Alternative Absurdity

Ask investors what they want from their portfolio and you will likely receive these two answers (in alternating order):

  1. Make Money
  2. No Risk

Therein lies the problem plaguing most investors, those two desires are mutually exclusive. Making money requires risk and the level of perceived risk taken is directly tied to expected return. In other words, making more money means taking more risk. It’s a very simple reality that most investors wish they could overcome. 

Wishing for something doesn’t mean will get it. Oscar Wilde said it best, “When the gods wish to punish us they answer our prayers.” My variation on that message is, “When Wall Street wishes to rob us they give us what we ask for.” You can substitute “banks” or “insurance companies” for the term “Wall Street.”

Wall Street’s latest (and hottest) attempt to make your wishes come true comes in the form of a variation on the good old tool of well-heeled investors, the hedge fund. Now pitched as “alternative investments,” these repackaged versions of a host of well worn (and regularly bad) investment concepts are being heavily sold to smaller (less that $1 million) investors in mutual fund or ETF form. 

One of the biggest purveyors of complex, expensive, and trendy investment vehicles, BlackRock touts alternatives saying that “adding them to your portfolio can offer scope for broader diversification and the potential to reduce risk while also enhancing returns.” Basically, they claim “more money, less risk.” They forgot to mention “and higher fees for us.”

How can this incredible financial alchemy work? Let’s look more closely at one of BlackRock’s alternative products, BlackRock Global Long/Short Equity (ticker: BDMAX). Let’s start with the costs from BlackRock’s own literature:

    Sales load: 5.25%

    Annual total expenses: 2.54% (alternative funds average is about 1.90% - Morningstar)

Now, let’s assume that the total global stock market appreciates at an average of 7% per year over 20 years. A $10,000 global index investment would grow to a bit over $40,000. To match that return in BDMAX, the fund would have to earn 9.75% per year on its portfolio (to overcome the effect of expenses). I only know of one way to earn a 40% higher long-term return. Take about 40% greater risk!

You certainly can’t beat the market by having a portfolio that both owns stock (long) and sells stock it doesn’t own (short) unless you can consistently predict when to be long (before stock prices rise) and when to go short (before prices fall). Since there is NO evidence of fund managers having any consistent predictive skills, the odds are not in BlackRock’s (or any other manager’s) favor. In fact, there are reams of academic data (drop me a note, and I’ll send you some) showing that the best indicator of success is low fees and that the rare glimpse of superior active fund management is due to luck.

Hedging your bets (and, therefore, hedging your investments) may be an effective way to reduce risk, but it is impossible to also increase returns. It can’t be done! No matter how much we wish it could.

If you want less risk in your investment portfolio accept the fact that you will make less money. Just don’t give your broker and fund manager what is likely to be a very big piece of your reduced returns. Doing so is likely to make you broker and them much richer.

Don McDonaldComment