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The New Movement in Alternative Investing: What Goes Up...

A new movement is afoot—one focused on alternative investments that can alter the way people invest. Clifford Jack introduces his book, which explains the increased globalization and the hyper-connectivity of today’s markets, and the volatility all of it brings.
This chapter is from the book
  • Did you hear the Dow is going to 36,000?

At least that’s what James Glassman, former Washington Post columnist and Undersecretary of State to President George W. Bush, argued in his 1999 book, Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market. Co-written with Kevin A. Hassett, the title hinted at a steep rise in the stock market within five years.1 The DowSM, of course, refers to the Dow Jones Industrial AverageSM , a market barometer that measures the price-weighted average of 30 actively traded blue chip stocks.2 As it turned out, the bull market Glassman and Hassett predicted ended up being a bubble that popped when the Dow hit 11,722.98 on January 14, 2000.3 “One of my colleagues...told me to never tie the Dow to a specific date,” Glassman said in an interview more than a decade later. “I wish I had gotten the advice sooner.”4

He was hardly alone. Consider similarly miscalculated statements made just before and during the economic downturn of 2008.

  • “I expect there will be some failures...I don’t anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system.”

    —Federal Reserve Chairman Ben Bernanke, February 20085

  • “I think this is a case where Fannie and Freddie are fundamentally sound, that they are not in danger of going under...I think they are in good shape going forward.”

    —House Financial Services Committee Chairman Barney Frank (D-Mass.), July 20086

  • “I’m not an economist, but I do believe that we’re growing.”

    —President George W. Bush at a press conference, July 20087

So-called experts who try to predict market behavior seem to appear every time we find ourselves in the midst of an expansion or contraction we believe may never end. Some new innovation, global condition, political environment, or earth shattering event leads one to believe it’s different this time—only to find out later, it wasn’t.

In the wake of the global housing and market collapse of 2008, I’ve heard much the same—prepare for lower returns, global growth will be muted for the foreseeable future, economies will bump along the bottom, and recovery will be a long, slow slog. But while the benefit of hindsight makes it easy to scoff at predictions of market cycles past, is it truly different this time? I would say, yes and no.

Too many investors make the mistake of believing that each market boom or bust necessitates a complete change in investment strategy, but this is rarely the case. Rather, simple adjustments could help stabilize a portfolio. In fact, the theories of modern investing pioneer Harry Markowitz, whom I will discuss at length throughout this book, have been used for decades in all sorts of market climates. His frameworks are constant, they just require new inputs. Think of it this way: the science (framework) behind Ford’s Model-T doesn’t much differ from cars today. Fuel powers a combustion engine that causes four tires to rotate. But new efficiencies and features (variables) developed in recent decades mean cars can set out for destinations in all kinds of conditions and on all kinds of terrain.

To continue the metaphor, different investment strategies have been developed to help navigate any number of terrains. While there is always risk of losing money, access is available to strategies that have been designed specifically to help minimize (or maximize) the impact of the terrain, depending on one’s intention. For example, alternative investments, variable annuities, and hedge funds are all products that may help during a market shift. Each of these products will be defined at length in the chapters that follow, along with their potential risks. One of which, of course, is the loss of the investor’s money.

Here’s a little known fact about 2008. While the world was awash in economic chaos over fears that entire countries could go under, when the populace panicked, and almost every sector seemed to be down,8 several alternative and fixed income indices fared better than traditional equity indices. Focusing on alternative indices, while many alternative indices were down, several of these indices performed better than the overall market (as measured by the Russell 3000 Index).9 For this analysis, I examined the performance of 17 separate indices, including alternative indices, equity indices, and fixed income indices that I used as a proxy for asset classes. It is important to know that indices are not available for direct investment.

Although in existence for decades, the increasing interest and strategic use of alternative investments in this new economic environment is the catalyst for what I’ve termed “Generation Alt—The New Movement in Alternative Investing.”

Generation Buy and Hold, what I would call the prior cohort, carried the flag for years thanks to strong overall economic growth and steadily lowering interest rates. Unfortunately, very little of what happened then looks like the post-2008 markets of today. In fact, after the meltdown, investors in Generation Buy and Hold quickly became Generation Buy and Fold, exiting the market altogether to wait for signs of life—and some are still waiting. As of March 2013, investors were still sitting on $9.81 trillion in cash and cash equivalents (which comprised of money market mutual funds, money market deposit accounts, and small-denomination time deposits).10

Enter Generation Alt, a new era of investors who understand that time is money and that heading to the sidelines to escape volatility will not help to achieve their long-term goals. I think they need an investment strategy that helps them stay invested no matter how markets perform. Alternative investments may be one possibility to help investors do just that.

