SPECIAL REPORT:
Alternative Investing 101
by John F. Mauldin
INSIDE:
Introduction
Alternative To What?
Alternative Investing a la Carte
Access To Alternatives
Hedge Funds: The Prime Alternative
Risk-Adjusted Returns?
Aren't Hedge Funds Expensive?
Risks of Hedge Fund Investing
How Do I Learn More?
Introduction
Longtime readers know I'm a fan of “Alternative Investing.” While I have had some success in
traditional investments over the years (along with my share of failures), I've also found it
beneficial to think “outside the box” with some of my capital. This is especially true since the
beginning of the secular bear market cycle which began in 2000 (and which I have written about
at length in Bull’s Eye Investing and also in my weekly letters).
Whenever I speak at conferences, people want to know two things. First, what in the world are
these alternative investments? Second, how do I find them? Both answers are complicated –
unnecessarily so in my view, but that's life.
In this brief report I'll give you a quick overview of Alternative Investing. I'll answer the
questions above plus a few others. The key word is “quick.” This isn't an academic paper and
you won't need any higher math skills. My goal is to keep it simple. If all I do is whet your
appetite and make you want to learn more, I'll count myself successful. Let's get started.
Alternative To What?
When we talk about “Alternative Investing,” we beg another question: Alternative to what? The
entire concept makes no sense unless you also have a category of well-known, commonly
understood “Regular” investments. So what are they?
Professional opinions vary on this. What's normal to one person can be quite unusual for
someone else - and that's OK because we're all in different circumstances. For our purposes
today, we'll consider three asset classes to be “traditional” investments.
Stocks are the cornerstone of most long-term portfolios. If you own shares, you're part owner of
a business. Assuming it is a successful business (and many aren't), you'll be rewarded with
dividends, capital gains, or both. This category also includes mutual funds, ETFs, and other
pooled instruments that conveniently package various stocks for you.
Bonds are nothing more than liquefied loans. Party A lends money to Party B for an agreed-upon
term and interest rate. The parties can be individuals, companies, banks, national governments,
local governments, or anyone else. What makes a loan a bond is securitization. The original
lender can sell his rights to principal and/or interest to someone else at whatever price he finds
acceptable. Bonds can be (and usually are) tossed around repeatedly between initial issuance and
their eventual maturity. They are also pooled into “bond funds” that are easier for individuals to
own.
Cash is money you can spend right now: paper currency and bank accounts. A related but
slightly different category is cash equivalents. These are not-quite-cash in a technical sense, but
for most practical purposes they are just as useful. Treasury bills, short-term certificates of
deposit, commercial paper and money market funds are all cash equivalents.
Stocks, Bonds and Cash can be sliced, diced, mixed, combined and molded into myriad shapes. I
could write an entire book on how to succeed in each class, and another book about how to blend
them into a portfolio that fits your goals.
Unfortunately, just about all such strategies are tied to the economic cycle. They also tend to be
one-sided bets: you make money only if your stocks go up. You lose money if you're a
bondholder and the debtors can't repay you.
For me, that's not good enough. I want the ability to profit in a falling market, too, at least with
part of my money. This is where Alternative Investments come in handy. In various and sundry
ways, they give you potential for gain even when stocks and bonds don't. That's why we call
them “alternatives.” (I should note there is also the potential for loss, as with any investments.
Alternatives are not a free lunch.)
To me – and I suspect to you as well – this is common sense. You don't put all your eggs in one
basket because the basket might break. In fact all baskets do break, eventually. When (not if)
this happens, it's very nice to have more baskets with more eggs.
In the investment world we call this “diversification.” But you can't simply collect identical
products in different packaging. To be truly diversified, you need a portfolio whose components
don't do the same thing at the same time. If you own 100 randomly selected stocks, and then add
100 more randomly selected stocks, you probably aren't twice as diversified. You just have twice
the paperwork.
Not rocket science, is it? Yet some of the smartest people in the world still didn't “get it” as
recently as 2008. They thought they had unbreakable baskets. Then it all fell apart.
The good news is that the last bear market spurred Wall Street into action. New alternative
products come out all the time, and old ones are becoming more accessible. In the next section
we'll review the menu.
