Updated Thursday, July 24, 2014 as of 1:46 PM ET
The Perils of Some Alts
Thursday, July 3, 2014
Print
Email
Reprints

Having low or negative correlations to stocks isn’t a good enough reason to add an alternative asset to a clients’ portfolio; they must also have positive expected long-run returns.

Here are three alternatives advisors should be wary of.

 

BEAR MARKET FUNDS

Bear market funds bet that stocks will go down and perform spectacularly if stocks plunge. An example of such a fund is the ProShares Ultra-Short S&P 500 fund (SDS) which borrows to bet against the S&P 500. Its one year annualized return is -33.89% and its five year annualized return is -34.04%, making a $1 million investment now worth around $113,000.

Morningstar shows the overall bear market category having a -26.9% annualized return over the past five years. Five years ago, the “Great Depression Ahead” seemed certain for many.

I often hear advisors say that they use bear market funds to hedge against a market plunge. The problem is they are betting much of the clients’ portfolio that stocks will go up, and the rest on the possibility that stocks will go down. An apt comparison would be betting on both Seattle and Denver to win the Super Bowl, a bet you are sure to lose. 

MANAGED FUTURES

Next, managed futures seem like the ticket and were quite hot for a while though returns have turned negative over the past few years. But do you know that, in the aggregate, not a penny has ever been made in the futures market? And that’s before costs, meaning your expected return is negative after costs. Futures were designed to manage risk and it certainly makes sense for an airline to buy jet fuel futures to make a major cost component predictable.

MARKET NEUTRAL FUNDS

Finally, market neutral funds sound wonderful as they aren’t betting on any market direction. They become less wonderful when considering that a true market neutral fund has a zero beta or, in other words, its expected return before costs is the risk-free rate which is pretty close to zero. The after-cost expected return is also zero.

These three alternative asset classes are appealing in theory until you stop and think about them. I wouldn’t want to be explaining to a client why I recommended any of these three asset classes and suggest you avoid them, too.

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.

Read more:

 

(2) Comments
I would be hesitant to dismiss managed futures funds out of hand. According to BarclayHedge, the Barclay CTA index has gained an annualized 10.23% since January 1980. http://www.barclayhedge.com/research/indices/cta/sub/cta.html

Managed futures provide particularly effective diversification during stressed equity markets such as in 2008 when managed futures was one of the few strategy categories to do well during the crisis.

The strategy generally has higher volatility than some other strategy categories but managed futures typically has low correlation to other asset classes and strategies. Used prudently as one part of an investor's portfolio, managed futures can add valuable diversification and add to a portfolio's total return over time.

Posted by William D | Thursday, June 05 2014 at 2:54PM ET
I would agree with William. While recent year (broadly) has been difficult for managed futures mandates, there are a number of trend and counter trend approaches that have produced the returns (after fees) one would expect from this asset class. To state that not a penny has been made is flat out false and misleading. Even simple rebalancing strategies across a diversified commodities futures portfolio over time has been able to generate meaningful positive returns.

On the market Neutral side, don't confuse zero beta with no market exposure. What you described would assume you are taking a net zero market exposure through a broad based index approach and therefore assuming earning the risk free rate on the cash position of the portfolio. A zero beta exposure or loosely net zero market exposure could also be accomplished with equal short and long positions in individual securities where value could be added through both positions - zero beta while capturing manager alpha through security selection. As a group, like managed futures, recent performance as a group has been mediocre. However, still more than the risk free rate with managers over the prior 5-years generating returns north of 5% per year. It can be difficult to see the benefit and value they add to a portfolio when viewed in isolation and during periods of strong performance. I would encourage you to see what adding these strategies to a portfolio of traditional assets does from both a performance and risk adjusted performance basis.

Posted by Steven S | Thursday, June 05 2014 at 4:59PM ET
Post a Comment
You must be registered to post a comment.
Not Registered?
You must be registered to post a comment. Click here to register.
Already registered? Log in here
Please note you must now log in with your email address and password.
Lists
2014 Summer Reading List for Advisors

Current Issue

The June Issue is now online!


TWITTER
FACEBOOK
LINKEDIN

Industry Events

August 10, 2014 |

September 9, 2014 |

September 17, 2014 |

September 20, 2014 |

September 28, 2014 |

Already a subscriber? Log in here