Alternatives Are Not Toxic

My response to Josh Brown and Jeremy Schwartz' debate on alternative investment funds.

Josh Brown wrote a scathing and reasonably skeptical post about the negative aspects of funds that purport to offer access to alternative investments where the high-level objective is a low correlation to equities with less volatility that might somehow also go up when the market is going up but protect when the market is going down. Before the term liquid alternatives became widely adopted, I referred to these as diversifiers.

A few days later Jeremy Schwartz, Director of Research at ETF provider WisdomTree wrote a rebuttal to Josh’s post. In his post Jeremy discussed the attributes of the WisdomTree Dynamic Long/Short U.S. Equity Fund (DYLS) and the WisdomTree Dynamic Bearish U.S. Equity Fund (DYB). DYLS is long/short such that the beta is targeted to be between 0.6 and 0.7 and DYLS is more hedged, dynamically targeting a beta ranging from +0.25 to -0.25.

Reading both articles would be productive and while I don’t believe there is the makings of a blogging war they both make strong points that hopefully underlie one universal truth which is that investing in this space is difficult. Not difficult in terms of access, there’s plenty of funds (61 ETFs according to ETF.com) plus who knows how many mutual funds (Morningstar says AQR is the Vanguard of alternative investing). It is difficult in terms of knowing what to use and when to use it.

I am a huge believer in using alternatives (diversifiers). My introduction to the concept goes back to reading about Jack Meyer who long ago ran the Harvard Management Company (the college’s endowment) and thought of timber land as reducing correlation to equities as well as reducing volatility. My early blogging days back in 2004-2006 I wrote regularly about the alternative space as the funds started to come to the market thinking that I would incorporate modest exposure in client accounts as part of a defensive strategy for whenever the next bear market was going to come along.

A little while later of course the next bear came and I had a lot of luck using a few alternatives including managed futures, gold and an inverse fund (symbols were RYMFX, GLD and SDS) along with selling some positions. A quick primer on how I do this is that I move gradually in case of whipsaw as the S&P 500 goes below its 200 day moving average, I heed a yield curve inversion and the 2% rule (if the SPX averages a 2% decline three months in a row which happens very infrequently).

Managed futures tends to have a low correlation to equites, negative really, and so the returns have been lousy during the bull market but then again that should not surprise anyone, holding a large position during a bull run is probably not a good idea. Its performance in the previous decade and the current bull market give me confidence that the negative correlation can persist and that it can do well in the next bear market. While RYMFX was the best proxy I could find ten years ago I might use something else on the next one (I will write about it when the time comes).

Gold is another one that has enough of a track record of low and negative correlation to equities for me to have confidence in it as a diversifier. I have held GLD for clients since it first launched but did have a lucky partial sale in 2011. If you don’t own gold and are interested in learning about it, take the time to also learn about SPDR Long Dollar Gold Trust (GLDW). If gold goes up during times of crisis or shock and the dollar does the same thing, then owning gold versus other currencies (not the dollar) it can be a more efficient exposure. GLDW is small though so I am not sure if it will stick around.

Using a fund that one way or another sells short would seem likely to be an effective way to mitigate a large decline in the stock market. Yes, an inverse index fund may not do exactly what you hope/expect over longer periods of time. If you start with a small position and the market actually goes down then the inverse fund should grow to hedge more of the portfolio, thus you are net long a smaller amount.

I have become a fan of merger arbitrage, not for the strategy itself necessarily but the attributes it brings to the portfolio. The result tends to have very low volatility sort of absolute return like or even as a fixed income proxy based on its total return. Along with GLD, I maintain exposure here with MERFX.

I would have no interest in a fund like DYLS as mentioned above in terms of buying it as part of a defensive strategy. A beta of 0.6 doesn’t sound like a great place to hide during a bear market although it might be a good overall objective for an entire portfolio. DYB on the other hand, if its process effectively goes to a negative beta, does sound interesting.

Most clients also own Pacer 750 ETF (PTLC). This fund is long large and some mid cap stocks but will switch to t-bills based on a breach of the index’ 200 DMA for a period of days. Yes the fund is expensive for its long exposure but it is one more source of defense without having to make a trade which can be a huge plus for taxable accounts. If you buy and hold for any length of time you probably have some huge gains and selling them for defensive reasons only, may not be a great idea (more on that in a subsequent post).

I have started investigating different ways to implement defense in addition to what I have written about today and will share that as we go along. The key to effective use of alternatives is not holding a lot of them in a static fashion. Equities are the thing that goes up the most, most of the time so it would be logical to be mostly invested in equities most of the time subject to the constraints of a suitable asset allocation. Occasionally the market goes down a lot and that is the time to look less like the stock market in your portfolio based on a process that provides a reasonable expectation of warning of a serious drawdown. If none of that resonates with you then you won’t likely take defensive action and you won’t likely use alternatives.