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Alternative Investments Gone Wrong: The Story Of The Dallas Police Pension Plan

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Alternative investments can both reduce risk and boost returns in a well-constructed portfolio, particularly at a time when traditional investments like stocks and bonds are expensive and priced to deliver disappointing returns.

But the key word here is can. Alternative investments can deliver that holy grail of higher risk-adjusted returns if chosen carefully and in prudent allocations. But if done poorly, alternative investments can just as easily take a wrecking ball to a portfolio and destroy years’ worth of gains.

As a case in point, consider the story of the Dallas Police & Fire Pension System (DPFP).

Dallas cops are in a dangerous line of work, a point that was made clear by the sniper attack this summer that tragically claimed the lives of five officers. But in exchange for the risks they take in keeping the rest of us safe, cops get certain perks, such as retirement at age 55 with a traditional pension plan. Well, today, those benefits are under serious threat.

After making a series of questionable investments during the go-go years of the real estate bubble, the DPFP took massive losses that effectively bankrupted the plan that over 9,000 current and former police officers, firefighters and their families depend on. Before the dust settles, Dallas taxpayers will probably have to shell out $600 million or more to keep the plan afloat, and the police and firefighters may be forced to work longer or accept benefit cuts. No matter what the final deal looks like, it will likely be a raw one for the police and firefighters… and for the taxpayers they serve and protect. And all of this is due to the incompetence of an investment manager.

What Happened?

Well, it made sense at the time…

Following the 1990s tech bubble and bust, the plan’s managers wanted to diversify outside of the risky stock market. But in order to make the targeted 8.5% return, bonds weren’t going to cut it. So the fund diversified into the wild, wild west of alternatives.

Hey, I get it. What was true in the early 2000s is even more true today. Stocks are expensive and looking wobbly, and bonds yield so little as to be unworthy of consideration for many investors. But what the fund’s managers did next is remarkable for its lack of basic prudence and common sense.

At one point, the fund had over half of its investments in alternatives. Now, in a vacuum, that’s not necessarily a bad thing. The Harvard University endowment fund has famously kept about half of its portfolio in alternatives for years. It’s the particular choices of assets that the DPFP held that should have been a major red flag. Among other questionable assets, the fund owned interests in the American Idol production company, luxury homes in Hawaii, a Napa vineyard and Uruguayan timberland.

I think there might have been some oceanfront property in Arizona in the mix too.

Not All Alternative Investments Are Created Equal

Apart from sheer strangeness (Uruguayan timber?), the alternative investments owned by the Dallas police pension had some other aspects in common. To start, all were extremely illiquid. Now, illiquidity is not necessarily a deal breaker. I’m comfortable with an asset being somewhat hard to sell so long as it is relatively safe and throws off consistent income. For example, the Dallas police would have probably been perfectly fine owning a diversified portfolio of rent-producing apartments or warehouses… but instead their managers bought them glitzy luxury properties and raw land held for speculation.

Along the same lines, the assets they owned, in general, did not have observable prices. Now, again, that is not necessarily a deal breaker by itself. It’s silly and cost prohibitive to get real estate appraised every month, and appraisals might not be accurate in the absence of reliable comps. And investments in private equity or private individual businesses also lack observable prices. But this is why you keep investments like these as a small piece of your portfolio and, again, make sure that they throw off a reliable stream of current income.

Doing It Better

So, how can we avoid falling into the same traps that ensnared the Dallas police and firefighters? After all, with stock and bond prices still very elevated, the case for alternatives is stronger than ever. So how can we avoid investing in alternatives that blow up?

To start, use the same common sense you would use in a traditional stock portfolio and keep your position sizes reasonable. What is “reasonable” may be subjective, of course, but common sense applies. Putting 10%-20% of your portfolio in a single alternative fund may be completely reasonable if that fund is itself very well diversified and liquid. Putting 10%-20% of your portfolio into a single property or into an operating business in which you are a passive investor with no operational control is probably not reasonable.

When I put together an alternative portfolio, I generally like to see four conditions in place:

  1. The alternative investments should be uncorrelated to both the stock market and to the other alternative investments in the portfolio.
  2. The returns should be consistent and, ideally, have a current yield component.
  3. The assets should be relatively liquid. I don’t have to have 24-hour instant liquidity, but I need to know that my clients can get their money out in a month or two if they need it.
  4. The investment should have observable prices or, at the very least, accurate financial statements that give me an indication of financial health.

In the interests of full disclosure, I co-manage a liquid alternative robo advisor specializing in risk parity strategies. So, I’m obviously a believer in alternative investments and make them a major part of my practice.

