book review
Assessing the Alternatives
The Only Guide to Alternative Investments You’ll Ever Need:
The Good, the Flawed, the Bad, and the Ugly
by Larry Swedroe and Jared Kizer. Bloomberg Press. 320 pages. $25.95.
In the classic approach to portfolio construction, just three types of assets suffice to fulfill all investment objectives. Common stocks produce long-run capital gains that are taxed at comparatively favorable rates, while also constituting a hedge against inflation. Bonds serve as a bulwark against recession and they come in tax-preferred varieties. Liquidity needs can be satisfied with ultra-safe money-market instruments such as Treasury bills. By utilizing these building blocks in proper proportions, individuals can position themselves as desired along the risk-versus-reward continuum.
Considering that all three basic classic assets can be purchased in forms that feature high levels of transparency, deep secondary markets, and minimal fees, why would investors even consider messing around with anything else? The reason, as systematically explored in The Only Guide to Alternative Investments You’ll Ever Need, is that financial-services firms constantly dangle before investors hybrids and exotica supposedly capable of producing a superior risk–reward tradeoff. In one version of the better-mousetrap story, these firms combine the desirable features of two asset classes to eliminate the undesirable features of both. In another, they reduce risk by cost-effectively providing a diversification benefit not offered by stocks, bonds, or cash.
Larry Swedroe of Buckingham Asset Management, and Jared Kizer, formerly of the same firm, demonstrate how unnourishing most of these allegedly free lunches are (except in the sense that the innovations tend to be highly profitable for their purveyors). For example, a covered call strategy delivers low volatility, but at the cost of sacrificing upside potential. The scheme also replaces capital gains with income (in the form of option premiums) that is taxed at higher rates, besides entailing hefty transaction costs.
For some alternative-investment classes, the promise of superior returns is entirely a function of measurement error. For instance, Swedroe and Kizer cite empirical research contradicting hedge funds’ claims of superior performance, even before taking survivorship bias into account. Furthermore, one study found that survivorship bias—the exclusion of failed funds from performance-measurement databases—causes the group’s returns to be overstated by a staggering 4.4 percentage points annually.
Swedroe and Kizer demonstrate how unnourishing most of these allegedly free lunches are (except in the sense that the innovations tend to be highly profitable for their purveyors). For example, a covered call strategy delivers low volatility, but at the cost of sacrificing upside potential.
Additional distortion arises from the disparity between time-weighted and dollar-weighted returns. Many managers post high returns on small amounts of assets under management in their early years, but fail to replicate those results after investors pour large amounts of capital into their funds. The authors state, in reference to one legendary fund manager, that although his fund “showed a return of 25% per year over its life, investors in the fund may have actually lost money.”
While some hedge funds, as well as selected private-equity funds, have genuinely beaten the market, obtaining exposure to these asset classes is no surefire means of improving upon a more conventional asset mix. Indeed, a major success of The Only Guide to Alternative Investments You’ll Ever Need is its demonstration of how to obtain the purported benefits of nontraditional asset classes more cost-effectively through adjustments to the reliable old stock-bond-cash allocation. Swedroe and Kizer also helpfully emphasize the importance of asset location (i.e., deciding which assets to place in fully taxable accounts and which in tax-deferred accounts). Furthermore, the authors have done the spadework needed to recommend to readers the specific funds that most cost-effectively implement the alternative strategies they deem valid.
Yes, it is true—notwithstanding their iconoclastic tendencies, the authors find that six alternative investments are worthy additions to the traditional asset-class lineup. Real estate, through equity REITs held in tax-advantaged accounts, heads the list. Also recommended are real-return bonds—namely, TIPS (Treasury inflation-protected security)—and I bonds (inflation-linked savings bonds). Investments that fail to make the cut constitute a much longer list, including such standbys as convertible bonds, preferred stocks, precious-metals equities, and variable annuities.
For its thoroughness and objective approach, investment advisers will find The Only Guide to Alternative Investments You’ll Ever Need an immensely useful resource. In applying its findings, though, it is important to bear in mind that the analysis is conducted almost entirely in an MPT (modern portfolio theory) framework. Some real-world clients may prove to be less preoccupied with balancing long-run mean returns and standard deviations than MPT assumes.
To cite just one example, elderly mutual-fund investors might be more focused on collecting current income than on accumulating wealth over several decades. They might be barely concerned at all about quarter-to-quarter fluctuations in NAV (net asset value). For such individuals, high-yield-bond funds could make more sense than Swedroe and Kizer perceive.
This is by no means a disparagement of the authors’ MPT-oriented analysis of the high-yield asset class, which draws on this reviewer’s research. Moreover, Swedroe and Kizer recognize that they will not dissuade all investors from using assets they consider flawed, bad, or ugly. To individuals who are determined to invest in such a category, the book offers guidance on the least risky way to proceed. By covering that final base, The Only Guide to Alternative Investments You’ll Ever Need lives up to its title.
Martin Fridson, CFA, is the chief executive officer of Fridson Investment Advisors.
