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Bernstein: How Overgrazing Ruins Alpha

Thu, 18 Oct 2012

As more investors flock to the hottest alternative asset class, the more its alpha will shrink toward negative territory as expenses overwhelm the returns, warns financial specialist Bill Bernstein.


Video Transcript

Christine Benz: Hi. I'm Christine Benz for Morningstar. I recently traveled to the annual Bogleheads event, where I had the opportunity to sit down with asset-allocation expert and author Bill Bernstein.

Bill, thank you so much for being here.

Bill Bernstein: My pleasure.

Benz: Bill, some of your latest research looks at the growth in alternative-style investments, let's start by talking about why that concept of some asset class that's going to diversify away from stocks and bonds is so appealing?

Bernstein: Oh, it's like looking for Santa Claus. An asset class that has a low correlation with other risky asset classes, that has high returns, it's the Holy Grail of portfolio theory. It's what everybody is looking for in their portfolio, but unfortunately there is no Santa Claus.

Benz: You note that there are some practical impediments to alternatives being worthy additions to investors' portfolios. Let's talk about the central thesis there. You call it overgrazing. Why does that happen, that investors all glom on to a single asset class at the same time?

Bernstein: Well, we're talking about two separate phenomena. Let's talk about the first phenomena, about the return side of it. There is only so much alpha, excess returns in a given asset class whether you're talking about the whole market or a sub portion of the market, and if there is only a single manager grazing that asset class, they’ll generate this much expenses in transactional costs moving the market around charging fees, and they'll do just fine because there is an enormous amount of return left over.

But if you have 1,000 managers following that asset class and dealing in those markets, then there comes a point where the alpha disappears and becomes negative when the expenses, the aggregate expenses, overwhelm the excess alpha. And I think we're well past the point where that's happened now with the major alternative asset classes.


Benz: So, one fairly recent example that you discussed in the research is David Swensen at Yale who has built this portfolio that consists of a lot of alternative assets. You note that he was among the first to really be enthusing about these alternative asset classes, but many of them have subsequently been overgrazed.

Bernstein: Yes. So, that's the first aspect of it, the return aspect, the overgrazing. The first person to the party gets filet mignon, the last person to the party gets a hamburger or worse. And unfortunately everybody is trying to be little David Swensen right now, and not everybody can be David Swensen.

But there is second aspect of it, as well, which is the correlation aspect. The first people to the party, the first people to invest in a new asset class or the first people to invest in a recently disgraced asset class that's had a catastrophe--it doesn’t have to be a new asset class, it can be an old one that's gotten hammered--the first people tend to be very disciplined. They tend to have very strong hands. They will hold on during the market decline. But when everybody and their dog owns the asset class, when the average exposure to alternatives, for example, in an university endowment is well over 50%, a lot those people are going to be weak hands. They're going to be people who will sell at the first sign of trouble. And when that happens, the correlation goes way up, and the classic example of that recently, of course, was commodities funds. The correlation now with commodities funds with the stock market since the crisis is in the range of 0.7 or 0.8; it used to be much lower. And that appears to be a permanent condition, that appears to be a permanent shift.

Benz: Well, let's discuss that a little more, this contango that has been going on in commodities. You think that, that is driven by this newer frenzy that investors have had for commodities. Let's walk through that specific issue?

Bernstein: Well, that's an interesting issue. Commodities were first noticed as a diversifying asset class back in the early '90s when the data first became available from the Goldman Sachs Index. And the problem was that before 1990, you couldn’t really get exposure to them and unless you are the very biggest of players like David Swensen. What you have to do is literally jump into the pits and deal with these futures; you couldn’t actually buy a fund, or a simple vehicle that did it. You had to find at best a manager that could do it for you. And those were very thin on the ground. You didn’t who they are, and very few people knew about this asset class.

The more people who found out about it, the more the alpha got overgrazed. And with commodities there is a very easy way of measuring how overcrowded it is, which is what's something called the role return which is the difference between the futures index and the spot index. And that became negative sometime around 10 or 11 or 12 years ago, and it has been persistently negative ever since as the PIMCOs and the Oppenheimers and the Goldman Sachs and the Yales of the world have all piled into it.

Benz: They're buying the futures, and that is different from the spot price?

Bernstein: Yes. Exactly. The first thing to answer is why can't you own the spot price? And the answer is you can but you have to be willing to take delivery of tens of millions of barrels of crude oil to do that. The only commodity that's practical to do that for is gold. But 20 years ago the biggest players in those markets were simply producers who wanted to hedge themselves against deflation. So, the speculators who would trade with them had be a offered profit, that role return, in order to buy the long futures from them.

Now the biggest players in the world are large in financial institutions and now those people and their clients want protection against inflation. And so, they earn a negative role return.

Benz: Let's discuss, what belongs in an investor's toolkit then. If you think that this phenomenon will continue to happen with whatever new alternative is introduced, should investor’s portfolios be simply cash stocks and bonds? Is it as simple as that?

Bernstein: I think at the present time that's a fairly safe bet. For me, the classic diversifying asset classes are real estate and either precious metals, equity or gold. I prefer precious metals equity; at least it pays a dividend. I think in times of severe inflation, I think almost any commodity producer is a good way to go. Those will have higher correlations with stocks, but they’ll also have higher returns.

At the present time I think the both real estate and precious metals equities are both overowned. Real estate investment trusts now yield in the mid-3% area, and their real dividend growth long term is probably in the range of minus 2%, minus 1.5% in real terms because of course they have to seek their capital elsewhere because they have to turn back to the shareholders 90% of their earnings as dividends. So, their growth rates are negative in real returns. So, you add minus 1.5% to plus 3.5% and you get an expected real return of 2%. That's not, to me, adequate in terms of the expected return you're going to get out of them.

Benz: So, perhaps attractive components long term, but not particularly attractive right now?

Bernstein: Not particularly attractive now. Eventually if you wait long enough, the market comes to you, and I that will happen with both precious metals stocks and REIT stocks.

Benz: Bill, well always great to hear from you. Thanks for being here.

Bernstein: My pleasure. Thanks.

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