The pension crisis has led many Dallas police officers to retire early and request a full distribution of their pension out of legitimate fear that the plan will fail. If you’re one of those officers, give my office a call to see if our liquid alternatives might be the answer for your portfolio.

Charles Sizemore is the principal of Sizemore Capital Management, a registered investment advisor based in Dallas.

This piece first appeared on Forbes.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Taking Their Pound of Flesh: How Much Should You Pay an Alternatives Manager?

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My friend and colleague Ari Rastegar was mentioned by the Wall Street Journal this week.  You can read the full article here, but I’ve covered some of the highlights below.

If you think paying a 20% cut in profits is steep, try paying 25% or 30%, or how about 50%?

Ari Rastegar, who worked for Chelsea Hotels Chief Executive Ed Scheetz and real-estate investor Nate Paul, is striking out on his own to raise $250 million to $500 million for a fund that invests in income-producing real-estate assets like self-storage facilities and discount retail locations in secondary and tertiary markets, a person familiar with the situation said.

He is proposing a 1.2% management fee, and would take half of the profits above an investment return hurdle of 8%, the person said. The fund also deviates from standard private-equity practice in not charging commissions and fees on acquisitions and add-on purchases, or for monitoring investments, in the hope of ditching the complexities in fee structure and better aligning with investor interests, the person said.

Although it is an extreme example, Mr. Rastegar’s fee structure is a reminder that the two-and-20 compensation model that many private-fund managers typically employ is primarily a behavioral norm, albeit one that is deeply entrenched in investor mind-sets.

 

Charles here. As I recently wrote in In Defense of Hedge Funds, you shouldn’t automatically discard a hedge fund or other private investment because of high fees. If the fund is doing something truly unique, adding real diversification to your portfolio by being uncorrelated to your existing investments, and posting good returns, high fees might be completely reasonable.

Should you pay the standard 2% of assets and 20% of profits to a long-only large-cap growth fund? Absolutely not. In highly-liquid and efficient market like large-cap equities, you’re probably better off going with a Vanguard ETF or mutual fund because it’s highly unlikely the manager will outperform enough to justify the fees. But if your alternative manager is adding real value and giving you something you’re not getting elsewhere, you shouldn’t begrudge them their pay. They earned it.

In fact, a high incentive fee — if structured well — will incentivize the manager to work harder at creating value. Just make sure you understand the fee structure and that you’re not incentivizing the manager to take excessive risk at the same time.

As the WSJ continues,

Now that the investor conversation has focused on fees, it is hard to steer it back to performance. Rastegar’s fund is an attempt to do just that. So far, some high net worth investors and one public pension fund, the District Attorneys’ Retirement System of Louisiana, have signed up for the fund.

 

Charles here again. While I applaud Vanguard and other low-cost pioneers for saving their clients money, I do find it discouraging that cost is the only factor a lot of investors bother to consider these days. Fees matter — a lot — but performance and diversification can matter more. Most patients don’t choose their doctor or dentist based on the lowest cost. Cost is definitely a consideration, but they focus on quality and reputation first. I’d recommend you take the same approach with your investments. It’s perfectly reasonable to pay up, so long as you’re getting value for your money.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Why I Built a Liquid Alternative Robo Advisor

liquid alternative robo advisorMost financial advisors and money managers are terrified of robo advisors. And frankly, if your job description consists of selling expensive mutual funds for a commission, you should be worried. Your business model has been slowly dying for decades, and low-cost robos are the final nail in the coffin.

Technology and competitive capitalism are doing to the financial services industry what they have already done to countless industries before. They’re cutting out the middle men and passing the savings on to the ultimate consumer. That’s a good thing. A very good thing, because every dollar saved in fees is a dollar that remains in your clients’ account to compound and grow over time.

Upstarts like Betterment and Wealthfront (as well as old hands like Vanguard) can build decent traditional stock and bond portfolios that perform every bit as well as the average man-made portfolio. But where they have been less effective is in the alternative space. And this matters — a lot.

As I wrote recently for Forbes, the traditional 60/40 portfolio is dead, and it’s not coming back any time soon. With both stock and bond prices extremely elevated, returns are almost guaranteed to disappoint over the next decade. Bonds, in particular, have gone from offering a “risk-free return” to offering a “return-free risk.” So, investors wanting to earn a respectable return will be increasingly pushed into alternative investments, such as hedge funds (see In Defense of Hedge Funds…).

But the problem with hedge funds is that they are only available to the wealthy, and they tend to have high minimum investments and high fees, along with limited liquidity and transparency. While hedge funds can make all the sense in the world in the right portfolio — and I use them extensively with my accredited investor clients — they obviously won’t work for every investor.

