US Investors – Seeking Alternatives – Shoot Themselves in the Foot
By Staff News & Analysis - September 02, 2011

Clients clamoring for alternative investments — and advisers obliging … More than three-quarters of retail advisers say they have put clients into nontraditional assets; 'huge opportunity' … More than three-quarters of retail advisers use alternatives in their client portfolios, with an average of 11% of their book invested in venture capital, private equity, hedge funds, structured products and other such investments. Of the 78% of advisers who told Cogent Research that they use alternatives, 8 in 10 said they use the nontraditional investments for diversification. – Crain's Investment News

Dominant Social Theme: Get out of those mutual funds and into hedge funds and other sensible configurations.

Free-Market Analysis: This would be funny if it weren't so sad. The economic crisis of the past few years has shaken the confidence of middle-class American investors, weaned on dysfunctional investment magazines and TV tout shops; but the result seems to be a clamor for different structures rather than different instruments.

We've discussed the unreality of the investment industry in the past, especially in the US where personal investing has achieved a kind of cult status with a large, white collar population. This article, excerpted above, takes the unreality to a new level by proposing that the dysfunction of securities investing can somehow be magically transformed by using other configurations that focus on the same underlying securitization.

Twenty years ago, one of the elves here at DB wrote a book predicting that computers would make financial instruments obsolete. In fact, they have. There is no reason – other than regulation – why a single individual cannot tailor (with a keystroke) a portfolio including futures, equities, Treasuries, options and commodities.

But of course it is not so simple. Futures especially remain outside the ken of "normal" investing. Even asset-class allocation doesn't utilize commodities or futures. Diversification remains stuck in equity doldrums. And worst of all, most investors still use the pack animal of investment – the mutual fund – as the main portfolio workhorse.

As we have pointed out, mutual funds are the wildebeests of investing. Watch wildebeests try to cross a river during their migration time. Inevitably, some or even many get stuck in the river or on the opposite bank and die. The crush is tremendous. They are all moving in the same direction. Many are stepped on or even trampled underfoot.

And so it is with mutual funds and other products of mass consumption. Regulators have ensured there is not an iota of difference between funds. When central banks are inflating, mutual funds swell with profits. When central banks deflate along with the stock market, mutual funds die a lingering death en masse.

By depriving investors of the richness of strategy, regulators have made sure they will be stuck in the panic that envelops stock markets every 10 or 20 years as the business cycle turns and money printing ceases to expand the envelope of faux-prosperity.

So what is the solution? Investment advisors have now begun to recommend "alternative" investments. Of course, if these were REAL alternatives, investors might be well served. Futures, options and especially commodities can provide valid alternatives when stocks are failing.

But what is cited in this article? Such potentially disastrous instruments as limited partnerships and venture capital funds. Limited partnerships basically give investors exposure to much of the down side of an investment while the principals skate with the good stuff. Venture capital funds are only as good as the last round of central bank monetary stimulation. Without a "boom," venture funds are often a bust.

Hedge funds are problematic as well. They are not "hedged" anymore in the traditional way (as they once were) and often rely on very risky strategies to make a profit. As the manager is seeking to take up to 20 percent off the top, the profits that need to be made are substantive indeed. This can lead to most aggressive strategies. Hedge funds are not for the faint of heart. Here's some more from the article:

"Most of our clients are retired and more of them seem anxious with the general stock market so they are using more and more alternatives," said Erin Scannell, an adviser with Johnson Scannell & Associates, which manages about $500 million for clients. He said many clients are looking to invest close to 20% of their portfolios in alternatives.

About 83% of advisers who do put their clients into alternatives said they use venture capital, followed by private equity (72%), hedge funds (64%), exchange-traded notes (59)%, limited partnerships (49%) and structured products/notes (43%), the research report showed.

Advisers are least likely to seek alternative strategies through exchange-traded funds and mutual funds that invest in non-traditional assets. That may be about to change, however. Over the next year, 41% of advisers using alternatives said they will hike their use of ETFs. More than a quarter of that same group said they will boost their use of mutual funds that access alternatives, the report said.

"Advisers of all stripes and tenure have embraced the notion that managing client portfolios in today's environment requires the tools to provide greater asset class diversification and better risk management strategies," said John Meunier, a Cogent principal and author of the report.

On every level, this approach raises questions. Even the use of the term "asset-class diversification" is problematic. One has to have a substantive history to create a class of assets and how is one supposed to do that with a hedge fund, which is a vehicle not an underlying asset?

It is true that asset-class investing (as opposed to asset allocation) has a theoretical basis and a logical approach. We would even argue that the basic assumption that the market is efficient is correct. It is the sector, not the individual instrument, that drives profitability. This has been proven over and over again. In the 2000s, money metals have proven the most successful sector, with gold being up tenfold in a ten-year period.

But asset-class proponents have not taken advantage of their arguments. Asset-class investors have never utilized commodities or money metals and thus have passed up a rare opportunity to make the point once and for all that the market is (fairly) efficient and that asset-class investing is a superior strategy.

We are left with the dregs of irresponsible investing. The investors and their clients are clutching at proverbial straws. Limited partnerships, venture funds, hedge funds – most of these vehicles are still focused on equity-type products most of the time. The wrapper changes but not what's inside.

The Crain's article concludes by telling us that "research suggests a 'huge opportunity' for firms that provide mutual funds and ETFs to meet what will be a growing demand 'for institutional-quality alternative investment strategies that are both scalable within their practices and palatable to skeptical investors.'"

Now what the heck does that mean? It sounds good – to use institutional-quality alternative investment strategies. But last time we looked, Ben Bernanke was shipping nearly US$20 trillion to those same institutions around the world – as they were all busted and about to go out of business. As we've written many times before, the dollar reserve system is broken and there's not much the establishment and their leading elites can do to fix it.

The article does conclude on a positive note (from our cynical point of view). "Of the 22% of advisers who aren't using alternatives, about 47% blamed their lack of knowledge about the investments, according to the research. Of those advisers who do use alternatives, half said a 'lack of client knowledge and sophistication' stops them from using alternatives further." Hey … thank goodness!

It really is sad. The business cycle is what drives investing. How can people spend their whole lives advising people on how to invest without acknowledging the Austrian-style business cycle? Those who do understand the cycle began to buy gold back in the early 2000s. Silver, too. Their investments have accrued from five to ten times. Stocks have languished. And now – especially in the US – even Treasuries are suspect.

Instead of appreciating fundamental principles (and with the Internet there is no excuse not to) these investment advisors have opted to advise their clients to place their cash in "alternative" investment structures. But it is not the structure that makes the difference but the sector and the investment itself!

One is baffled to read such an article ten years into a gold and silver bull market. There are millions of investors out there, especially in the US, and hundreds of thousands of full time investment advisors. Yet too often the entire industry seems organized around the blind leading the deaf.

Granted, regulation makes it nearly impossible to provide really sensible advice or to organize profitable portfolios for the long haul, but one expects more than this. When it comes to investing, the industry itself – nevermind the customers – struggles in the throes of a kind of determined ignorance.

Gold and silver are up hugely in the past ten years. The industry meanwhile wants to steer its customers into "alternative" products, mostly along equity lines, characterized mostly by illiquidity and murky pricing. What sense does that make?

After Thoughts

Perhaps the explanation is that advisors are simply not doing very well these days and are seeking instruments from which they can draw expanded revenue. But if they are swapping out mainstream instruments (already rigid and unpredictable) for opaque and illiquid ones, without changing the underlying securitization, they will likely regret it, and so will their clientele.