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2008 Turns Investors Toward Alternatives

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar. I'm here at the Morningstar Ibbotson Conference. I recently had the opportunity to sit down with John Rekenthaler. He is vice president of research for Morningstar. We discussed the proliferation of alternative investment products, what exactly constitutes an alternative, and what role, if any, these securities should have in investor portfolios.

John, thank you so much for being here.

John Rekenthaler: Pleasure being here, Christine.

Benz: John, there has been so much discussion about alternatives, so many alternatives products rolled out over the past several years, and I know that you keep an eye on that asset class and a team of analysts at Morningstar covers that asset class.

First, I'd like you to broadly define what is kind of an amorphous group. What constitutes an alternative investment?

Rekenthaler: I'm glad you asked, because there really is not consensus on this, so it's a term that tends to get thrown around a lot, and people are not always communicating with each other. It has different meanings. 

We can start by differentiating between alternative strategies. So, an alternative strategy would be something like a long-short fund or maybe option writing strategies where you own securities and write options or manage futures. And then there is an alternative asset, say owning a commodity, owning oil futures or something like that.

So, you've got alternative strategies that are, broadly speaking, often what we think of when we think of hedge fund strategies or hedging strategies, and then exposure to alternative assets. They are both called "alternatives," but they are quite different. All they have in common is, well, I'm alternative.

Benz: They are not stocks; they are not bonds?

Rekenthaler: They are alternatives. But ... really what we have is, we have stocks, we have bonds, we have hedging-type investment strategies, and then we have other stuff, which is exposure to strange and different and smaller--they are not always smaller, like oil--but certainly different asset classes than we're used to.

So, really I think breaking alternatives down with those strategies versus assets, but even within there, there's still differences within each of those fields as well.

Benz: So, the unifying theme, though, the idea is to diversify away from those traditional asset classes that have long formed the core of most investors' portfolios?

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Rekenthaler: The unifying theme is 2008, when stocks just got clobbered, and as well as credit bonds got clobbered, and that's what really has sparked it. ... People are looking for something besides stocks where they can make more money than they can with cash or bonds at 1% yields. And the money has been flowing into all kinds of alternatives for that reason, and it's really 2008-driven. Before then, there were arguments for these funds that they diversify a portfolio and so forth, but they weren't getting a lot of assets. When the performance in the traditional assets really disappointed people is when we've seen a switch.

Benz: Right. So, looking back to 2008, really the only asset class that performed extra well was long-term Treasuries. So, why are alternatives gaining traction in the wake of that environment, because things like commodities didn’t necessarily perform all that great?

Rekenthaler: They didn't, but most of them performed better than losing 38% in stocks, which you did almost no matter where you were in, whether U.S. or outside the U.S., small cap, large cap, value, growth. So, they were relatively speaking better. For example, hedge funds had a bad year for hedge funds, but they were down about half that much. And managed futures funds were actually up. Managed futures was the one alternative group that was actually up about 5% that year. So, I think these are not perfect diversifiers, but they are striking people certainly better than what they had before, when everything went down at the same point time.

Benz: Now my stock line about alternatives, I'm not a big bull on the asset class. I always say, "Oh, they're going to give you something between a stock and a bond return and yet charge you a lot more for it." Is that a fair assessment or do you think that's probably too broad a brush?

Rekenthaler: No, I think it's a fair assessment for a lot of the alternative strategies, because those tend to be priced at 2%, these long-short funds, and we had the 130/30 funds, various funds that are doing hedge fund type strategies. And they feel they are cheap because it's not 2% and 20% of performance as with the hedge funds; they say "We're cheap. We're only 2%." Well, that's not really cheap, especially when your expectations for returns are not particularly high, because you are hedging, and you're not taking on a lot of so-called beta of a risk factor, and generally you don't get something for nothing. If you are not taking on a lot of risk, you probably ... don't have high long-term return expectations. So, then you pull that down by 2% for expenses.

Now with the alternative commodities, some of these are available in exchange-traded funds, ETF form, for 50 basis points, 40 basis points, very reasonable cost. So, not all alternative funds are expensive. But most of them, unfortunately, that are the alternative hedging strategies or alternative strategies are too expensive, and I think they need to come down. I don't think it makes any sense. You don’t need more portfolio managers; there is nothing inherently more expensive.

Benz: It's just kind of a convention of the industry?

Rekenthaler: Yes. Buying a stock and selling a stock as opposed to buying two stocks--yes, it's an industry convention that needs to change.

Benz: Okay. So, if I've decided that, yes, I have stocks and I have bonds, but I want to add something to my portfolio to diversify and to provide me with that different type of exposure, what should be my starting point if I do want to add a small slice of something alternative to my portfolio?

Rekenthaler: Look for something that costs less than 1% a year.

Benz: So, commodities, it sounds like you think may be a decent alternative investment, and may also provide some inflation hedging capabilities as well?

Rekenthaler: Right or TIPS, which I struggle to call alternative, but the fact is they are inflation-protected securities .... They may not be at the greatest entry point right now for TIPS. They are not so cheap, but from a long-term perspective they do behave differently, and really I would say although they are common these days, they give you what you want from an alternative asset class in giving you different behavior. So, I would throw that in the mix as well.

But there are some hedging funds out there, hedging strategies that are available, not a lot, but at a reasonable cost, and I would look into them as well.

Benz: Well, John, thank you so much for sharing your insights on this topic. It's a fast-growing field, and it's really great to hear some thoughts on how investors can make sense of it. Thank you for being here.

Rekenthaler: Sure thing Christine.