Review & Outlook

Our take on the investing, financial, & economic themes of the day

Alternative Investments and Diworsification

15 August, 2014 by Ben O'Brien in Commentary

We’ve been beating the drum against alternative investments for a while now, but I couldn’t resist one more post on the subject because it seems as though finally the problems with this questionable asset class are starting to be acknowledged more widely.

Earlier this week the Wall Street Journal reported that the SEC is looking into the matter of mutual funds that are marketed as alternative investments. Yesterday Bloomberg editor Ben Steverman wrote some advice for the SEC:

A suggestion for the SEC: Look closely at mutual fund marketing material, then ban all use of the term “alternative.” It’s meaningless. People seeking to diversify their portfolios or protect themselves from losses can end up in highly leveraged funds better suited for professional traders. It’s as if a ’90s record store put Nirvana CDs in the ‘alternative’ bin along with albums from Boyz II Men, Garth Brooks and Philip Glass. And in investing, sloppy categories lead to confusion and bad decisions — far worse consequences than a discordant playlist.

We couldn’t agree more.

Another article in the Wall Street Journal today reports on a study the paper did along with research firm Morningstar to test the impact of new asset classes such as emerging markets, hedge funds and commodities. The study back-tested the performance of a range of portfolios–some with lots of alternative assets and some with none–over the last twenty years:

The portfolio that generated the highest return over the 20-year stretch was the simple 70-30 mix of U.S. stocks and bonds, with an annualized gain of 9.1%. … Reward is only one aspect of the investment equation, however. You also must consider risk. So how did that basic combination of U.S. stocks and bonds fare during the 2008 market meltdown? It held up nicely, losing roughly 25% versus 37% for the U.S. stock market, as measured by the Wilshire 5000 index. Only one other portfolio—the one that included all the asset classes, including hedge funds—fared as well, although nearly all the portfolios’ 2008 returns fell within a tight range. The exception, again: The portfolio made up of domestic and foreign shares, U.S. bonds and emerging-market stocks suffered the biggest loss in 2008: 33%.

Of course such a study is not precise enough to be the final word on the matter. The performance patterns over the past twenty years might not repeat in the future. But still, the study suggests that at least over the last twenty years,  diversification with alternative assets has actually been “diworsification”. Diworsification is when investors overreach in their attempt to find new and different assets and end up simply adding lower quality ones.

The SEC would be wise to rein in the marketing of alternatives. There are clearly limits to the benefits of diversification. The evidence indicates that adding complex and expensive “alternatives” does not improve performance or lower risk.