Fallacies of alternative investments

You have to know what to look for.  As we have explained in Splitting Pennies and Splitting Bits – things are not as they appear.

Just because something is ‘different’ doesn’t make it ‘better’ – just because something is not mainstream doesn’t make it ‘honest.’  We all here agree that mainstream investing sucks, but do we use the same rational methodology when evaluating alternatives?  Crypto has proven this is not the case.  Investors lost their minds and did all the things they have been told not to do over the years.

So what are alternative investments and how big is this industry?

Alternative Investments are basically any investments other than stocks, bonds, or cash; including stock listed funds like mutual funds.  So alternative investments include hedge funds, strategy specific funds (such as a short term bridge loan fund), commodity trading advisors, and even real estate.

As of 2017 there were $8.8 Trillion in Assets in the alternative investment industry according to institutional investor, a media publication that tracks the industry[i].  But what’s interesting is that it’s predicted to grow to $14 Trillion by 2023, only 4 years away:

The alternative investment industry is expected to grow by 59 percent by 2023, reaching $14 trillion in assets in five years’ time, according to new research from alternative investment industry data provider Preqin.

The industry managed $8.8 trillion as of the end of 2017, according to Preqin, which says growth will be driven by investors’ need for yield, alternative assets’ strong track record, and a declining number of publicly traded companies. The report, published online Friday, is based on surveys with 300 fund managers and more than 120 institutional investors completed by Preqin in June.

The data show that investors plan to increase their allocations to three major categories in the next five years: 79 percent said they would increase their private equity allocation, 70 percent plan to boost allocations to infrastructure, and 62 percent plan to increase allocations to private debt.

Whether you are considering that a shift of funds from one investment sector to another, or just inflation – it still means growth.

So what are the big challenges?

Ultimately, there are only so many strategies.  Markets go up, they go down, there are new issues, there are economic events – there are limited components in which to derive a strategy from.  And you can bet that Wall St. has analyzed every which way to make a buck, including buying highways from local governments and turning them into toll roads.  The problem with many strategies is that they become crowded.  That means as the Assets Under Management (AUM) grow, at some point the strategy may reach a limit where it cannot perform at the same level with more capital.  Investors like markets like FX and Stocks because liquidity is so deep.  However, some strategies may not support assets upwards of $1 Billion USD.  Take for example commodities futures strategies.  When you start buying $4 Billion worth of S&P contracts, you are likely going to move the price.  In fact, hedge funds have used a market making strategy whereby they would buy the futures as a head fake to go short the stock (the capital required to move the futures market vs. the stock market is a mere fraction).

Also managers experience something there is even a term for now ‘style drift’ – it means that managers don’t do what they say they are going to do.  This is a big problem.  So finding a good manager isn’t easy.  Obviously if the industry is growing someone is doing something right.  But everything looks good on the surface.  When you walk into a bookstore, many of the books look interesting – but you certainly can’t walk away with the whole store.  The method of most customers is to focus on a genre they prefer and hone in on some authors they are familiar with or who have high recommendations.  These are good strategies but unfortunately like with any product the only way to see if a book is good is to read it.  And with investing it’s not a good idea to test a strategy with your own money. 

Finally, the track record fallacy needs to be emphasized.  The regulators force CTAs to say “Past performance is not indicative of future results” because it’s an open glaring tautology.  In first order logic, tautology is something that is always true no matter what.  For example 2+2=4 even if you are on an airplane or are mentally deranged. 

Just because a strategy did well for the past several years – what makes you think it will do the same in the future?  In fact the opposite is true. 

But perhaps the best analogy explaining this phenomenon comes from our smart friend Nassim Taleb in his series of books

“Consider a turkey that is fed every day, Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”

This can happen to any strategy – 5 good years of performance and one bad day can wipe it all out.  That’s not defeatism, that’s just a possibility.  It happens.  So the catch is to find strategies that aren’t overleveraged, or who have risk management in place to at least attempt to capitalize positively on volatile moves that would otherwise negatively impact performance.

Every strategy has a potential flaw – we’re not here to suggest there is any perfect strategy.  Our idea is that if you can eliminate or at least reduce losses – what you have left is profit.  That means investors should be even paranoid about things that can go wrong, like the I.T. guy who thinks the world is going to end.  Remember that there was a guy screaming to the SEC that Madoff was a fraud.  Usually things are staring right in front of you.  Like with Gold & Silver – sorry guys, the markets are manipulated.  The argument for Gold 50,000 is strong – but if the market is completely rigged than the price is whatever the Rothschild fixing group says it is.  So until there is another system in place, Gold isn’t going to 50,000 and neither is Bitcoin. 

But if there’s one takeaway from this article it should be that if you don’t have the time, expertise, money, and nerves to invest in doing your own investing – find a professional who can do it for you.

[i] https://www.institutionalinvestor.com/article/b1bg5lknj62d7l/Report-Alternative-Investment-Industry-Will-Hit-14-Trillion-By-2023

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