Last week I read a well-done research piece.
It is about illiquid alternative investments, a topic that I find really interesting (I wrote about alternatives here and here). The underlying idea is to look for investments that added to a traditional stock and bond portfolio can lower its drawdowns without sacrificing returns too much.
There are basically two types of investments in this category that appeal to retail investors:
- (allegedly) safe investments that can provide high returns compared to a standard saving account. Think about Bondora Go&Grow. I would love to use a positive example instead of a bad product but it is difficult to find one because…it does not exist. If you want to invest in something safe and liquid, you have to lower dramatically your return expectations. That’s it, there is no shortcut here.
- investments that can provide (allegedly) stable double-digit yearly returns; imagine stocks-like returns with a much lower volatility.
The Factor Research piece focuses on the latter. How come all the illiquid-alt out there outperform the S&P500? Here are the examples they provide.
Wine:
Private Equity:
Art:
Farmland:
Looking at this data, there are a lot of great alternatives / additions to a stock portfolio for retail investors.
Is it so? Not so fast, says FR. These advertised returns are cherry-picked, manipulated by marketers to sell their products. Here is the great marketing recipe: find the right historical period, benchmark and model, create the perfect back-test, prove your thesis and sell your narrative. FR is absolutely right.
Wait, are not you an investor in some of these categories and products?
Yes.
So, if you agree with FR are not you…a fool?
A Different Perspective
Even if there was a way to create an index that would represent the average return for each of those asset classes, no investor would be able to invest in it. They have no investable beta.
Can you achieve stock market returns? Yes, pick an ETF linked to a broad index. Can you achieve bond market returns? Yes, but in a little bit less precise fashion than the stock case, because bonds come in multiple shapes and forms (govies, corp, inflation-linked, covered, etc.) and not every market (USD, EUR, GBP and so on) has the full product spectrum. Real Estate? Ehm, some proxies are available but you have to accept some discrepancies; otherwise, it would not be such a mess to link your savings for a house down-payment to that market price dynamics. Commodities? Maybe worse than the real estate case but feasible.
In my mind, not having an investable index almost nullify the issue of looking at an index that can, and most likely has been, manipulated.
Masterworks has to create an ‘art-index’ because they cannot go out and say to potential investors: here is our platform, your performance will depend almost exclusively on the investment choices you make and it will range from -100% to 40%/year. Even if that is what is going to happen in reality. If Masterworks publishes its investor performances, I bet you will see a wide dispersion of returns. With minimum investment at $1k, reaching meaningful diversification requires each investor to allocate…$100k? And proper diversification is also subject to Masterworks’ ability to access a very wide group of artists.
This is not a problem confined to the retail investor realm. I receive presentations like the one below on my work email quite often:
Let’s take the Absolute Return category as an example. In its most simple version, you give a manager an unconstrained mandate to invest in bonds (sometimes with some FX risk) and their investment decisions will should generate a positive return irrespective of market conditions. In a traditional bond mandate, the manager has to stay invested, stick to a certain duration even when rates go up, so the investor has to endure periods with mark-to-market losses. Not within this strategy: the manager can go to cash or lower the portfolio duration to minimize even unrealized losses. It is easy to conclude that these are pure alpha products, the return you get depends on the manager(s) you chose and their ability to navigate markets, more than the direction of the market itself. And yet they are marketed by investment consultants as the above picture, where there seems to be a beta component, the ‘median manager’. Unfortunately, no one can invest in that manager.
These active strategy indexes might be subject to the same manipulations RF identifies for retail illiquid-alts products. Think about survivorship bias, to mention one. More than an attempt to take advantage of unsophisticated investors, this is an exploitation of cognitive skill deficiencies.
One year ago I wrote a post about Capital Efficiency; recently Corey Hoffestein published his model portfolio related to the concept:
One of the asset classes he identified as a great addition to stocks and bonds is managed futures, a strategy that in the above table is represented by Standpoint and Abbey Capital. “Two common approaches for trading managed futures are the market-neutral strategy and the trend-following strategy. Market-neutral strategies look to profit from spreads and arbitrage created by mispricing, whereas trend-following strategies look to profit by going long or short according to fundamentals and/or technical market signals” (from Investopedia). We are back to the Absolute Return issue: the strategy is well defined, in theory, but your manager selection ability is going to be the main return driver.
Your ability to select a manager, and more crucially your ability to access a manager. I cannot replicate Corey ‘index’, even if he uses the most rigorous and transparent method, because I cannot buy those mutual funds.
A problem that goes back as far as the moment people started investing
The process to quantify the beta component for an investment strategy is harder than the average investor thinks. Way harder. You might be convinced that issues start when dealing with venture capital or, god forbid, art but even with something as established as Real Estate, there is an abundance of theories. I read papers that say RE provided higher returns than stocks (thanks to leverage), others that model returns as a mix of bonds and stocks, others that say returns should simply match inflation and cost of replacement.
We all agree on the conceptual usefulness of an index, a benchmark to compare any investor return, a tool to reply to fundamental questions like: has this manager a peculiar ability? Is there an exploitable profit in this specific sector? Is the manager simply overloading on some risk factor?
In the case of other, fancier, categories like art, wine and cars, I think investors themselves want to believe they can achieve high(er) returns while pursuing their passions. Investors and platforms almost implicitly collude in this shared illusion. It is like a kid telling their parents they play video games because it is going to help evolve their brain skills; not 100% a lie but a concept that is more convenient to them than to reality.
I do not remember the exact year but I was living in Luxembourg, so at least a decade ago, when someone told me that Credit Agricole was launching a mutual fund that was investing in wine. There was no f***ing index that could convince me to invest because…because to be honest I do not drink wine and ultimately I do not care. I do not care up to the point that if someone is going to get rich out of it I would still consider it as a waste of time for me. Who was the first person to tell me to invest in whisky? A barman. The first friend to invest in a classic car? A guy who wanted to be a professional driver.
How many times did I reference Magic the Gathering on this blog? It is because I (still) really like the game. I invest in Masterworks because I like art. I would invest in an NBA team if I could for the same reason, not because I think it would be a good investment (it is) but because I am passionate about it.
Is Masterworks/Citigroup Art Index within a range that is plausible given the research I did? Yes. Would I have invested even if Masterworks did not publish any data/index? Probably yes.
When I started to invest in p2p lending I was way more interested in other investor returns than the average gains advertised by each platform. I wanted to understand how I was doing compared to others because I knew my results were linked to my circumstances: which investment parameters I choose, how long ago I opened my account compared to them and so on. A platform marketing data is only useful to me as a data point to understand…how much I can trust them. How plausible are their reported yields?
Obviously, you have to pick your peer-investor group very carefully. Boosting high performances sell for platforms and for blogs.
If there was a way to invest in an index replicating the performance of illiquid alternatives and active strategies, I would definitely be very mindful of how they are built. But conscious that my performance as an investor can and would likely be far from the advertised numbers, not only because of how those numbers are put together, I tend to care less.
What I am reading now:
(in reality, I am listening to the companion podcast ;))
Follow me on Twitter @nprotasoni