By Cliff Stanton and Jeremy Frank
The field of Behavioral Finance has contributed greatly to our understanding of how investors make decisions. Unfortunately, many of the findings from this growing body of work have confirmed that investors routinely make sub-optimal decisions. What we know is that investors routinely chase performance; buying high and selling low. This cycle repeats itself to the point that the typical investor barely keeps up with inflation.
Consider that the annual study of investor behavior authored by Dalbar Inc., found that from 1995-2014 a 60/40 portfolio of U.S. stocks and bonds, as represented by the S&P 500 and the Barclays US Aggregate Bond Index, generated an annualized return of 8.7%, while the average investor earned just 2.5%, a mere 10 basis points above the rate of inflation over that period.
We can also look at mutual fund data to see this behavior in action. Morningstar calculates and reports the dollar-weighted returns earned by investors in each fund, along with the time-weighted returns reported by the funds themselves. The differences are substantial and persistent. Of the 44 mutual fund categories that we track, dollar-weighted investor returns were lower than the time-weighted returns for the fund category averages themselves between 93% and 100% of the time over 1-, 3-, 5-, 10- and 15-year periods ending in December 2015.
And before our readers make the assumption that this is simply reflective of the naivety of individual investors, take a look at Callan’s “2015 Alternative Investments Survey” found here. Within the Hedge Fund section of the report, Callan’s data indicates that 88% of institutional investors surveyed—those investors considered among the “sophisticated” crowd—will terminate a manager in two years or less for underperformance. Fully 57% of respondents put managers on an even shorter leash, dumping them if they didn’t meet expectations over a one-year period! And while we aren’t fans of the exclamation point—it’s far too overused and seems a tad bit unprofessional—we’ll add: one-year!!!!!! There is only one strategy we can think of that met performance expectations over every one-year period, and Mr. Madoff isn’t taking new money presently. Under this paradigm, it seems even God would quickly get fired.
We spend our days managing, and speaking with advisors about, alternative investment strategies. And it’s common during those conversations to hear something to the effect of “…but we’ve been burned multiple times by alternatives that didn’t work”. To which we have to ask, what exactly does “work” mean? What we find is that whether or not something “worked” is almost always a function of time frame, a very short time frame that is.
As 2016 has gotten off to a rocky (or rotten) start, it would be in our best interest to tout the fact that liquid alternatives are performing well year-to-date. But “year-to-date” is a whopping seven weeks old at this point. We should no more cheer good short-term performance than we should curse poor short-term performance. A thoughtfully designed, well diversified portfolio of traditional and alternative assets and strategies should get you through the good times and bad, but you’ve got to give it a chance to succeed.
The year certainly started off rough for equities, as various indexes were down 5% to 10%. This created a significant headwind for any alternative strategies that carry beta. The worst performing strategy was, unsurprisingly, long/short equity, which lost more than 3%. But given what long/short equity is meant to do, this seems a decent outcome on average. The winner for the month was managed futures, as a continued decline in oil prices, among other things, led trend-followers to strong gains. This brought their three-year return to the #1 spot among categories we track. On a one-year basis, the only positively performing strategy was equity market neutral, eking out a 0.4% gain. The worst performing strategy has been multialternative, losing 4.5% over the last 12 months.
As could be expected, given recent performance, managed futures funds saw the largest inflows during January, garnering nearly $1.5 billion in new assets. Somewhat unexpectedly, given recent lackluster performance, multialternative funds continue to bring in sizeable asset flows, gaining over $1 billion during the month. They have also had the strongest inflows over the last 12 months, bringing in nearly $14.5 billion (mirroring the trend in the hedge fund space). Managed futures funds have also seen large inflows at just over $9 billion during the last year. Lastly, long/short equity continued to experience net outflows, losing more than $400 million in January and $5 billion over the last year.
Alternatives in the News
Bill Miller Joins the Hedge Fund Universe
Bill Miller is starting a hedge fund, Seismic Value Partners 1, that will blend in a quantitative model developed by Open Hazards Group to forecast earthquakes, hoping that it will also forecast equity “earthquakes” and help Mr. Miller to avoid market crashes such as occurred in 2008. Not all are convinced; Joseph McCauley, a physics professor at the University of Houston and author of “Dynamics of Markets: Econophysics and Finance,” put it rather bluntly stating “I don’t think it has diddly to do with financial markets, I’m surprised somebody is still messing with that stuff.” I look forward to seeing how it works out for Mr. Miller.
Distressed Investors Waiting to Pounce
Distressed debt funds in North America and Europe are sitting on record levels of committed capital, according to Prequin.
Black River Completes Spinoffs
Black River, a subsidiary of Cargill, has completed the last of its three spinouts that were announced late last year as Gard Capital Partners has officially launched. Reportedly, all of the existing investors have transferred over to the new firm, which specializes in relative value fixed-income investments. The previous two spinouts included the firm’s emerging markets credit business and its private equity business, which spun out into Argentum Creek Partners and Proterra Investment Partners, respectively.
There’s a New Sheriff in Town
Ray Dalio has dethroned George Soros as the most successful hedge fund manager, according to London-based LCH Investments.
Given the performance of equity markets over the last year, coupled with lackluster economic fundamentals, lofty valuations and low interest rates, long/short equity strategies are increasingly being sought out to help manage risk while preserving upside potential. These strategies have, on average, matched the performance of equities with essentially the same level of volatility as a 60/40 stock/bond portfolio, and with better downside protection from 1994-2015 (1994 was the inception of the Credit Suisse Long/Short Equity Index).
But we frequently hear from advisors that identifying a good long/short manager is a difficult challenge. In order to properly analyze any investment strategy, it’s imperative to identify the risk factors embedded in the portfolio. All returns come from bearing risk in some form, so what risks are prevalent within long/short equity portfolios? At the most basic level of course, investors in long/short equity strategies take on equity risk, and therefore garner the lion’s share of their return from the equity risk premium. As an aside, because most long/short funds are systematically long biased (and few ever get remotely close to being net short), we believe long/short equity should be allocated to as part of the equity allocation, and not the amorphous “alternatives” bucket. Ultimately, long/short equity delivers equity beta, even if in a lessened form from long-only funds. If you’d like to learn more about evaluating and using long/short equity funds, click here.
In a follow-up to last month’s #FlipGate, Hillary Clinton apparently won six out of six precincts by coin toss during the recent Iowa caucus, as votes were reportedly too close to call. The odds of such an outcome are 1 in 2^6, or a roughly 1.56% probability. We’re starting to think coins just can’t be trusted anymore…
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