Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
The past decade has brought a proliferation of alternative investments. Joining me to discuss the category is Michael Kitces; he is partner and director of research at Pinnacle Advisory Group.
Michael, thank you so much for being here.
Michael Kitces: Thanks. It's great to be here today.
Benz: So, Michael, we've seen this explosion of investments calling themselves alternatives. Let's talk about what, in your view, is the definition of an alternative investment type?
Kitces: So, great question. I take, I guess I'd call it, a relatively simple approach in looking, trying to find what an alternative is and even to define the word alternative, which I think in practice we mean to be an alternative to stocks and bonds, sort of our traditional asset classes.
What I define to be an alternative asset class is something that actually has unique economic characteristics onto itself as an asset class. It's affected in its own manner by economic factors, supply and demand, whatever those sort of underlying metrics are that drive income growth and profitability for that asset class. And so we certainly see that one set of behaviors around what drives everything from supply and demand and economics for stocks. We see a different set of factors for bonds, and so other asset classes would be defined as alternative asset classes if they show their own unique economic characteristics that are separate from stocks and bonds.
Benz: So, let's discuss some of the things that you think are truly alternative, because they do have those unique economic characteristics. I know you'd mentioned commodities.
Kitces: So, certainly, I think, commodities which trade … not only on their own economic basis, but have their own supply and demand factors that, granted, in the shortest run sometimes get overwhelmed by market movements, but certainly in the long run become very material driving factors.
We'd certainly look at real estate as being an alternative asset class onto itself that operates on some of its own economic fundamentals.
So, we do see some separate categories out there that I would absolutely call asset classes. The challenge, I think, is as stock returns and bond returns have become somewhat meager, looking back over the past decade, we're seeing this explosion of anything that is not precisely and only a long-only stock or long-only bond position must be an alternative asset class. The challenge is when we start really looking in detail some of them, they don't really hold up, I think, to that scrutiny of saying, does it really have different economic fundamental supply-demand characteristics, other things that would define it as a unique asset class?
Benz: So, let's talk about some of those categories, some of those investment types that have kind of tucked themselves under the alternative umbrella, but that you don't really think are truly alternatives by the definition that you’ve laid out?
Kitces: So, I think there are few out there, and really the most common characteristic across all of them is that they are essentially categories that actively trade other things that are recognized asset classes. So, I would put in this category things like long-short funds, global macro funds, which are still at the end of the day, simply proactively trading stocks or stocks and bonds … domestic and international, maybe even real estate, commodities, and other things, and that's not to say they are bad strategies.
Benz: So, global macro, just to back up, would be a fund that is sort of taking a tactical, go-anywhere approach.
Kitces: A tactical or go-anywhere approach. So they are the go-anywhere funds.
As we really look at those, they’re simply proactively trading traditional asset classes or maybe traditional and what I'll call the true alternative asset classes. And the way I boil this down essentially is simply to say, alpha is not a new asset class. It may be valuable, it may be something that the manager is doing; it certainly enhances long-term returns when alpha is positive. So I don't mean anything negative about that, but simply to recognize that trying to generate alpha by actively trading things does not define a new asset class; it's simply a trading strategy for the things that you already own.
So, long-short folks happen to go long and short, the go anywhere folks may shift amongst lots of different asset classes in search of value. We even see a version of that, that’s derivatives driven, for managed futures, which are doing a similar thing across lots of different asset classes with their own trading algorithms. But still at the end of the day, their returns are not driven by some new unique asset class characteristics; the returns are driven by A) what's going on in the underlying original asset classes, and B) what's happening with their trading activity: Are they generating alpha positively by engaging in their trades?
So I think it's important to separate those, because it impacts essentially the due diligence process.
When I look at [these] things as asset classes, there is a natural temptation to say, well then clearly I should have some slice of that because owning more asset classes is good diversification, which it is.
Owning more asset classes is good diversification; owning more active managers who generate alpha should be a manager-specific decision about whether you think that manager is going to generate alpha or not.
So that's why, to me, this distinction is so important. If you're going in areas like go-anywhere funds, long-short funds, managed futures, evaluate the manager, make sure this is a manager you believe can genuinely bring alpha to the table, and if they can, by all means, go forth invest there accordingly.
But if you don't think they’re going to be able to bring alpha to the table, don't invest in it just because it has returns that aren’t correlated to stocks and bonds. I can throw darts randomly at the paper long on Mondays, short on Tuesdays, long on Wednesday, short on Thursdays, and go to cash on Fridays, and I guarantee you my dart-throwing strategy will have a low correlation to all traditional asset classes. But I didn’t invent a new asset class by throwing darts. I just created a trading strategy and probably not a terribly good one.
So, hopefully active managers have much better trading strategies and will do a much better job, but the fact that they are being active and trying to create alpha doesn't make them a new asset class. It simply makes them a manager trying to generate alpha and invest accordingly.
Benz: So, how about a category like private equity? Would you consider that to be an alternative?
Kites: I would tend toward private equity as being an alternative, although really I would still sort to drill down into what are they actually buying as private equity? Some of the folks who work around definitions of asset classes will note that, as some of the mechanics around how things are traded can start to drive. So if I'm a private equity fund that's still buying stocks in companies, is that a different asset class than buying publicly traded stocks and companies?
And that's sort of an open debate right now in this space. Some people will say, well at the end of the day, they're stocks and they're driven by the same economic fundamentals, regardless of whether they happened to be market-traded or private-traded. And others make the case, well they are bought and sold around slightly different fundamentals or mechanics, so maybe they look a little bit different.
So, I would still even at the private equity level really want to drill down into, what are you actually buying or, from the more general sense, what kinds of premia are you trying to really capture? If we go back to some of David Swensen's work from Yale, frankly private equity was as much about capturing an illiquidity premium, as it was actually capturing some magical new asset class with low correlations. So, even be cognizant about what it is we’re trying to capture out of it.
But I think private equity gets into a little bit of a wildcard space from in that it really depends on what value proposition you’re trying to capture? What risk premia are you trying to capture? What is the underlying private equity actually buying?
Benz: Michael, thank you so much for sharing your insights into this important topic.
Kitces: My pleasure.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.