Bad Alternatives

The latest hot investment fad are these things called "alternative funds." "Fad" rhymes with "bad." However, investing fads have a great deal more incommon with the word "bad" than just those last two letters. In most cases they are defined by the word.

Much of the investment advice industry doesn’t think much of you, their clients. I learn a lot about the self-interest and motivations of brokers, financial planners, and investment advisors by reading the pages of industry publications, like Rep and Investment News.

Investment News columnist, Jeff Benjamin’s recent article on alternative investment provides some frightening insights into the mindset of many investment advisors.

He starts by stating “the case for traditional long-only allocations to stocks and bonds is getting weaker by the day…” Yet, he fails to provide any evidence to support his assertion.

According to Benjamin and his carefully selected “investing” experts, we are entering a new investing “paradigm.” Now, why does that sound so familiar? Apparently, advisors are worried that investors are starting to understand the basics of real investing and the previously obscenely lucrative advisory business is “becoming commoditized.”

Let’s read between the lines from these advisors perspective:

Because investors now realize that there are no tricks or gimmicks that can consistently add value, advisors need new strategies to keep clients guessing to justify high fees.

Two of the advisors quoted in the article, Money Management Services and Blackrock, have starting annual fees of 2% or more. Add to that the average 1.8% per year charged by alternative mutual funds, and you have to wonder how the clients make anything.

One advisor discussed, Alpha Capital Management, only charges 0.65% for investment advice, but the in-house alternative funds they use charge 2.75% to 2.8% annually.

No matter how you slice them, alternatives don’t look healthy for clients:

The average annual return for S&P 500 for the last 20 years is about 9%.

Assume that alternatives stated goal of reducing volatility should mean that they cannot match the returns of more volatile equity funds (risk and reward are linked).

Because they must, on average, make less because of their hedging costs, let’s generously assume that alternatives can post average returns of 7% annually before expenses.

Start with 7% per year.
Deduct 1.8% for fund expenses.
Deduct 2% for advisor fees.

Client’s average annual share of the returns: 3.2%

From a client’s perspective the “60-40: Paradigm of the Past” referred to in the article (60% stocks/40% bonds) is starting to look pretty darned good.  The 20-year average return of a globally-diversified 60/40 portfolio has been around 7% per year.

The article concludes with a quote from Bob Rice, managing partner at Tangent Capital Partners (“a merchant bank focused on alternative assets” -from their website), “…if you're an adviser and you're not seriously looking at alternatives, when all the math and metrics are staring you in the face, because it's hard or confusing or you just don't understand them, then you're not doing your job.” 

It’s the simple “math and metrics” of high fees that convinces me that those advisors who offers complex, confusing (some, like me, might claim purposely so) alternative investments to clients are, in fact, the ones not doing the job.

Don McDonaldComment