The Alternative Answer

The Nontraditional Investments That Drive the World's Best Performing Portfolios

Bob Rice

• Publisher: Harper Business
• Year: 2013
• Print ISBN:
  9780062257901
• eBook ISBN:
  9780062257918
• Topic: Personal Development
• Subtopic: Accounting

Alternative Answer, The EPB delivers a complete toolkit for smarter asset allocation, showing you how to:

• Active Risk Management: Move beyond the outdated 60/40 model and learn why loss avoidance—not just chasing gains—is the real key to long-term wealth creation.
• Inflation-Protected Income: Discover how assets like MLPs, royalty trusts, and timber can generate higher, tax-advantaged yields that grow over time.
• Long-Term Growth Enhancement: Explore the world of private equity, venture capital, and other powerful strategies designed for substantial upside, once accessible only to elite investors.
• True Diversification: Assemble a “panoramic” and “risk-tolerant” portfolio using uncorrelated assets to protect your wealth from the next major market shock.

CHAPTER 1

The Alternative Manifesto

Divide your portion to seven, or eight, for you do not know what misfortune may occur on earth.

       —KING SOLOMON, ECCLESIASTES 11:2

Yale’s endowment is up 100% over the past, extraordinarily difficult, decade. I won’t ask how you did.

So, what’s up? Using all that IQ to pick great stocks? Hardly. The trick, in fact, is that mostly they aren’t picking stocks at all: in 2012, only 6% of Yale’s portfolio was in U.S. equities. Instead, fully half resided in things called “absolute return,” “private equity,” and “real assets” strategies. Another big chunk was in emerging markets. Those are the secret ingredients of an investing formula that is now widely followed by most other endowments, foundations, and the rest of the smartest money on the planet.

The lesson is loud: in our ever more volatile and complex world, a long-only, domestic stock and bond portfolio is inadequate. Those traditional securities represent only a tiny sliver of the potential investment universe: many of the best opportunities are, simply, elsewhere. Even more to the point, the biggest key to long-term wealth is loss avoidance; and, as I bet you’ve noticed, traditional portfolios are subject to periodic, devastating, crashes.

Until very recently, there wasn’t much typical investors could do to expand their horizons or limit their downsides. Not to diminish their spectacular results, but those institutional investors and their ultrawealthy friends have had an unfair advantage: access to strategies and vehicles that were both unknown and unavailable to the rest of us.

That is changing extremely rapidly. Average investors are no longer stuck with the children’s menu of investment options.

But what about the standard investing gospel, like our much-beloved 60/40 stock-bond portfolio? Are the old rules really passé? Well, in the most recent (and certainly not last) crisis, they provided about as much protection as a five-dollar umbrella in a hurricane, but you knew that. The real issue is that our bedrock principles actually have quite a poor long-term track record for safety and consistent returns. Let’s consider the three big rules that everyone’s been taught . . . but that are wrong.

Mistake 1: A 60% Stock/40% Bond Portfolio Is Ideal. At first glance, the results of this standard allocation don’t look so horrible: a long-term average annual return of 4%. But this is a wonderful example of just how misleading statistics can be. The damning truth is such a portfolio suffered six collapses in the last century in which the losses exceeded 20% . . . utter disasters that each took more than a decade to recover from in real terms. There is no reason to expect this pattern to change.

Another way to look at that long-term average: throw a dart at a list of the last hundred years, and pretend you had invested in whatever year it hits. The odds are nearly 25% that, a full decade later, such a position would have shown a loss. That sound like a conservative strategy to you?

OK, but those bad periods aside, surely the rest of the time the returns have been great? Hardly. We’ve had eleven decades of experience with annually rebalanced 60/40 portfolios since 1900. In the majority of cases, seven out of those eleven, the average annual real return was less than 1%. Surprisingly, the current Mojave Desert of returns is absolutely historically normal.^*

That gaudy 4% average annual return is explained by just four absolutely exceptional decades: the ’20s and ’50s (postwar periods), and the ’80s and ’90s (the end of yet another war, this time cold; and our unrepeatable debt accumulation, which we’re now working off). So unless you think we’re on the cusp of another historically anomalous growth period, 60/40 is not the way to go. At least, not without a camel.

Even that history doesn’t relate the whole scary story. The bond bubble that’s been expanding for decades makes the “safe” component of a 60/40 portfolio into a potential hand grenade. The last period in which Treasury bond valuations were comparable to today’s was followed by forty-five years of negative real returns. Forgetting history, it’s simple common sense that the Fed’s ferociously loose monetary policy makes inflation, and a major tumble in bond prices, highly likely at some point. And, no, it won’t work to simply hold the bonds to maturity so you get all your principal back, because those dollars will have, by definition, then lost major purchasing power. That’s precisely what bonds are supposed to protect.

Mistake 2: Stock Diversification Equals Safety. The standard method of “diversification” involves spreading stock selections across the “nine buckets.” Those are defined by a matrix with “small, medium, and large” down the side, and “growth, blend, and value” across the top. Fill up all the buckets, and you’re good to go. But, as you know, the crash emptied all nine at once.

