I have been on the road quite a bit recently, appearing at several professional conferences around the country. One fellow speaker at a conference in San Diego was Dr. Christopher Geczy, a finance professor at the Wharton School and the new academic director of the Wharton Wealth Management Initiative. His impressive resume features a B.A. in economics from the University of Pennsylvania and a Ph.D. in finance and econometrics from the Graduate School of Business at the University of Chicago. Professor Geczy’s talk was both much anticipated and well received. That will help provide some context for an email I later received from one of the conference’s sponsors (Bob is not his real name). [divider] Hi Ken, It was a pleasure to meet you (though only briefly) after your panel discussion at the SSG conference. After listening to your comments and reading a couple of your Pinnacle Monthly’s (I liked the Moneyball one), I was particularly interested in getting your feedback on Professor Geczy’s presentation (if you even had a chance to watch it), and otherwise your perspective on alternatives* and their place in client portfolios. I know you’re a busy guy, so I’d keep any conversation brief. But it would be great to get your feedback. All the best, Bob [divider] Hi Bob, Thanks so much for writing, and I appreciate your interest. I did see Professor Geczy’s presentation. He is obviously smarter than the rest of us by multiples so any comments I share should be read knowing the great respect I have for someone who has accomplished so much. I only find alternative investments interesting to the extent that:
- You need to “hedge” the risk and returns of traditional investment allocations in your portfolio.
- The value proposition of any particular alternative investment is attractive based on traditional definitions of value.
If you believe that traditional asset classes will “misbehave” in the future, and if you are forced to own them, then alternatives are your last best refuge. The belief (hope, prayer) that somehow alternative managers (hedge funds or private equity) or alternative asset classes (timber, etc.) will deliver high returns with less risk and low correlations to traditional asset classes makes them look terrific in optimizing models that are populated with data that is based on past performance. If you believe that hedge managers are smarter than other managers; that alternative asset classes like timber, precious metals, managed futures, etc., will outperform; and that leverage properly used will add to returns, then by all means load up with alternative investments. For our part, we prefer to manage risk by tactically changing the allocations in our portfolios based on our forecasts for markets. If we don’t like traditional equity positions, we are free to own less of them, or (theoretically) none of them, to manage risk in bear markets. I much prefer this to loading up 20+ percentage allocations to opaque and hard to understand alternatives. While we can and do own alternative investments at Pinnacle, we certainly own less of them than we did five years ago. Using alternative investments to hedge fixed income positions seems more attractive to me than any other asset class. I can see several low volatility alternative strategies being added to Pinnacle portfolios in the future once the bond market finally breaks (which might still take some time). However, I find the long-term value equation for bonds to be frightening, so perhaps alternatives will find a home here as fixed income alternatives. In closing, modern finance is filled with those who model the most “efficient” portfolios with models that depend on assumptions of returns, correlations, and variances that are no better than yours or mine. So the models — impressive as they appear to be — run the risk of seeming to be scientific when in fact they are no more than bottles of snake oil wrapped in the persuasive package of obscure Modern Portfolio Theory terminology and math that only ‘experts’ can understand. Don’t be fooled by any of this. Instead, concentrate on why asset classes will perform well in the future. What is the value equation for each of them? Your conviction in these answers should guide your investment philosophy. I address much of this in my book, Buy and Hold is Dead (AGAIN): The Case for Active Portfolio Management in Dangerous Markets. You might enjoy it. I hope this helps, Ken Solow * “Alternatives” refers to non-traditional investment strategies like hedge funds, or non-traditional asset classes like managed futures, commodities, timber, etc. Photo