And this is precisely why I created a liquid alternative robo advisor. I wanted my clients to have access to some of the same strategies used by multi-billion-dollar hedge funds. But I wanted to make them available to all investors rather than just the wealthy ones. And I wanted to do it at a reasonable price with full transparency.

Our liquid alternative robo advisor takes clients through a risk questionnaire, much like the more mainstream robo advisors. But rather than dump them into a generic stock/bond portfolio, it assigns them to a volatility-targeted risk parity portfolio. (For a longer explanation of the strategy itself, see our presentation.)

Our fees, at 0.80%, are a little higher than those of Wealthfront or Betterment. But remember, we’re not competing with these traditional robos. We’re competing with hedge funds and other alternative managers,  which generally charge 2% of assets and 20% of profits.  And our solution is held in separately managed account at a reputable third-party custodian.

Creating the liquid alternative robo advisor allows me to serve clients I’d otherwise never be able to serve. The biggest impediment to an advisor growing their practice is time. Your instinct is to try and serve every client that knocks on your door. But the reality is, you can’t. There aren’t enough hours in the work day to do sit-down meetings with clients that have only modest sums to invest. Time has a monetary value, and unfortunately, you actually lose money on smaller clients. And you have the same amount of regulatory compliance responsibilities with a $10,000 client as a $10,000,000 client. Arguably, you actually have more.

But a robo setup changes that. With a robo setup, you can still profitably serve smaller clients, get them the same portfolios you would give a high roller, and all the while keep the regulators happy. A robo setup also allows a larger client to “kick the tires” and try out your services before committing a larger portion of their net worth to your management.

The financial advisory business is changing — quickly. With the rise of the robos, there will be a lot of attrition, and a lot of marginal advisors will end up folding their practices. If you want to survive and thrive in this line of work, you need to bring something new to the table. My advice is embrace the robo and build one that leverages what you do best.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Looking Beyond the 60/40 Portfolio in an Era of Low Returns

I wrote earlier this year that the 60/40 portfolio is dead. Well, rumors of its death were not greatly exaggerated. The 60/40 portfolio that served retired investors so well over the past 30 years is gone… and it’s not coming back any time soon. As investors, we have to move on.

Rest in Peace 60/40 Portfolio

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While it’s true that a simple 60/40 portfolio of the SPDR S&P 500 ETF (SPY) and the iShares Core US Aggregate Bond ETF (AGG) is actually enjoying a nice run in 2016, up a little more than 3% for the year, don’t get used to it. The math simply doesn’t work out going forward.

Let’s play with the numbers. Back in 1980, the 10-year Treasury yielded a fat 11.1%, and stocks sported an earnings yield (calculated as earnings / price, or the P/E ratio turned upside down) of 13.5%. This implied a back-of-the-envelope portfolio return of about 12.5% per year going forward, and for much of the 1980s and 1990s that proved to be a conservative estimate. Both stocks and bonds were priced to deliver stellar returns, and both most certainly did.

But what about today? The 10-year Treasury yields a pathetic 1.6% and the S&P 500 trades at an earnings yield of just 4%. That gives you a blended portfolio expected return of an almost embarrassing 2.8%. [Note: The usual disclaimers apply here. These are not intended to be precise market forecasts.]

You know the refrain: past performance is no guarantee of future results. There is no guarantee, at least with respect to stocks, that expensive assets can’t get even more expensive. It’s possible that the great bull run in stocks could continue indefinitely, however unlikely it might be.

But I can’t say the same for bonds. Starting at a 1.6% yield to maturity (or even the 4% you might find on a mid-grade corporate bond) you cannot have returns going forward that are anything close to the returns of the past several decades. Bond yields would have to go negative, and I don’t mean the (0.15%) we see today on the Japanese 10-year bond. I’m talking (5%) or (10%) or even more.

That’s not going to happen. Or if somehow it did — if investors got so petrified that they piled into bonds to the extent that yields went negative to that degree — then I would assume the stock portion of your portfolio effectively fell to zero at that point.

The bottom line here is that even under the most optimistic scenario, investors are looking at disappointing returns in a standard 60/40 portfolio.

So, what are investors supposed to do about it? They can’t just stuff their cash in a mattress for the next 5-10 years. Most of us actually need to earn a return on our money.

I’d offer the following suggestions:

Consider taking a more active approach to investing.

To the extent you invest in traditional stocks and bonds, don’t be a buy and hold index investor. Yes, low fees are great. But the fact that you paid Vanguard only 0.09% per year in management fees won’t really matter if you’re returns are still close to zero.

