The Mainstream Case for Alternative Investing | ETF Trends

Alternative investments can feel like a separate world from the rest of investing. The term evokes everything from hedge funds to fine art to a myriad of things in between. But as anyone who’s included REITs in a client’s income portfolio can likely tell you, the reality is a bit grayer than that.

That gray area is the sweet spot of Phil Huber’s recent book, “The Allocator’s Edge.” In fact, he implores readers to “embrace the gray” of the alternative investment world in the book’s first section, as he details the many shades of gray that exist.

Solving 60/40

We’ve spent quite a bit of time looking at the cases for and against the 60/40 portfolio. (Consider this, and this, or this, to mention a few.) While this allocation has performed well for the last several decades, past performance does not indicate future results. In fact, when taken as a whole, past performance is a bit bleaker than recent history would suggest. 

In the book, Huber points to research from GMO, which cites several periods where real returns for a 60/40 portfolio were flat or negative. Two of the biggest risk factors are, unsurprisingly, two things we’re grappling with right now: inefficacy of bonds and inflation. 

Huber spends time discussing why bonds are no longer an effective hedge for stocks: “It’s worth taking a step back and refreshing ourselves on why bonds tend to do well during equity drawdowns in the first place. When the economy is on shaky ground and equities are falling, investors typically forecast central bank action in the form of interest rate cuts to stimulate activity.”

In the case of 2022, not only are rates not falling, they’re rising. Just look at this week’s decision by the Fed to hike rates 25 basis points, paired with hawkish language, despite a brewing war in Europe.

The reason for that is, of course, the second major risk to a 60/40 portfolio: inflation. After looking through data from Bridgewater Associates, Huber writes, “elevated inflation is a structurally challenging environment for stocks and bonds to thrive in … virtually all the excess returns from both asset classes came when inflation was falling.” 

This perfect storm is why Huber, along with hedge fund managers like Clifford Asness (who wrote the book’s foreword) are rallying investors to take another look at alternative investments. For RIAs and BD reps, however, the options for alts are far more limited than those at, say, a hedge fund. And that’s where Huber hopes to help with “The Allocator’s Edge.”

Alt Aversion

As he was researching the book, Huber turned to one of our favorite platforms, #FinTwit, to ask advisors and investors what they think of when they hear the term “alternative investment.” Responses spanned from the benign (complex, misunderstood) to decidedly negative (scam).

And yet, clients are interested in alternatives, whether it’s cryptocurrencies or access to private markets. So, Huber sets out to figure out what’s causing the aversion to alts among advisors and to reframe the conversation. 

The biggest point Huber makes is that alts tend to deal in what Asness dubs the three dirty words of finance: leverage, shorting, and derivatives (LSD). However, as Huber points out, these terms aren’t inherently bad. Leverage is how most people buy homes. Shorting can help investors hedge; it also creates a mechanism for holding management teams accountable. And derivatives… well, even Warren Buffett uses those. 

At the same time that he takes the claws out of the scary parts of alts, he also offers a reframing that can help not just advisors, but their clients as well. For investors scared of illiquid private markets, for example, he points out that the risk that private companies face tend to be the same as those facing public companies. When it comes to novelty, something like bitcoin is only novel to anyone over a certain age who hasn’t been paying attention.

Your Guide to Alternatives

The other challenge, once you get past the aversion to alts as a general asset class, is figuring out how to invest in them. As Huber points out, “Advisors don’t know what they don’t know and can be prone to paralysis by analysis if overwhelmed with all the moving pieces involved.” 

It might help, then, to think about alternatives in broad groupings, the way Huber does: private equity, hedge funds, real estate, and natural resources. Huber goes on to talk about the theoretical and tactical factors driving investments in each. That includes a look at how to invest in these alternatives. 

Huber notes that some strategies don’t work well in an ETF wrapper, due to regulations based in the Securities Act of 1940 which limit how things like derivatives and leverage can be used. Other strategies, however, can work well in an ETF, including catastrophe bonds, managed futures, long-short equity, and commodities, to name a few.

“All of those things don’t have a lot to do with each other, but they get broadly bucketed and categorized as alternatives,” Huber said in a recent interview with ETF Trends. “It is a lot harder for investors and allocators and advisors to have an understanding of that universe because it’s so unclearly defined, and it’s always evolving, too.”

Huber’s book not only provides a guide to advisors looking to use alternative assets in their clients’ portfolios, it also provides a framework for how to discuss these investments. As Huber — whose day job is chief investment officer at top-ranked RIA Savant Wealth Management — said that prior to publication, alternatives “accounted for the majority of the conversation around the portfolio in review meetings with clients, because it’s the least-understood portion of what we’re doing.” This is despite the fact that alternatives were a relatively small allocation intended to complement traditional assets.

To better understand some of the specifics, in terms of the strategies, products, or both, you can grab a copy of his book, “The Allocator’s Edge.” You can also come to his Book Club at Exchange: An ETF Experience, where he’ll be discussing the book and answering questions. We’ll also have copies available.

Phil Huber is a member of 2021’s #ETFintwit #Top50 list; follow him @bpsandpieces for additional insights. (You never know, his polls could end up featured in a book!) Another worthy follow is AQR Capital’s Clifford Asness, mentioned above.

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