The Quarterly Report

  • The Quarterly Report
  • First Quarter 2011
  • Chuck Osborne

There is no ‘Alternative’

Alternative (adj). ~ Employing or following nontraditional or unconventional ideas, methods, etc.; existing outside the establishment.

Alternative is a loaded word, and I have to admit that it is not one I particularly like. My history with the term goes back to my high school years. It is always dangerous to date oneself, but I was in high school when “Alternative music” became popular. To be clear, I liked the music. I hated the term. You see, being alternative, a.k.a. unconventional, would mean I was different than the mainstream. Yet, everyone of my generation seemed to listen to so-called alternative music. Isn’t everyone doing it the definition of mainstream a.k.a. conventional?

Of course that was all in the childishness of high school, until it followed me into my profession. Nothing is more mainstream in today’s investment world than “alternative investments.” Just like high school I still hate the term. However, unlike then the word alternative carries different meaning in the investment world. If I get nothing across in this newsletter I hope I can drive this point into my readers: the word ‘alternative’ in the investment world has one meaning – outrageously high fees. This is the only universal truth of all investments under the so-called “alternative” label. If someone approaches you by saying, “I have a great alternative investment opportunity for you,” you must translate that as, “I have a great outrageously high fee investment opportunity that will pay me a lot more than any traditional investment I could sell.”

We will get back to that, but first some history. Where did this idea originate that there is some kind of alternative? It is all Harvard and Yale’s fault. In the late 1990s and early 2000s while the rest of the world was all excited about dot com-this and world wide web-that, the very smart people who ran the endowments for Harvard and Yale were investing in long-short absolute return strategies, private equity, natural resource limited partnerships, and other less obvious investments, moving away from the “traditional” equity market. The tech bubble burst and the stock market experienced a lost decade of huge volatility and no actual returns, and those smart guys at Harvard and Yale were making solid double-digit returns in their “alternative” investments.

The greatest form of flattery is imitation, so advisers and consultants started employing the ‘endowment model’ of investing, which led to a heavy use of so-called alternative investments. However – and this is key – Harvard and Yale endowments have huge asset bases and unparalleled networks for direct access to investment opportunities that smaller institutions and individual investors just cannot copy. So, in comes Wall Street with the solution: instead of investing directly in the private equity and/ or hedge funds that invest in these alternative spaces, smaller investors can use a ‘fund of funds.’ This means you would invest in a fund whose manager does not actually make investments but rather hires other managers who actually invest the money.

This is an extremely expensive way to invest money, because it adds yet another layer of fees. Even the supporters of this strategy will admit that it is less than ideal, but they claim it is worth it because this is the only way to gain access to these alternative assets and imitate the successful endowment funds. What do the guys who are being imitated say? David Swensen runs the Yale endowment and he discussed this phenomenon with The Wall Street Journal in January, 2009. When asked about investors imitating his success at Yale he responded, “…investors think they are emulating Yale, but they are not. Most use fund of funds and consultants, rather than making their own well-informed decisions.” When pressed further about fund of funds, Swensen said, “Fund of funds are a cancer on the institutional – investor world. They facilitate the flow of ignorant capital.” This may seem harsh, but blunt truth often does.

What struck me about Swensen’s comments was not actually the harsh words about fund of funds, since every legitimate investor will share this sentiment. What struck me was him saying people think they are imitating him but really they are not. So I revisited his book, Pioneering Portfolio Management, in which he describes the process he and his team use to invest the Yale endowment fund.

In his book Swensen describes a process that uses a great deal of direct decision-making. He talks about his team of investment professionals using their judgment in accurately valuing assets and determining reasonable future return estimates. He talks about knowing exactly what they own, and he spends a great deal of time discussing the importance of lowering cost. They do use hedge funds, although he never mentions that term; he talks instead about what the managers actually are doing. He also talks about complete transparency, working in partnership and negotiating the fees down. He also uses examples of specific investments Yale made directly.


What does he mean when he says that the emulators are not actually imitating? I believe he means that they simply are imitating the result – a result that is retrospective – and not the process, and especially not the cost discipline that led to the result.

So what was it in which Yale and Harvard were actually investing that has become known as ‘alternative?’ The list can be long and some people include many more investments than others – yet another reason to hate the term – but I will discuss the main three alternative investments: private equity, commodities, and hedge funds.

Private equity is simply ownership in private, or non-publicly traded companies. Historically, investors in this category look for companies that are new and have the potential to one day become publicly traded. The alternative pushers will pretend that there is some kind of magic about private equity. There is a natural mystique to it because you must be an accredited investor to participate. However, the reality is that owning a company is owning a company regardless of whether that company’s stock is traded publicly or privately. There is no reason that private equity would produce better returns than public equity over any meaningful investment horizon, and in fact it hasn’t.

Private equity funds do however have meaningfully different fees than public equity funds. It is not unusual for a private equity manager to charge four percent and take a large chunk of the profits. If you access these investments through a fund of funds you add another layer of fees and then pay your adviser, and by the time it is done it is unlikely you will ever see a positive return. We have seen cases where investors had to overcome nine percent in total fees before making a dime. That just about equals your expected return for private equity, which would net you a zero percent expected return.