Alternative Investing a la Carte
Sit down in a fine restaurant (as I do whenever possible) and consider the menu. You'll probably
see appetizers, tapas, main courses, desserts, coffees, a wine list and more. Within the main
courses are some simple dishes along with more elaborate creations. Yes, you can stuff yourself
with bread and salad dressing, but they are not a complete meal.
You can think about alternative investments along the same lines: the first course may be all you
want right now, but plenty more is available. So let's start with the Alternative Investment
appetizers.
Real estate is probably the most widely-held alternative simply because most Americans own
their homes.* Property values are only loosely related to the stock market and can also vary
dramatically by location.
“Absolute Return” mutual funds employ advanced trading techniques like short-selling and
arbitrage, with the goal of delivering steady results in any market conditions. Numerous such
funds are available. They've had mixed success.
Market Timing is a strategy that shifts between stocks, bonds, and/or cash with the goal of
escaping exposure to downtrends. More aggressive timing systems may use inverse funds or
derivatives to try for profit as the benchmarks fall.
Commodities like gold, silver, oil, grains, and livestock tend to perform especially well during
inflationary times. This makes them a good counterbalance to long-term bonds. They can also be
leveraged and sold short with futures contracts, if you can stand the risk. I believe most investors
should use futures only with professional guidance.
All these asset classes are accessible through publicly-available mutual funds, exchange traded
funds, or money managers. They're good ways to get started in the alternative investment world
– but they are still only appetizers. For the real feast, you need to turn the page on the menu.
Access To Alternatives
Suppose, however, your menu ends at the salad page. Thinking this strange, you ask to see the
rest of it. Your waiter says, “I'm sorry, you must be an Accredited Eater before I show you the
main courses. Only sophisticated diners can choose from the full menu.”
*
days.
More precisely, they will own their homes if they pay off their mortgage, which is far from certain these
Such a scenario is ridiculous, of course. You are perfectly capable of deciding what to eat. Yet
this is exactly how U.S. law treats small investors who want to go beyond the appetizer menu.
The alternatives I discuss in the rest of this report are available only to “accredited investors.”
Why? Because Congress thinks they are too sophisticated or risky for “average” investors to
understand.
How does one become accredited? The Securities Act of 1933 defines several criteria. For
individuals, the main requirement is that you have a net worth of $1 million or more, excluding
equity in your residence. You can also qualify if your income is $200,000 or more for each of the
two previous calendar years.
It gets worse. The people who sell alternative investments are required to get written proof of
your accredited investor status before they even tell you what they can offer. That's why your
menu was missing some pages.
This is tragic on many levels. First, the requirements have never been adjusted for inflation. We
all know having a million dollar net worth in 1933 was far less common than it is now. Ditto for
the $200,000 income test.
Second, why should we presume that anyone who has money is automatically “sophisticated?”
I've known some very wealthy people who were, quite frankly, less intelligent than the rocks on
my patio. I've also known some extremely knowledgeable investment professionals with only
modest personal assets.
Nonetheless, the law is the law and we have to obey it. I've been working behind the scenes for
decades to bring some sanity to this situation. Maybe someday it will happen. Until then, I am
in an awkward situation because I don't know who is reading this report. I can describe some of
the opportunities in general terms, but I can't give you any specific names or performance
numbers. If you do qualify as an Accredited Investor, I'll tell you how to learn more.
Hedge Funds: The Prime Alternative
You've heard about hedge funds in the media, most likely because they were being blamed for a
bad market day. These huge and mysterious pools of money do exert a lot of influence. They
aren't the root of all evil, though. Every penny in every hedge fund ultimately belongs to a
human being who puts his pants on one leg at a time.
Oddly, “hedge fund” is not a precise term. The generally accepted definition is something like
this:
Hedge Fund: A private investment fund that trades in a variety of assets and attempts to protect
investors from market downturns while still delivering attractive returns in bull market
conditions.
In other words, a hedge fund can invest however the manager sees fit. The regulations that
govern funds and banks don't apply to hedge funds. Why? Because they are “private.”
What is “private” in this day and age? Hedge funds can't advertise, can't accept non-accredited
investors, and usually have very high minimums if you want to invest. A million dollars or more
is common for top-ranked hedge funds. For tax reasons, some funds won't accept any amount of
money from U.S. citizens. Many reserve the right to kick out investors they find troublesome.
