Morningstar - Q2 2023 - 46

Strategies
Although that shouldn't be an absolute
no-no, the alternatives allocations of many
individual investors are way too high.
According to Schoeff, Stephen Soper, a senior
vice president at Wright Investors' Service,
claimed at a planners conference that
high-net-worth investors " allocated about 26%
of their portfolios to alternative investments
in 2020, while [ultra-high-net-worth] investors
allocated about 52%. " 16
Advisors to high-net-worth individuals should
not encourage such risky behavior. While
it's theoretically possible for alternatives to reduce
overall portfolio risk through low correlation
to stocks and bonds, that claim is made far too
often. Moreover, advisors and their clients
are in a poor position to evaluate it. Investors
should assume that the risk of a liquid alternative
is what it appears to be from the standard
deviations. Any diversification benefit is gravy.
Funds that zig when others zag are the holy
grail, but (as we learned from Indiana Jones)
it's hard to find the holy grail.
Soper concluded that " if you want to speak to
these target markets, you better have
alternatives in your mix. " Those are strong words,
dangerously leading advisors astray.
It may be true that potential clients want large
helpings of alternatives, but advisors are bound by
fiduciary duty to recommend investments that
are good for the client. Soper assured advisors that
" liquid alternatives ... for the most part don't
pose a regulatory risk " to advisors. That's a little
like saying that driving 120 mph in Germany
doesn't pose a legal risk because there is no speed
limit on the autobahns. It misses the point.
The risk on the autobahn is physical. Likewise,
the risks in alternatives for the masses aren't
regulatory or legal; they're market and institutional
risks, which we listed earlier.
Don't accept Soper's dismissal of legal and
regulatory risks. An advisor who places a client in
funds with expense ratios toward the high
end of the range shown above, when index funds
average 0.05% and long-only active funds
0.69%, might be in violation of their fiduciary duty
to the client and vulnerable to a lawsuit.
More to the point, alternative investments can
go down-way down. One multistrategy
liquid-alternatives fund operated by a prestigious
manager fell 17.5% per year, compounded, over
the three-year period ending Sept. 30, 2020.
This was a very strong period for traditional
markets (the S&P 500 was up 12.3% per year). Now
that's diversification! The alts fund zigged
when the market zagged, but the result was more
like the Temple of Doom than the holy grail.
Alternatives are more fun than traditional
investments. They make the holder feel
sophisticated and special. They foster good
conversation at cocktail parties. But a very modest
allocation to alts can provide those psychic
benefits without costing the investor much money
if the returns are bad. A 26% allocation in
a high-net-worth investor's portfolio is way too
much. And most individual investors would
be better off without any.
Alternatives Are Not Bond Substitutes
Alternative investments came into their own as an
institutional return booster and diversifier during
what the consultant Ennis called the golden
age of alts, 1994-2008. During that period
and, in response to the success of alternatives,
more recently, institutions upped their alternatives
allocations, sometimes to astounding levels.
Meanwhile, they stripped their fixed-income
portfolios down to almost nothing, reasoning that
alts, with their putatively low betas, would
provide the " anchor to windward " that had been
the traditional role of bonds.
This is a terrible idea for individuals saving
and investing for retirement. Alternatives
are not bond substitutes. They do not provide
a fixed income. They are a form of active
management, usually active equity management.
Alternative investments have their place in
certain institutional and ultra-high-net-worth
16 Those numbers include all alternatives, including real estate, directly held hedge funds and private equity, and so forth-not just liquid alts.
17 Carlson, B. 2017. " An Investment Book for the Masses. " A Wealth of Common Sense blog. Oct. 24.
46
Morningstar Q2 2023
portfolios, but, with rare exceptions, they
do not belong in retirement-focused portfolios
of less than $10 million.
After a seemingly endless period of financial
repression when bonds yielded nothing
(in some countries they actually had negative
yields), the bond winter seems to be over.
A 4% yield on Treasury bonds is normal.
And advisors should allocate normal amounts
to fixed-income investments.
Some clients will insist on having alternative
investments. To keep them as clients
and attract new ones, you may have to respect
such demands. For such clients, liquid alts
make more sense than the illiquid assets on
which they're based, but advisors should
do everything they can to keep the allocation
small. The default allocation should
be zero. Any nonzero amount should be the
exception, not the rule.
Finally, of the three principal dimensions of
investment management-return, risk, and
fees-fees are the only one under the investor's
direct control. While some actively managed
investments are worth their high fees, we don't
know in advance which these will be, so
the default presumption should be that low fees
are better than high ones.
As Jack Bogle said, " Where returns are concerned,
time is your friend. But where costs are concerned,
time is your enemy. " 17
K
Laurence B. Siegel is the Gary P. Brinson director of
research at the CFA Institute Research Foundation, and
an independent consultant, writer, and speaker
specializing in investment management. The views
expressed here are his own.

Morningstar - Q2 2023

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