entirety of a portfolio, in my opinion, because there’s no downside risk protection.

Has the alternative investment industry seen its fair share of bad actors and dud products? Of course. Can the same be said about active management? Yes. But when alternatives were introduced to a retail audience, the intent was to provide investors with added diversification and inverse correlation to a multitude of segments in the market. Likewise, a smart and active manager acts in the same manner by lessening a client’s exposure to underperforming asset classes, whether that’s during bull markets or in times of distress. In my experience, these are undoubtedly good things for investors when balanced responsibly.

As with nearly everything in life, you get what you pay for as an investor. Just because something is a bit more expensive (and both active management and alternative investments tend to be) doesn’t mean that it’s bad. We don’t apply that standard to anything else in life (like cars, clothes, and real estate). So I don’t recommend we do it when it comes to the most important financial decisions.

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