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RESEAR CH


Alternative Investments Demystified MYTH: Alternatives are risky A RESEARCH REPORT BY INEICHEN RESEARCH & MANAGEMENT, COMMISSIONED BY VIRTUS INVESTMENT PARTNERS


Executive summary


• Alternative investments are still not fully de-stigmatized by many investors despite the fact that their inclusion in balanced portfolios has proven their merit at least twice during the previous decade. The purpose of this article is to demystify some of the myths and misconceptions still surrounding alternative investments. An “alternative investment” is essentially an investment that has not yet gone mainstream.


• It is no secret that the public image of so- called “alternatives,” (e.g., hedge funds, vulture funds, private equity), is far from pristine. Hedge funds are regularly blamed for market movement, often irrespective of their being involved in a concerted fashion. Vulture funds have been in the news recently for ”helping” Argentina with its debt issuance, and private equity firms are often taken to task for the externalities left behind from corporate reorganization. Generally speaking, alternatives are perceived as risky.


• Every investment, when viewed in isolation, is risky. This is true for any single investment, be it stocks, bonds, hedge funds, farm land, art, etc. However, most investors do not hold a single investment; most investors maintain portfolios comprised of single investments.


• The basic idea of portfolio management and portfolio construction is to diversify single entity risk. From this perspective, when risk matters, there is hardly a reason for the bulk of the whole portfolio not being in what we today call “alternatives.”


• There is still a lot of myth with respect to alternatives being risky. Much of it is built on anecdotal evidence, oversimplification, myopia, or simply a misrepresentation of facts. Hedge funds aim for absolute returns by balancing investment opportunities and risk of financial loss. The same logic is applicable to constructing portfolios with alternatives. Where a single investment might be “risky,” it is the combination of different risks that makes a portfolio less sensitive to accidents and losses. Diversification might be the only free lunch in finance.


“Skill is successfully walking a tightrope over Niagara Falls. Intelligence is not trying.” —Anonymous


Introduction “Risk, to state the obvious, is inherent in all business and financial activity.” — Alan Greenspan


Every investment, when viewed in isolation, is risky. This is true for any single investment, be it stocks, bonds, hedge funds, farm land, art, etc. However, most investors do not hold a single investment; most investors maintain portfolios comprised of single investments. Investors diversify; diversification is often touted as the only free lunch in finance. The idea of diversification is very old and is essential to survival.


Equities once an alternative investment too One way to define an “alternative investment” is essentially an investment that has not yet gone mainstream. An investment in equities was once perceived as an “alternative investment.” Bonds were traditional investments 50 years ago; equities weren’t. Stocks were perceived as “speculative” and many investors steered clear from the equity market. In some countries, equities were an alternative investment until the late 1990s. Investments in emerging market equities and bonds were also once alternative investments, something “one ought not to buy” – something that, when viewed in isolation, was perceived as too risky. Investments in both equities and emerging markets have lost their “alternatives” tag. Many of today’s alternative investments are currently going mainstream too. Viewing an investment not in isolation, but in the context of a portfolio, is central to an asset class or investment style going mainstream.


“Diversification is the golden rule for prudent investment. If you add some judicious futures to the bonds, stocks, insurance, and real estate assets that are already in your portfolio, you can hope to sleep better at night.” — Paul Samuelson (1915-2009), first American economist to win the Nobel Memorial Prize in Economic Sciences


The basic idea of portfolio management and portfolio construction is to diversify single entity risk. This is often perceived as the second best idea in finance, the best idea being the invention of the ATM. The key to portfolio construction is combining entities with different risk characteristics. An ETF on the S&P 500 Index, a merger arbitrage hedge fund, and a Chardonnay wine-making farm in New Zealand might, at first glance, have nothing in common. The past returns might not be correlated. However, the experience from market corrections, and associated wealth destruction, is that carefully


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constructed portfolios with alternative investments withstand the storm much better than traditional portfolios. From this perspective, when risk matters, there is hardly a reason for the bulk of the whole portfolio not being in what we today call “alternatives.”


Accidents happen and risk matters “The important thing in science is not so much to obtain new facts as to discover new ways of thinking about them.” — Sir William Bragg (1862-1942), British physicist and winner of the 1915 Nobel Prize in Physics


Risk is often equated to volatility. However, risk is not perceived as volatility. Private investors certainly do not perceive volatility as risk. Losing large chunks of one’s capital, on the other hand, is a more pragmatic understanding of “risk.” Recent financial history has shown that at the end of the day, it is losses that matter most. It is large losses that destroy the rate at which capital compounds. Risk, therefore, becomes the probability of losses, especially large ones. There are many ways to define risk. One way to put it is defining risk as “exposure to accidents.” Accidents do not always unfold in a crash like 1987. Long periods of compounding capital negatively can too be viewed as historical “accidents” and can be more destructive to wealth than a sudden, one-day shock.


“There are decades when nothing happens; and there are weeks when decades happen.” — Vladimir Lenin


Accidents happen. They are surprising by definition. If they were predictable, they wouldn’t occur. This logic might apply to slipping on a banana skin. However, this logic doesn’t necessarily apply to finance. The introduction of the euro, for example, is an accident that is unfolding as we speak. It just took a while until it became apparent to everyone; well, nearly everyone. An investor has the choice to participate in the accident or hedge or invest elsewhere. Japan is not yet an accident but is one in the making due to its current debt levels and unfavourable demographic trend, or is, as author John Mauldin likes to put it, a “bug in search of a windshield.”


“Fashions change but style endures.” — Coco Chanel


Coco Chanel once said: “Fashions change but style endures.” We are tempted to argue that this is applicable to the world of investments. Fashion is something that ebbs and flows. It is a question of time until your author’s Hawaiian shirts will be fashionable again. (His old aviator Ray-Bans already are.) The same is true with long-only investments; they come and go, ebb and flow. However, an


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