Why would anyone put up with these conditions? For one reason, and one reason only: they
think the results will be worth it. Hedge funds do actually post very impressive numbers
sometimes – but there are no guarantees about the future.
As I said, the term “hedge fund” covers a lot of territory. Every fund has its own unique strategy.
Some trade in specialized markets unknown to most investors. The better-known hedge funds fall
into three categories: Global Macro, Long/Short Equity, and Managed Futures. I'll give you a
brief description of each.
Global Macro: The funds in this category are highly opportunistic. They are willing to go
anywhere, do anything, and then change their minds in a flash. Think of legendary managers like
George Soros and they usually fall into this group. Global macro managers like to trade
currencies and government bonds because those huge markets are very liquid. They also dabble
in stocks and commodities.
Long/Short Equity: As the name suggests, these funds trade equities from both long and short
sides. In the simplest form, the manager invests half the fund in stocks he thinks are going up,
and the other half in stocks he thinks are going down. The time frame can be anywhere from
seconds to years. More elaborate long/short strategies may employ options, futures, and other
derivatives.
Managed Futures: The dynamic futures markets offer plenty of opportunity, as well as plenty of
risk. Futures contracts let traders exploit trends in stocks, interest rates currencies, gold, energy
and more. Even better, futures traders can capitalize on downtrends by going short just as easily
as they trade the bullish side. Managed futures funds do this by placing a seasoned trader at the
helm.
All these fund types share the same goal: superior risk-adjusted returns. You hear that term a lot
but you may not know what it means. In the next section I'll try to explain.
Risk-Adjusted Returns?
Return is a fairly simple concept. We all generally agree that a gain of 10% is more attractive
than 5%. We further agree that 5% is better than 0%, and that 0% is preferable to -10%. Risk is
not so easily explained. The statisticians measure risk with various formulas, all of which have
both advantages and problems.
We would all, of course, like our returns to be as high as possible and our risk to be as low as
possible. In my case, I would like to make a gain of 50% a year, every year, without ever having
a single losing day. Sadly, I have not achieved this goal. I comfort myself with the knowledge
that no one else has either.
The hard truth is that risk and return typically go hand-in-hand. If you want big gains, you have
to accept the chance of big losses, too. And if you insist on avoiding all possible loss, you must
realize your returns will always be minimal.
“Risk-adjusted return” is an attempt to balance these competing goals. Suppose, for instance,
two managers both had a 20% gain last year. Manager A posted four straight winning quarters.
Manager B had a big first quarter loss, recovered in the second quarter, and then outperformed
Manager A in the last two quarters.
At the end of the year both managers have the same net result. Manager A, however, delivered a
much smoother ride. His clients didn't spend half the year losing money and then trying to get
back to even. Both managers had the same annual percentage gain, but Manager A had better
risk-adjusted performance. He achieved the same end result with less risk.
Doing this isn’t as easy as it may sound. Anyone can double their returns just by leveraging up.
Increasing your returns without raising your risk level is much harder. So is reducing risk
without cutting into returns. Managers with a history of superior risk-adjusted results are rare
and expensive. Are they worth it? I think so. But let's take a look at the costs involved when
you invest in a hedge fund.
Aren't Hedge Funds Expensive?
The quick answer is “Yes.” The fees built into a hedge fund are significant. Yet plenty of very
wealthy, intelligent investors gladly pay up - because they're confident the value they receive
exceeds whatever they spend. Hedge fund fees fall into several categories.
Management Fee: Most managers get a fixed percentage of assets. On an annual basis, the
management fees tend to run between 1% and 3%. I've seen a few particularly successful
managers ask for (and get) management fees in the 4-5% range.
Incentive Fees: This is where hedge fund managers make their big money, keeping a percentage
of whatever gains they generate. 20% is fairly standard. So if a hedge fund makes a gross yearly
profit of $100 million, the manager gets $20 million off the top. The investors split the
remaining $80 million. Sometimes incentive fees are tied to beating a benchmark or achieving
certain risk-adjusted returns.