Instead, try a more active strategy, perhaps focusing on value or momentum. Or perhaps try a dividend focused strategy. With a dividend strategy, you can realize a cash return even if the market goes nowhere for years at a time.

Consider investing outside of the market.

If you’re willing to get your hands dirty, consider starting your own business or investing in a cash flowing rental property. Yes, there is more work involved, and there is the risk of failure. But there is also risk in trusting your savings to a fickle market when both stocks and bonds are both expensive by historical standards.

Consider a truly alternative asset allocation.

This final point is really my specialty. To the extent I can, I am eliminating traditional bonds from the portfolios of most of my clients and replacing them with non-correlated (or at least minimally-correlated) alternative investments. A standard 60/40 stock / bond portfolio might instead become a 50/50 dividend stocks / alternative investments portfolio.

“Alternative investments” is a generic term that can mean just about anything. In practice, for me it has meant a combination of long/short strategies, options writing strategies, absolute return hedge funds, and liquid alternative portfolios. I’ve even incorporated a liquid alternative robo advisor into the mix.

Will a non-traditional portfolio like this outperform over time?

Frankly, I don’t know. No one does. We’ve never seen a market like today’s.

But to me, it’s the only move that makes sense. Taking the traditional path is a virtual guarantee of disappointment. Incorporating alternatives into the portfolio at least give us the potential for solid returns.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.

Photo credit: Pheonix149

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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In Defense of Hedge Funds…

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Photo credit: Sean Davis

Hedge funds don’t get a lot of love these days. They’ve underperformed for years, and their fees — the standard is 2% of assets and 20% of profits — make them pariahs in the age of indexing and low-cost robo advisors.

Hey, I get it. The high fees and lousy performance of competing hedge funds was a major reason that I started a liquid alternative robo advisor with my partner, Dr. Phillip Guerra. We run a suite of risk parity portfolios that hold their own against comparable hedge funds… and we do it at a fraction of their fees.

Yet let’s not throw out the baby with the bathwater. While many — perhaps most — hedge funds add no real value and certainly don’t justify their fees, there are plenty of hedge funds that absolutely do add value and deserve every last cent. But how do you separate the wheat from the chaff?

Ask yourself the following questions:

Does the fund do something unique that realistically cannot be replicated in a cheaper and more transparent vehicle, such as an ETF, mutual fund or managed account?

Really dig deep here. If the fund is a long-only large cap fund, you should be skeptical as to whether the hedge fund structure is necessary. If the fund employs sophisticated hedges that would be hard to implement in a smaller managed account, then the hedge fund structure is probably justified.

Does the fund deal in illiquid securities that would justify the lack of liquidity of the fund itself?

Years ago, a hedge fund in the DFW area made a fortune buying idled planes from the major airlines. Needless to say, that sort of thing would be impossible to replicate in a mutual fund, ETF or managed account. It’s virtually impossible (or at least impractical) to securitize an airplane. On a similar note, in the past I have placed accredited investor clients in a fund that finances medical accounts receivable that might take two years or more to pay off. It’s hard to see a strategy like that working in a mutual fund that promises daily liquidity.

Defaulted Argentine bonds… large macro bets with credit default swaps… I could go on all day giving examples of illiquid opportunities that wouldn’t make sense outside of a hedge fund. But an outsized bet on Apple or Valeant Pharmaceuticals? Not so much. You can do that on your own in a discount online brokerage account without having to pay the 2 and 20 to the manager.

Does the fund have a strategy that would be fundamentally undermined by investor redemptions?

Think about corporate raiders like Daniel Loeb or Carl Icahn. These guys are known for amassing massive stakes in companies and then using their clout to force change, including booting out management that is underperforming. That only works if you have a stable pool of capital. Imagine Loeb attempting to take over a company and then having to back away with his tail tucked between his legs because he had a wave of shareholder redemptions.

When your advisor pitches you a hedge fund, you shouldn’t necessarily recoil in horror. I regularly incorporate hedge funds into the portfolios of my accredited investor clients when they fill a specific niche I’m trying to fill. And to date (knock on wood), I have yet to have a major disappointment on this front. I’ve lost plenty of money for myself and clients in low-cost ETFs and mutual funds, though I’ve never lost money (again, knock on wood) investing in a good alternative manager or hedge fund. I probably will at some point. You know the drill, past performance is no guarantee of future results. But I can credibly say that it hasn’t happened yet.

Before you invest a single red cent in a hedge fund, ask yourself the questions above. Hedge funds are certainly not for everyone, but if utilized correctly they can reduce portfolio volatility without sacrificing returns.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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