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 intention of alternatives investments that are uncorrelated to stocks or bonds, which therefore should temper volatility and enhance returns while reducing risk is valid, the execution hasn’t always been stellar. From my observation as the founder of an investment research and management firm, the problem is that some of these products are either poorly designed, poorly executed, or both. Plus, many of them have high upfront fees. The combination of these factors can produce losses for investors and as a result has led to a string of negative headlines over the years. But there is more to know about alternative investments and their human counterparts, active managers.

What is an alternative investment?

Simply put, these 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 at a profit, allowing investors to get back their principal and a percentage of the gains. This is the ideal scenario. Unfortunately, it doesn’t always work that way.

Why do they have a bad reputation?

One of the most notorious examples of the negative headlines mentioned above took place in 2014, when RCS Capital, an unlisted company real estate investment confidence (REIT) controlled by Nicholas Schorsch, began to collapse after one of its units engaged in a massive accounting fraud. The spinoffs included jail time for a senior business executive and RCS Capital bankruptcy filing.

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. In my experience, most product sponsors are meticulous, careful, and have a solid track record of creating offerings that help investors achieve their financial goals.

While it’s true that alternative investments aren’t for everyone, they were never meant for everyone. Indeed, only a select few investors are likely to have the ability to tie up significant capital for long periods of time to allow these investments to run their course. However, if we consider again what the alternatives, in part, are meant to do – provide access to assets that are inversely correlated to equities – it is primarily a risk mitigation strategy, and I don’t think there really is anything controversial about it.

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

According to both 2015 and 2018 CNBC reports.

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

As a result, many Americans now have very similar wallets. In many ways, this mirrors other times when investors piled into “one-shot” investments, including the shrewd fifty infatuation, the dot com frenzy and the hold continues to modern portfolio theory. When this has happened before, the result, while not uniformly disastrous, has been suboptimal. Think of anyone, for example, who bought into modern portfolio theory during the rise of stocks New York Times reported over the past nine plus years. A 60/40 mix of stocks and bonds during this period would have lagged, perhaps significantly, any portfolio that even lost 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 indices or each other, much like alternative investments. This is often described as having an amazing ability to spot value where others cannot. But equally important to the value of an active manager is the ability to reduce exposure to depressed asset classes whether markets are booming or floundering. In other words, much of their inherent value lies in how they mitigate risk – which, again, is uncontroversial.

However, I don’t believe anyone should suggest that investors be active all the time. Passive investments have a place in almost any portfolio. They just shouldn’t make up an entire portfolio, in my opinion, because there’s no downside protection.

Has the alternative investment industry seen its fair share of bad actors and failed products? Sure. Can the same be said of active management? Yes. But when alternatives were presented to a retail audience, the intention was to provide investors with additional diversification and inverse correlation to a multitude of market segments. Similarly, a smart and active manager acts the same way by reducing a client’s exposure to underperforming asset classes, whether during bull markets or times of distress. In my experience, these are definitely good things for investors when balanced responsibly.

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

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