Well, maybe we should have included foreign equities, too? Not a terrible idea, certainly, but that won’t get you the sort of diversification that yields safety. That idea may have helped when world markets sang in different keys; today, however, they have fulfilled the ardent wishes of that famous old Coke commercial, and learned to sing in perfect harmony.

Well, then, what about diversification across asset classes? That’s headed in the right direction, but is still not enough; my guess is that in the Great Recession your home value didn’t exactly cushion your stock losses. Merely spreading dollars around, even among apparently many different assets or strategies, does not necessarily provide the safety we need. A key reason is that some assets are inherently more volatile than others, so that dollar weighting does not equal risk weighting. For example, the long-term performance of a 60/40 stock/bond portfolio mimics a stock-only portfolio nearly perfectly: 95% of the combined volatility is driven by stocks alone. Bonds do almost nothing to balance out stock performance.

The crash was so devastating for a different reason, though. It turns out that apparently diverse asset categories can share an unnoticed Achilles’ heel (often, leverage). Forgive the trite example, but different financial assets can be taken out by a single risk in much the same way that different telecommunications systems—phone, television, and the Internet—all bit the dust in Hurricane Sandy for “triple play” customers who relied on a single wire for all three.

The way to address this sort of risk is by emphasizing “uncorrelated” income streams and “absolute diversification” in the portfolio. We’ll dive into this later, but meantime here’s an interesting fact to hold you over: the biggest timberland owner in New Zealand happens to be . . . Harvard. Now, we’re not exactly suggesting that you start buying trees on the other side of the planet (yet), but good modern investors will certainly adopt radically broader portfolios in aiming for safety.

Mistake 3: Buy and Hold [insert asset class here] Always Wins in the Long Run. No parent trying to pay tuition from a devastated college fund needs to hear what’s wrong with this idea. Nor do folks who once thought real estate “can’t go down, because they aren’t making any more of it” . . . as this is written, fully one-fifth of all U.S. homes remain substantially less valuable than the mortgage on them. Maybe the Fed’s desperate attempts to engineer inflation to fix this problem will eventually work, but those homeowners will never recover what they toss away each month on the underwater mortgage.

Stubbornly holding on to assets as they head south can just kill you. The cruel math of losses means that a 50% loss—from $100 to $50—requires a 100% gain—from $50 to $100—to break even. It’s simply unrealistic to expect people with periodic (and often unpredictable) actual cash needs to wait through these cycles long enough to recover.

Instead, investors should be looking at portfolios with internal shock absorbers that are designed to minimize losses in the first place, or even profit in periods of general turmoil. There are an array of new options for this: you can turn to simple solutions like basic long/short mutual funds, or go exotic with a “global macro” manager. Much more on all this later.

So how then, you might ask, did these traditional investing ideas become so ingrained as common wisdom? In retrospect, it’s not really a huge surprise. America has happily experienced a long and absolutely unprecedented stretch of economic prosperity and political hegemony. The factors behind that are legion: a superior political system; an open culture; success in the big wars; favorable demographics and immigration waves that captured talent; a superior education system and strong work ethic; vast natural resources; and many other wondrous elements that combined into the greatest country, and the most prolonged economic miracle, the world has ever seen.

Naturally, that created an investment opportunity like no other. In fact, for a very long time, it was hard to be wrong, so long as you were long . . . anything. So, sure, 60/40 sort of worked, just as most other combinations did; waiting out dips made sense; and “diversification” among a bunch of similar boats, simultaneously floating ever higher, felt real.

But the world has gotten infinitely more . . . well, complicated. I’m an optimist, but still: with algorithms executing billions of trades in nanoseconds without the slightest chance of intervention by human judgment, markets will remain frighteningly unstable, or grow more so. The absurdly overleveraged Western governments will try to print their way out of their debts, which could lead to massive inflation if they succeed, or massive deflation if they fail. World economies have become one long domino chain. The technology and information revolution will continue to make us more efficient in every possible way . . . likely creating growing structural unemployment and income inequality. Toss in cyber-terrorism, climate change, political gridlock, and military flare-ups, and the picture could take just a bit of the shine off your otherwise lovely day.

Simply put, it would be foolish to ignore these new and profound risks when investing. But it would be equally foolish to ignore the enormous and plentiful new opportunities inherent in our changing world. Just consider how many ways wealth will be created from robotics, the maturation of the Asian and African economies, or the surprising transformation of America into the world’s largest oil (and natural gas) producer, as the International Energy Agency predicts will happen over the next decade.

Thus, smart portfolios today must be panoramic and risk-tolerant. That’s the alternatives manifesto.

A “panoramic” portfolio reaches across a wide spectrum of assets, strategies, and time horizons to achieve higher current yields and more long-term growth. Royalties, start-ups, water, distressed securities, infrastructure, frontier markets, specialty finance, oil and gas partnerships, roll-ups, art, farmland, and scores of other categories provide compelling new opportunities to meet investor needs, from current income to generational wealth protection.

