Real estate, commodities and hedge funds are common asset classes for the Alternatives category. These assets are often called alternative investments because they attempt to have little or negative correlation with price moves of the overall stock market. For example, a negatively correlated hedge fund would go up when the stock market goes down and it would go down when the stock market goes up. This negative correlation is beneficial in reducing portfolio risk because you are hitting a good average of some gainers and some losers rather than having everything go up (euphorically) and then declining pricipitously (emotionally painful).
A simple example is a stock that goes up 20% in one year and it is flat in another year. The stock averages 10% but it is quite a roller coaster.
If a hedge fund is flat when the stock is up 20%, and then it is up 20% when the stock is flat, then the overall portfolio is much less volatile.
(Note the arithmetic isn’t that simple and actual investment performance is ignored for now.)
The alternatives category is often included in the broad-based equity category, instead of being explicitly identified as a separate alternatives category. It is noteworthy that real estate and various commodities are part of the S&P 500 index. In fact, real estate was identified as a new sector when it was separated from the Financial sector in October 2016. Nevertheless, it is useful to identify investment attributes within the Alternatives asset class category.
From a practical standpoint, Real Estate and Commodities are common asset classes found in many portfolios that historically provided both inflation protection and relatively lower correlations with other equities.
Real Estate is the most common alternative asset class, and it is primarily available through commercial real estate that generates income from monthly lease payments. Examples are office buildings, shopping malls, storage facilities, nursing homes, etc. There is a strong case for owning commercial real estate in portfolios via Real Estate Investment Trusts-REITS. REITs hold multiple properties and they pay out 90% of income.
REITS pay out higher income and have been attractive for income investors in a low rate environment. REIT performance was strong until rates started to rise in 2016-4Q. REITs will be negatively impacted by rising rates because investors will not seek this asset class as much when other higher bonds pay higher interest. Commercial real estate also uses debt and this means that debt service costs will be rising.
REITs also benefit from a stronger economy because lease payments go up.
Commercial Real Estate was not nearly as impacted in 08 financial crisis as residential real estate.
Residential real estate is typically packaged into securitized investments and sold to institutional and individual investors as mortgage funds.
Note: Cornerstone Model Portfolios hold REITs.
Commodities are the second most popular alternative asset class and are available through broad-based diversified funds. Since crude oil and refined products are the largest commodity category, oil is heavily weighted in commodity funds. Other commodity categories include: Gold and other precious metals, Industrial metals, Grains, and Livestock. Commodities are easily purchased through either mutual funds or ETFs.
The broadest diversified Commodity fund is the iShares S&P GSCI (Goldman Sachs Commodity Index)-GSG. Another broad commodity fund is the iPath Dow Jones-UBS Bloomberg Commodity ETN-DJP.
Commodities historically outperformed during inflationary environments, but they are volatile and highly cyclical. For example, funds linked to the GSCI index had returns over 100% from January 2007 through July 2008 as oil moved up from $65/barrel to $147/barrel. Then the GSCI drop -75% as oil dropped to $31/barrel by December 2008.
Cornerstone maintains commodities in our Model Portfolios through DJP.
More content coming soon.
Other Alternative Asset Classes:
Master Limited Partnerships-MLPs. MLPs generally invest in oil and natural gas pipelines and are best for larger investors. MLPs involve complex tax considerations, and require significant expertise from tax advisors.
More content coming soon.
Hedge Funds represent a broad range of alternative strategies that seek investment performance that is not correlated with other (primarily equity) markets. To the extent that the hedge funds are able to generate low/negative correlation, they “hedge” a portfolio’s overall performance. The reality is that many so-called hedge funds are simply non-public investment vehicles with wide-ranging investment objectives that pursue a total return strategy. Since hedge funds are not usually publicly traded securities, they have less regulation and oversight. This allows the use of financial leverage (debt), financial derivatives and other tactics to potentially generate huge gains and losses. It is important to note that typical hedge funds charge a 2% management fee and then they take 20% of gains (sometimes above a prescribed level). This cost structure significantly detracts from investor return.
Hedge Funds employ various strategies: Multi-Alternative, Market Neutral, Long/Short, Managed Futures, M&A Arbitrage, Bear Market, Currency and Nontraditional Bond. The Multi-Alternative/Multi-Strategy is the most common type.
Publicly Traded Funds using Hedge Fund Strategies: Although hedge funds aren’t typically available to individual investors, there are some publicly traded mutual funds and ETFs that utilize hedge fund strategies. Hedge Fund replication and Liquid Alternatives are products that attempt to follow various strategies. QAI is a common multi-alternative strategy. This group includes Fund of Funds which adds another layer of expenses.
Other examples are AlphaClone Alt Alpha-ALFA, Global X Guru Index-GURU
Alternative Asset Managers: Blackstone Group-BX, Carlyle Group-CG, KKR-KKR, Apollo Group Management-APO.
Hedge fund performance has generally been very weak. The table below shows the US Market-IYY equity ETF and two notable publicly traded hedge funds, and the performance has been week. A review of Hedge Fund Research Institute shows underperformance as well for private hedge funds. It must be noted that a few investor have done well with hedge funds and private equity. The Yale Foundation is an example of excellent long-term performance. They are able to do this by hiring some excellent people that aren’t available to most hedge funds. It is also notable that many of these investors (like Harvard in recent years) have had relatively weak performance.
Performance: 1Yr 5Yr 10Yr
IYY 11.7% 15.3% 7.0%
QAI 0.2% 2.0%
Diamond L/S 9.4% 10.0% 4.3%
In addition to weak performance, there have also been cases where investors lost nearly all of their investment. Long-Term Capital (with Nobel Laureates on its Board) collapsed in 1998, and Bernie Madoff was arrested in 2008 for his Ponzi scheme. Despite recent weak performance and major debacles, hedge funds somehow capture the fancy of investors. There seems to be a perception of investment sophisitcation and an aura of exclusivity that is not warranted by overall performance.
Although hedge fund performance has significantly trailed broad stock market performance, there is a risk-management place for this strategy. Good hedge funds can truly hedge downside stock market risk. I previously put a market neutral strategy into client portfolios in 2007 through 2009. This worked very well because the market neutral fund didn’t go down much the precipitous market decline of 2008 through March 2009. We outperformed during this time because we didn’t go down nearly as much. After the markets stabilized, we got out. It was good to get out because the equity market roared upward and the market neutral fund trailed significantly during the recovery.
It is noteworthy that the hedge fund group has suffered underperformance ever since the 2008/2009 decline, and it has been good to not have had exposure. While we believe that hedge strategies can offer potential risk management attributes under certain circumstances, we typically don’t see the need and we certainly don’t like the high cost structure that detracts from investor returns.
Cornerstone doesn’t currently have Hedge Funds in our models.
To summarize, Cornerstone utilizes real estate and commodities to reduce risk and provide inflation protection. Nevertheless, we continue to monitor all alternative asset classes and will use whatever alternative asset classes that we believe will enhance investor risk/return.