OK, let’s look critically at hedge funds and other alternatives

I met with a client a couple of weeks ago who has a family foundation account that is managed by a large bank (they handle all facets of the account, including grant reviews and check-writing).  This account had not performed as well as this client’s personal account that Sigma managed and in an informal review, it appeared that the “alternative investment” category (principally hedge funds) was the culprit that weighed down returns.

Alternative investments, or “alternatives,” are a sloppy catchall investment category for anything that is not a stock, bond or cash equivalent in the context of asset classes.  For those of us in practice thirty years ago, alternative investments generally just meant real estate and commodity funds.  According to Investopedia, “An asset class is a group of securities that exhibits similar characteristics, behaves similarly in the marketplace and is subject to the same laws and regulations. The three main asset classes are equities, or stocks; fixed income, or bonds; and cash equivalents, or money market instruments. Some investment professionals add real estate and commodities, and possibly other types of investments, to the asset class mix.”

Now, my peeve:  Focus on the last sentence.  “… and possibly, other types of investments…”.

There is no unanimity in the investment community that hedge funds are an asset class (as there is for equities, bonds or cash equivalents).  We group our real estate and commodity positions in with our equities.  We do not separate them out.  We tell our clients that they are part of our equity strategy (just as hedge funds should be identified as part of the equity strategy!).

So why my peeve?  Investment managers that have used hedge funds in client portfolios tend to leave these investment returns out of the equity or fixed income return mix, showing them in isolation and then comparing them to the returns of a hedge fund index.  The poor results therefore get “buried” and the manager fails to take responsibility.  We believe that the investment manager should identify for the client whether the hedge fund investment is to augment the equity or fixed income portfolio, and then proceed accordingly.  After all, it is the total investment return for the entire portfolio that is going to enable the client to meet his or her objectives.

As a postscript, we have evaluated scores of hedge funds and alternative investments (outside of real estate and gold/commodities) over the past several years, and passed on all of them.  We were dubious of their investment merit, and were suspicious of Wall Street, which has a history of pumping out products designed to score fees (think portfolio insurance, adjustable rate preferreds, sub-prime mortgage backed securities, etc.).

The August 14, 2016 issue of the New York Times published an article chronicling the difficult environment some life insurance companies have faced of late, including MetLife, a stock we used in some client portfolios that did not work out well.  This paragraph, lifted from that article, is just another example of the reputation that hedge funds have garnered:  “Last year, MetLife, the nation’s largest insurer, reported a 46 percent drop in its fourth-quarter profits, not because of low interest rates but because of poor performance in the company’s hedge fund and private equity investments. Although performance has improved somewhat, MetLife now says it will drop most hedge fund investments.”

Thanks for letting me get this off my chest.

All questions and comments are welcomed.

Bob Bilkie, CFA®