Understanding alternative investments (excerpt)On the Trading DeskSM—
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
Peter Chiappinelli, CFA, CAIA, joined Dr. Brian Jacobsen, CFA, CFP®, to help us understand alternative investments and the role they play in this excerpt of On the Trading DeskSM from Friday, February 1, 2013. Peter is an investment strategist with GMO LLC, which manages portfolios in the alternative space.
What are alternative investments?
The way the alternative investment industry has organized itself, it starts with what we’ll call the four horsemen of alternatives. It has typically been hedge funds, private equity, commodities, and real estate. Those, I think, are all agreed upon as, collectively, a common basket. The umbrella is much wider than that. There are certainly other asset classes like infrastructure, timber. And then we get into the very esoteric, more derivatives-based things like credit default swaps. You could have a view on option volatility, or volatility as priced in the options market. These would all fall into a commonly defined bucket of alternatives.
The alternative investment space is obviously an eclectic mix. Are there common risk features that differentiate alternatives or are they just so unique that you have to evaluate each one individually?
It would probably be an overstatement to say there’s a risk factor in alternatives unique to all. Maybe just to focus on one that is unique to many alternative investments that is a risk I think people understand and need to be compensated for. And that would the illiquidity of many of these alternative investments. Infrastructure, private equity, timber, agriculture, farmland—all these are legitimate investments to put into the portfolio, but there’s a different risk premium that needs to be given to entice an investor to put their capital at work in these illiquid vehicles because they can’t get their money out right way, unlike traditional [investments].
How do you approach managing risk?
We think one of the common misconceptions in the industry is that risk equals volatility. Risk can’t be boiled down to a number. The industry tries over and over again to invent a metric that somehow captures all of risk. We think of risk quite differently. There are three kinds of risk that we obsess about. Risk number one is valuation risk, overpaying for an asset, as simple as that sounds. Risk number two is fundamental risk. It could look like a cheap asset, and it might be, but you’ve got to do your homework. There might be a legitimate reason, a fundamental reason, why it’s been so poorly priced, and we’ve got to figure that out. And then the third is leverage. Leverage is a whole other kind of [risk] to be concerned about. Nothing can turn a bad investment into a good one. Leverage is one of the few things we know that can turn a good investment into a bad one.
One of the things I think GMO is somewhat famous for in the industry are the seven-year forecasts. Is there something magical about the seven-year forecast or that time frame?
Heh! There’s nothing magical. It’s just more of a good discipline. The math behind our forecast is not highfalutin math. Jeremy Grantham has often described this as eighth grade math, and by design. Typically, the more complex these formulas become, the less precision and the less confidence one should have in them. So by design, they are relatively straightforward, easy to understand. But yeah, they’re relatively long. A seven-year time horizon is very much out of sync with how many people are evaluating money managers, are evaluating performance. But to be perfectly honest, it’s also something that we can exploit. A fancy adjective to describe our methodology is time horizon arbitrage. It simply means if you can extend your time horizon, and see value where others don’t, we think there is money to be made.
What’s new within alternative investing?
Well, first of all at GMO we’re kind of dubious and skeptical of anything that’s new. We’ve got strategies that are new to people, but strategies that we’ve been using for 18 years. I think the difference now is making these vehicles newly available, and we sense a new openness.
Well, unfortunately, that’s about all the time that we have, but a parting thought.
Sure. I think the alternative industry throws a lot of jargon and lingo and has created this intimidating aura. Don’t be mesmerized. There’s nothing magical about alternative investments. They can play a legitimate role in the portfolio—if they’re priced well. Really, the key to investing is not alternative assets it is alternative thinking about the portfolio.
Peter, thank you for joining us On the Trading Desk.
The views expressed are as of 2-6-13 and are those of Chief Portfolio Strategist Brian Jacobsen; Peter Chiappinelli, CFA, CAIA; and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.