A “risk-tolerant” portfolio is like fault-tolerant building: it can absorb major shocks without collapsing. Such stability requires active risk management to guard against sudden stock market declines; “uncorrelated” positions that generate returns independent of one another in typical business cycles; and “absolute diversification” so that strategies do not share a single point of failure in a crisis.

Now, the big news is not so much that alternative investments can provide much smarter and safer ways to generate income, grow portfolios, protect wealth, and transfer it . . . that is an empirical fact, but it’s been known for many years. Rather, the headline is that these strategies are now accessible by nearly everyone, thanks to a slew of changes in the legal and business environment, and, bluntly, a growing realization even by the big brokerage houses that the old ways of doing things just aren’t working.

As a result, a tidal wave of new financial products is hitting the market to address our new reality, and at the same time, classic hedge and private equity funds are finding ways to offer their strategies to the merely affluent instead of just the super-rich. Now, investors can get hedged exposure to the stock market through “smart beta” mutual funds; earn inflation-protected income via traded master limited partnership interests; diversify into commodities through managed futures; play private equity through new registered funds; and protect against currency and inflation risk with real-asset ETFs. Simultaneously, online platforms are springing up to offer direct investments in start-ups, corporate buyouts, commercial real estate, hedge funds, and all manner of other deals.

This plethora of new options and opportunities is certainly welcome, but a bit overwhelming. The simple goal of this book is to put them into perspective and show how to use them.

So here’s the plan. First, we’re going to explain exactly how and why it is that “panoramic” and “risk-tolerant” portfolios generate superior long-term results. Then we’ll do a quick review of the basics of hedge funds, private equity, venture capital, managed futures, and real assets . . . and how they translate into new, different structures that allow almost any investor into these previously very exclusive opportunities.

That’s all fine, but exactly which alternatives should you consider? That depends on the jobs you need done inside your portfolio. There are four: generating higher, inflation-protected current income; “broadening the base” to reduce overall portfolio risk; enhancing long-term upside with some bigger return strategies; and ensuring your purchasing power against crises and currency devaluation. For each job, eight specific alternative strategies are suggested.

“The Big Picture,” chapter 9, then brings everything together with model blueprints for investors of different liquidity and wealth levels, and a discussion of which investments should do best under the various economic “regimes” we may see in the coming years. And, following that, we’ll detail exactly what to look for if you do go shopping for alternatives, and where you can find them.

Finally, there’s a big fat glossary. After digesting that, you’ll be fully fluent.

Ready? Let’s go.

CHAPTER 2

Do Alternatives Work?

I thank my fortune for it,

My ventures are not in one vessel trusted,

Nor to one place; nor is my whole estate

Upon the fortune of this present year.

—ANTONIO, The Merchant of Venice, ACT I, SCENE 1

Most people think investing means stocks and bonds. We’ve been indoctrinated that way. After all, no news broadcast since childhood has been complete without a recap and explanation of Mr. Dow Jones’s day, as normal as hearing about our family’s trials and tribulations over dinner. He’s one of us.

Well, yes he is. But just one. Other asset classes, like private equity and venture capital, have dramatically outperformed stocks for many years now (of course, it wasn’t actually all that hard, but still . . . ). Both of them dusted Mr. Jones by several percent over the past five years, and the edge really mounts up over time: PE more than doubled stock returns over the past ten years, while venture capital returns crushed them by more than 5x over the past fifteen.^* At the same time, royalties and real assets provide, respectively, higher income and better inflation protection than traditional securities. A panoramic portfolio, now within reach for typical investors, is really just common sense.

But in any family there are some members about whom people whisper. So in the interest of having a nice pleasant evening together, let’s just clear the air about the most misunderstood of the alternative siblings. The ugly talk is fueled by this breaking news:

“Last quarter, the S&P outperformed the average hedge fund by 2%.” The handsome anchor, with a knowing smile, manages to convey the folly of investing in something that didn’t “even” beat the S&P. And many pretty knowledgeable viewers gently nod in agreement.

The most important lesson you can take away from this book is understanding what’s wrong with that apparently innocuous headline.

Risk-Tolerant Investing

First off, on that same logic, our anchor m...

Table of contents

• Contents
• Introduction
• 1. The Alternative Manifesto
• 2. Do Alternatives Work?
• 3. Major Alternative Strategies
• 4. Major Alternative Structures
• 5. Higher, Inflation-Protected Current Income (Job 1)
• 6. Broadening the Base for Risk Reduction (Job 2)
• 7. Long-Term Growth Enhancement (Job 3)
• 8. Purchase Power Protection (Job 4)
• 9. The Big Picture
• 10. At the Dealership
• Conclusion: It’s Time!
• Acknowledgments
• Glossary
• Resources
• About the Author
• Praise
• Credits
• Copyright
• About the Publisher