Defined as anything other than stocks, bonds, or cash that may increase or decrease independently of traditional securities (think hedge funds, managed futures, real estate, and commodities), alternative investments have the potential to help manage the dual problems of increasing correlation and lack of portfolio diversification.

Although far from a simple one-size-fits-all strategy, alternative investments can play a role in day-to-day investment portfolios by helping to provide diversification in an increasingly globalized and homogenized investment world. Even though they’ve existed for years, I believe alternative investments, combined with new philosophies, are positioned to be the next disruptive movement in the ongoing evolution of the investment management and financial services industries.

Disruption, in this context, is a term that refers to any idea that overturns convention, questions assumptions, and takes steps toward a new future.11 At first they seem of limited interest, but eventually their ideas catch on and can encourage new thinking. Look at how the advent of MP3 technology and iPods completely changed the way we listen to and purchase music. Not only did songs become available for download, but it also sparked a movement to other forms of digital content—movies, TV shows, and books. The status quo, at one point a boom box or Sony Walkman, was disrupted. While I am not suggesting that alternative investments are the iPod of alternative investing, they may become an unexpected disruption in financial services due to a need for more diversification in the face of increasingly correlated markets—something we will discuss at length. With increased accessibility and education, I believe that alternative investments, or alts, have the potential to help investors navigate market uncertainty.

At the core of this uncertainty is volatility, or the sharp rise and fall in price within a short-term period. What’s creating it? I could point to several things. The blurring of investment lines internationally means investors can now quickly react to political and economic events worldwide. I’ve witnessed the effects of technology on the speed of investing, and not always to the benefit of the investor. While technology can be liberating, it can also, in my mind, create problems that did not exist as recently as 20 years ago.

Things like flash trading, day trading, and frequency trading have had an impact on sound investment structures and contribute to the manic markets we now experience. I would argue that in our increasingly interconnected world, dampening volatility absolutely makes sense. In 2008, it became evident that alternative investments might well be the right strategy for this volatile environment. How so? In contrast to the overall market drop, university endowments, for example, fared better during the economic downturn. Their “secret” was their use of alternative investments. I don’t mean to imply that endowments had gains in 2008, I am only pointing out that endowments fared better. And it is important to remember that while alternatives and endowments do not always outperform the market (as we saw in 2012), they certainly fared better during the most recent downturn. Most recently, in the year ended June 2013, endowments did slightly decrease their allocation to alts to 47% of their portfolio and returns were an average of 11.7% in one year.12

Long available to qualified, high-net-worth investors, they were little known to average retail investors outside of Wall Street wirehouse firms and the aforementioned universities. In fact, average retail investors, those investing for their own benefit (retirement, their kid’s college, etc.), still do not have access to exactly the same investments as endowments—yet alternative investments are now attracting the attention of these smaller investors for a number of reasons, which I will discuss. But perhaps the biggest is the increase in recent years in market correlation and volatility, twin concepts that figure prominently in the relative success and failure of any investment portfolio.

Think of it this way: It took 76 years for the Dow Jones Industrial Average to close above 1,000 on November 14, 1972, less than half that time to rise 1,300% to its pre-crisis high of 14,000 on July 19, 2007,13 and just 18 months to lose more than half its value to close at 6,547.05 on March 9, 2009.14 Our increasingly interconnected world means that if current trends continue, this type of compression in reaching market milestones, and the volatility that drives it, will likely increase.15 While 100-point swings in daily market performance are not unheard of, today they’re far too common.16 The lack of volatility in an investment portfolio may be a way to measure financial “success,” however, individuals, couples, families, or even foundations may have different tolerances when it comes to volatility.

As baby boomers retire, they may have the greatest need to access the full universe of available investments. Should another crisis appear, they no longer have time to wait for a rebound before drawing on their financial resources for retirement. By understanding the benefits of investment strategies with low correlations to traditional markets, I believe investors have a good chance of hedging against the same problems experienced in 2008. Throughout the book, we will explore how alternative investments were developed. We’ll also look at the success they experienced in the past, how the investment market has changed, and discuss why alternatives may be worth considering.

Additionally, we’ll answer a number of important questions, including:

  • How are alternative investments defined and how do they differ from traditional investments?
  • What is meant by high and low correlation?
  • How did alternative investments develop and what benefits have certain investors realized from their use?
  • What are the different types of alternative investments and what role do they play in investing?
  • What situations involving alternative investments should be carefully considered?
  • What impact can alternatives have on volatility and performance over the long term?

As I mentioned, a new movement is afoot—one focused on alternative investments that can alter the way people invest. I call it Generation Alt . The concepts detailed in Generation Alt are specifically designed to explain the increased globalization and the hyper-connectivity of today’s markets, and the volatility all of it brings.

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