Commodities are the hot thing today. RS Investments wrote a white paper about this subject, which the CFA Institue published. They even quoted Swensen. “Unlike commodity indices, which give investors simple price exposure, wellchosen and well-structured real assets investments provide price exposure plus an intrinsic rate of return. For example, oil and gas reserve purchases in the past two decades generated low double-digit rates of return above and beyond the return from holding period increases in energy prices. Price exposure plus an intrinsic rate of return trumps price exposure alone…. Pure commodity price exposure holds little interest to sensible investors.” In other words, owning a barrel of oil is never a sensible investment, but owning an oil well and/or an oil company can be. This was the conclusion of RS Investments study. An investor is better off in terms of both return and diversification by owning commodity related stocks than they are owning the commodities themselves, but one does not have to pay for the “alternative” label to own the stock of oil or mining companies.

Finally, in the land of alternatives, one must have hedge funds in his portfolio. As a side note, it pains me to even talk about hedge funds this way, because the words ‘hedge fund’ alone tells you nothing about in what you are actually investing. I don’t recall Swensen ever using the term. He, like any wise investor, is looking beyond legal structures and labels to the actual investment. ’Hedge fund’ is alternative language. There are just about as many hedge fund strategies as there are hedge funds, but the most common is some form of absolute return strategy where the manager is investing both long (traditional equity ownership) and short (selling stock you don’t actually own in the hopes the price goes down before you have to cover i.e. buy the shares you already sold). In other words, they buy and sell stocks and/or bonds. Please, say that again so you get it: ‘Hedge funds buy and sell stocks and/or bonds.’

The idea is that by going both long and short, the hedge fund manager can eliminate the effect of market movements. As long as his long stocks go up more or down less than the market, and his short stocks go up less or down more than the market, he can deliver positive returns. In other words the only return you get is the manager’s value added, instead of the traditional manager where you get the market return plus or minus the manager’s value added.

Here is the rub: the very same people who push hedge funds, and especially hedge fund of funds, are often the people who will tell you that managers can’t add value. There is no intellectually consistent argument for indexing your traditional equity exposure, supposedly because managers cannot overcome their traditional fees of one percent or less, and then allocating heavily in hedge fund of funds paying fees two to three times as high. After all, the only returns from the hedge funds are the managers’ value added, and by indexing the rest of the portfolio you are saying that you believe a manager’s value added is negative, at least on a net of fee basis. If that is your belief then you are investing in an instrument that you must believe represents a negative expected return from day one. This is idiocy dressed up in faux sophistication.

Wise investors avoid labels. Benjamin Graham defined an investment as follows: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return.” He didn’t use the word ‘stock’ or the word ‘bond.’ He didn’t say ‘traditional investment’ or ‘alternative.’ These terms are pure garbage spewed by people whose lack of true investing knowledge is only surpassed by their insecure need to be thought of as intelligent. It would be comical if they didn’t do so much harm.

One of the greatest impediments to Graham’s adequate return requisite is the cost of investing that must be overcome. In this regard Swensen is absolutely correct to call fund of funds a cancer. To truly emulate the Ivy league endowments one would invest as directly as possible, eliminating layers of fees. One would invest using a disciplined process that led to selecting investments that promised safety of principal and an adequate return. One would not care how those investments were labeled – traditional, alternative or otherwise. After all, when one looks under the hood, the only alternative thing about alternative investing is the cost. When it comes to investing, there is no alternative. When it comes to cost, alternative simply means outrageous fees.We will not follow the crowd in their folly. Our duty to you our clients is not to follow fads, but rather to seek safety for your principal and an adequate return.


Charles E. Osborne, CFA, Managing Director

Review of Economy

LAST QUARTER, we talked about how the consensus forecast had gone from being overly pessimistic to overly optimistic in our view. Well they have now come back down to earth. Consensus view is that the 1st quarter growth will come in around 2.7%, close to our estimate which has remained constant. We are still sticking with our view of slow growth somewhere between 2.5% and 3% for the year.

Unemployment appears to be improving, and the pace of job growth, while still slower than we would like, does seem to be accelerating. The March unemployment rate came in at 8.8%, but more importantly the previous month’s job growth number was revised upwards for the 7th month in a row. Upward revisions are a positive sign that the job market is improving. We were glad to see that trend continue.

Review of Market

THE S&P 500 WAS UP 5.92% for the quarter as the bull run continues. Macro optimism seemed to be driving the markets. We are a little concerned that this is a shear momentum move. Small stocks unexpectedly continued to lead the way, and within this universe it has been the lowest quality, most levered companies that have been rewarded. We don’t believe this is sustainable.

The rotation out of bonds into stocks continued. Yields on treasuries continued to climb in the quarter with 10 year Treasury now yielding in the 3.5% range. Just last summer rates were a full percentage point lower. The Barclays Capital US Aggregate bond index was up 0.42% for the quarter.

International did well but lagged the US, with the MSCI EAFE up 3.45%. Europe’s economic issues remain but valuations are attractive. European strategists are now more bullish than their American counterparts. Only time will tell if this is wise. Emerging markets also lagged the US as the MSCI EM index was up 2.10%, as inflation is a great concern in the emerging world.

Market Forecast

Our outlook remains cautiously optimistic. We believe corporate earnings will continue to grow for the year but would not be surprised if they disappoint lofty expectations in the short run. Our prediction for 2011 remains a 10% gain in the S&P 500, but it is likely to be another bumpy ride. We think we may feel one of those bumps in the 2nd quarter. A mild correction followed by a rotation into higher quality, better valued equities is our most likely scenario for the short-term.

The long-term emerging markets story remains intact, but look for monetary tightening in the emerging economies to continue to mute growth in 2011.

Bonds are our greatest concern and the one thing that could spoil the party for everyone. We think rates will continue to rise and prices fall. The most likely threat to our equity market prediction is if rates rise too quickly and start to spook equity investors.