Why we recommend the direct, not alternate route
We recommend investments which generally meet the following criteria. They should be:
- Understandable and transparent
- Low cost
- Tax efficient, if needed
- Not dependent on one or a few managers
- Not dependent on someone’s attempts to make forecasts or predictions, to be successful
- Liquid, so you can get your money when you want to
For fixed income investments, this would mean high quality individual bonds or other securities, or bond mutual funds, depending on one’s portfolio.
For stock investments, we recommend asset class mutual funds of various types, which together provide a globally diversified portfolio, such as US Large Company, US Small Cap Value or International Large Value, just to name a few.
Diversification is critical in developing a portfolio, as research shows that with both stocks and bonds, a diversified portfolio can provide greater expected returns along with less volatility, over the long term. This can be accomplished very effectively at a very low cost.
However, many people are attracted to “alternative” investments, in search of even greater returns or the promise of reduced volatility and good returns.
Alternative investments have many names and types. Examples include hedge funds, private equity, and strategies with names like market neutral, absolute return, long/short equity or managed futures.
We base our philosophy on research and evidence. And the evidence is that it is nearly impossible to identify an alternative investment in advance that will consistently outperform over the long term, after factoring in costs and taxes.
Based on research compiled by Dimensional Fund Advisors, the primary stock mutual fund provider we utilize, publicly available alternative strategy mutual funds have performed horribly over the past 10 years ending December, 2017, as compared to the broad US stock and bond markets. See Exhibit 2* below, which details these results:
This shows that these alternatives had annualized returns of less than 1% per year, versus stock and bond returns of around 8% and 4% per year, respectively. Clearly most publicly available alternatives were not beneficial investments over the past 10 years. The exhibit shows the alternative investments net of their fees, whereas the indices are not reflective of fees. Thus, I’ve stated the indices returns as less in this paragraph, to account for some approximate fees.
We generally do not recommend alternative investments for many reasons.
- They are almost always very costly, with expense ratios of 1.4% for public alternatives and 2% or higher for private hedge funds, whereas we can build a globally diversified stock portfolio for around .30%-.40%, depending on the allocation of the stock portfolio. That would mean an alternative strategy would need to outperform our recommendations by over 1%-1.7% per year, just to be even due to costs. That is hard to do.
- Many alternative investments are hard to understand. They can be like a black box. We want to understand what we are investing in. With many alternatives, you don’t know what the strategy is…and it can change very frequently. What stocks are they shorting today (which means they are betting that stock will go down)? They may only report their holdings a few times a year, so there is a lack of transparency.
- Another factor is often portfolio turnover. Greater portfolio turnover generally leads to higher tax costs for investors. The Liquid Alternatives in the study* above had a turnover of 200% per year, which means the portfolio is replaced twice a year. If they were successful, and turned over the portfolio that often, gains would be short-term capital gains, which are taxed at the higher, ordinary income rate. Again, a bad result.
- Liquidity. We want you to have access to your money when you want it. With our current investments, you can get access to your money within a few days. Many alternatives, even some real estate investment funds, limit your ability to withdraw your money to quarterly or even a certain dollar amount per quarter or year.
While there may be some good alternative funds, the benefits they tout do not usually pan out over time.
When evaluating alternative investments, you should consider if it will add a beneficial element, that you don’t already have in your portfolio.
If it meets that criteria, can it really reasonably increase your expected returns or reduce your expected volatility? If so, how confident can you be of these assumptions?
And, will it be cost and tax effective?
We are confident that the criteria we stated at the beginning of the post are solid, reasonable and in your best interest. We evaluate new and different concepts, but any new investment we would recommend must pass those standards, at least as of today.
Whitepaper, Alternative Reality, Dimensional Fund Advisors, August 2018.
*Exhibit 2: Past performance is no guarantee of future results. Results could vary for different time periods and if the liquid alternative fund universe, calculated by Dimensional using CRSP data, differed. This is for illustrative purposes only and doesn’t represent any specific investment product or account. Indices cannot be invested into directly and do not reflect fees and expenses associated with an actual investment. The fund returns included in the liquid alternative funds average are net of expenses. Please see a fund’s annual report and prospectus for additional information on a specific portfolio’s turnover and the expenses it incurs.
Liquid Alternative Funds Sample includes absolute return, long/short equity, managed futures, and market neutral equity mutual funds from the CRSP Mutual Fund Database after they have reached $50 million in AUM and have at least 36 months of return history. Dimensional calculated annualized return, annualized standard deviation, expense ratio, and annual turnover as an asset-weighted average of the Liquid Alternative Funds Sample. It is not possible to invest directly in an index. Past performance is not a guarantee of future results. Source of one-month US Treasury bills: © 2018 Morningstar. Former source of one-month US Treasury bills: Stocks, Bonds, Bills, and Inflation, Chicago: Ibbotson And Sinquefield, 1986. Barclays indices © Barclays 2018. Russell data © Russell Investment Group 1995-2018, all rights reserved.
Standard deviation is a measure of the variation or dispersion of a set of data points. Standard deviations are often used to quantify the historical return volatility of a security or a portfolio. Turnover measures the portion of securities in a portfolio that are bought and sold over a period of time.