I recently read a just published book on alternative investments called The Alternative Answer that I think is worth spending a few hours on.  It is written by Bob Rice, who is a Bloomberg TV editor, an advisor, and a partner at an alternative investments firm.  The book is remarkably even-handed given his obvious biases and useful for anyone considering getting away from more mainstream investments.  It is not a standard “Bogleheads” type book.  If that’s what you’re looking for, you’ll be better served with Larry Swedroe’s The Only Guide To Alternative Investments You’ll Ever Need.  However, I find it useful to read, from time to time, investing opinions that differ significantly from my own.  I found myself both agreeing and disagreeing with different sections of Rice’s book.

A Great Explanation of Alternative Investments

The strength of The Alternative Answer is the down-to-earth explanations of exactly what hedge funds, private equity funds, venture capital funds, business development companies, and master limited partnerships do and how they are different from the more well-known mutual funds.  Not only will you learn about the major strategies used by hedge funds, but you’ll likely learn about some investments you’ve never heard of, like Catastrophe Bonds, which investors can buy from casualty insurance companies to make bets on the likelihood of a hurricane hitting a particular area.

Too Pro-Alternative

Mr. Rice is clearly very pro-alternative investments.  His entire career is based on them.  This bias is felt throughout the book.  Like most pro-alternative writers, he doesn’t make much of a case against standard investments.  Most of these guys just cite “the lost decade” or the volatility of the last few years as evidence that investing in US stocks is for idiots.  Never mind that at the time of this post a total stock market fund is up 22% on the year, is up nearly 8% per year over the last decade, and has had only one down year in the last 10 (although admittedly, it was a doozy).  The biggest criticism I have of the book is that he writes from the perspective that US stocks and bonds shouldn’t make up much of your portfolio, if any at all due to their “obvious risks.”  He sets up a straw-man argument in the first chapter, then subsequently punches it out.  The straw man is that investors make 3 mistakes- they believe a 60/40 portfolio is ideal, they believe stock diversification equals safety, and they believe that buy and hold [insert asset class here] always wins in the long run.  I would have liked to see him address some of the studies cited by Swedroe about the relatively low (especially after-fee) returns the typical hedge fund gives to its investors.

Too Pro-Active Management

The second biggest criticism I have of the book is that he continually suggests hiring skilled managers.  Although he presents some very interesting data that suggests having a skilled manager makes a far bigger difference in alternative investments than in mutual funds, if you read between the lines you’ll realize that there are precious few skilled managers out there, there are even fewer once the ridiculously high (but decreasing) fees are taken into account, and most of those are either closed to new investors, or require such a huge minimum investment that the typical doctor won’t qualify to invest with them.  Are there skilled managers adding alpha for their investors?  Absolutely.  Can you invest with them?  Probably not.  And even if you could, his suggestion for picking them out in advance mostly boils down to past performance.  The mutual fund data suggests that is a lousy way to pick a fund, and I’m not convinced it is much better for alternative investments.

Big Differences Between Top and Bottom Managers

One of the most interesting parts of the book is a graph where he shows the variation between top hedge fund managers and top hedge fund managers, and compares that variation to mutual fund managers.  The range is much larger, although the averages may be similar.  For example, over 10 years the bottom quartile of US large cap equity managers had returns of 3.7% vs 7.5% for the top quartile.  But among “event-driven” hedge funds, that difference was 1.3% vs 18.8%, a much larger range.

Constant Warnings About Fees

I appreciated that Rice was very careful to point out the importance of understanding the fee structure (and the sheer amount of fees) of each of these investments, and even warning against many of them due to their unreasonable fees.  Many of these alternative funds still operate on the “2 and 20” principle- that you pay 2% a year and 20% of any gains to the manager.  If the fund averages 10% per year, that means you’re paying 40% of your return to the manager.  You take on all the risk, and only get 60% of the return.  That means the manager needs to be providing some serious alpha (a zero-sum game remember) to make up for those fees and still leave you a piece of the alpha.  Rice is also quite adamant that the best managers are also the most expensive and will remain in the traditional hedge funds with this fee structure (rather than some of the newer, cheaper options following the same strategies) because it is more profitable for them.

He also has a great discussion about “YTB” or “yield to broker” and the importance of avoiding high YTB investments, like privately traded REITs.  (I would include most insurance-based investments in this description of YTB products.)

Big On TIPS

Rice is also a huge fan of TIPS as  hedging strategy.  TIPS are great because they are one of the few financial instruments out there that hedge against both inflation and deflation, especially if you buy individual TIPS and hold to maturity rather than a TIPS fund.  I was happy to see him point out these types of “alternatives” that more typical investors can actually access.  He also includes discussions on international stocks, some mutual funds and ETFs following strategies that used to be available only in hedge funds, timber REITs, MLPs, and even Peer to Peer Lending.

Capturing the Illiquidity Premium

I also appreciated Rice’s discussions about how to get paid for illiquidity.  The truth is I am more than willing to give up a lot of liquidity in my portfolio if I can manage to get paid well for it.  The vast majority of my portfolio won’t be spent for at least 2 decades.  I don’t absolutely have to have investments I can get out of tomorrow, or even next month.  However, Rice shows just how out of touch he is with the typical investor by introducing his own formula for how much of your portfolio should be in illiquid investments (which he seems to think are those you can’t get your money back out of for just 2-5 years).  The formula is this:

Take your investable net worth, in millions.  That is the numerator.  The denominator is the larger of 1 or the amount, in millions, by which your current expenses outweigh your current income.  So his example is an investor with a $20 Million net worth, spending $3 Million a year on lifestyle with a $1 Million salary who would have a “liquidity ratio” of 10.  Or an investor with a $3 Million net worth who spends $500K a year gets a liquidity ratio of 3.

If you weren’t sure who this book was aimed at already, this chapter made it abundantly clear.  I found it interesting that someone who makes $1 Million a year, and spends $3 Million a year, would somehow end up with a net worth of $20 Million.  Where did that come from?

He then goes on to give several categories of alternative investments for those with a liquidity ratio under 2 (pretty much everybody), a liquidity ratio of 2-3, and a liquidity ratio of more than 4.  The “starter menu” includes MLPs, EM debt, multi alternative mutual funds, timber REITs, global stocks, and TIPS.  For some reason, he feels like you need to have a couple of million bucks before you should invest into managed futures funds, peer to peer lending, or gold ETFs.  This whole discussion didn’t make much sense to me.  I see no reason someone can’t use some of these alternatives far earlier in their investment career.  Nor do I see any reason why someone would need at least $2 Million in liquid assets.  Nearly everyone in this country retires on less than that.  I think he would have been much better served using a simple percentage or a multiple of your current spending as a rule of thumb.  Perhaps something like keep at least 25% of your portfolio or at least 5 times your annual expenses in liquid investments rather than his goofy formula that probably only works for The Great Gatsby.

Overall, the book is less dense than Swedroe’s (I read it in about 4 hours) but does a better job of explaining the alternative investment world.  There aren’t as many practical, definitive recommendations as Swedroe’s, and some of his recommendations don’t make much sense to me, but it is far better than the vast majority of investment books out there and worth a look for someone interested in adding some alternatives to a traditional portfolio.  Buy it off Amazon or pick it up at the library today!

What do you think about alternative investments?  Which ones do you use in your portfolio?  What did you think of Rice’s book?  Comment below!