Should You Use Alternative Investments?

In “Some ‘Alternative’ Funds Come up Short” in the Wall Street Journal, Daisy Maxey neatly sums up my take on alternative investments. I’ve always cautioned investors about running with the “in crowd.” There’s been plenty of recent research on the “crowd mentality” that we can apply to investing.Graphic_Hedge FundV2

In The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations, New Yorker business columnist James Surowiecki explores a simple idea: Large groups of people are smarter than an elite few, no matter how brilliant–better at solving problems, fostering innovation, coming to wise decisions, even predicting the future.

That idea certainly lays at the core of our political system, with our three branches of government and checks and balances. Trial by jury is another example, standing in contrast to trial by a judge, the single expert. The theory is that the crowd tends to make its best decisions because it is comprised of diverse opinions and ideologies. I don’t disagree.

But following the crowd can present problems. Think of the research that shows when a group of people cross the street, each person mistakenly figures the other is checking for oncoming traffic. That’s how accidents happen.

In the same way, investors who blindly follow the crowd to invest in alternatives, leave themselves vulnerable to harm. Maxey’s article is full of important information, but the key takeaway is this: Over the last five years through September11, 2015, the average managed-futures fund returned only 1% a year, according to investment researcher Morningstar. That compares with 14% for the S&P 500 Index and 3.4% for the average intermediate-term bond fund. That’s nothing to brag about around the water cooler.

Maxey also points out that “funds that invest in a variety of commodities fell an average 7.5% a year over the past five years–and a steep 17.1% in the period when the S&P 500 fell 11.9% this year. Meanwhile, they showed a fairly strong correlation to the stock market–0.61 on a scale on which 1 indicates perfect correlation and 0 means the investments move independently.”

Long/short equity funds returned a stronger 6.3% a year over the past five years. However, they typically move in the same direction as the stock market.

The lesson for investors is simple–The power of diversification delivers benefits to the portfolio that are akin to tapping the wisdom of the crowd to solve a problem. However, when you follow the crowd and invest in alternatives you might get hit by a bus and pay a lot more for it.

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