If you are used to the tiny percentages mutual fund and institutional portfolio managers receive,
these amounts may sound like highway robbery. They are not, and here's why. Successful hedge
fund managers must do far more than just keep up with the market. They have to deliver that
“risk-adjusted return” I described earlier. In technical terms, they must add “alpha” instead of
just “beta.” Few people can do what these managers do. You have to buy this talent, and it's
expensive because it is so rare.
Hedge funds also have a few other miscellaneous expenses:
Trading Costs: It costs money to buy and sell stocks, bonds, futures, currencies or whatever a
hedge fund does. The brokers who execute trades have to be paid, too. On a percentage basis the
trade commissions are negligible, but they can add up in the lightning-fast strategies used in
many hedge funds.
Accounting: Keeping up with all the activity in a hedge fund is a full-time job in itself. Most
funds employ outside firms, though the bigger ones often have internal fund accounting
departments. In either case, it takes a lot of time and expertise to make sure the numbers are
right.
Monitoring: Unless you are an expert yourself, it's a good idea to have some sort of go-between
who can help you pick the right fund, then tell you if you need to make a change. You can't
depend on the fund manager for this. For a manager, it’s always the right time to buy their fund.
You need a neutral party, and you'll have to pay them somehow. Many consultants and “funds of
funds” provide this service and often they will work for a small incentive fee, management or
consulting fee. Sometimes, they can negotiate a percentage of the hedge fund fees so there is not
“extra” cost to you.
Risks of Hedge Fund Investing
The fact that a hedge fund manager's goal is “risk-adjusted return” does not mean an investment
with that manager is “risk free.” Risk can never be eliminated. The best we can do is look at the
past, and it doesn't necessarily tell us anything about the future.
Hedge fund managers face the same market risks as anyone else. Their predictions can be
wrong. Ideally, they have ways to hedge and/or the ability to react quickly before losses become
too great. Many have systematic approaches which hopefully take out some of the emotion in
the investing process. Hedge funds still have some unique risk factors.
Liquidity Risk: If someone shouts “fire” in a crowded theater, you want to be near the door.
Hedge funds, especially the larger ones, always need an exit plan for every trade. If the exit plan
is insufficient, your money could be stuck in the wrong place for days or weeks.
Counterparty Risk: Every transaction in the financial markets has two sides: a buyer and a seller.
In high finance the other side is called your “counterparty.” If your counterparty can't keep their
end of the deal, you can be stuck. Some people learned this the hard way when Lehman Brothers
went bankrupt in 2008.
Tax Risk: Taxes are another fact of life, but the details aren't always crystal clear in complicated
transactions. Hedge funds are sometimes forced to act without full knowledge of the tax
consequences. Worse, the tax code can change any time.
Regulatory Risk: Hedge funds try hard to skirt bothersome government interference, but they
can't always escape. I've seen some great trading strategies grind to a halt because a bureaucrat
somewhere decided to interpret a rule differently. It can happen any time, and without any
warning.
If you look at any hedge fund's “private offering memorandum” or “offering circular” (basically
a prospectus), you'll find an exhaustive, lengthy list of risk factors. It will probably include those
I've mentioned here and a few others. Reading them is a great way to talk yourself out of
investing in a fund.
Here's a little inside scoop. The risk factors aren't written out in such detail because the manager
wants you to be fully informed. They are there in order to protect the manager from you. If you
ever complain or file suit, the fund manager's attorney will respond like this: “You shouldn't be
surprised, Mr. Jones. We told you this could happen. It's right there on page 157, paragraph 3, of
this document we gave you five years ago. You signed right here certifying that you read and
understood it.”
Courts and arbitrators find this line of argument very persuasive. That's why you need to read the
offering documents carefully before investing in a hedge fund. The risk factors are not just
boilerplate mumbo-jumbo.
How Do I Learn More About Alternative Investing?
If you are still with me by this point, you probably have a more than passing interest in hedge
funds or other alternative investment opportunities. I cannot say which, if any, particular
opportunities are suitable for you. What I can do is direct you to some resources I think are
useful.
My “go to” source in Canada is my exclusive partners at Nicola Wealth Management. John
Nicola has built what I think is the premier alternative and absolute-return investment team in the
business. They have access to some of the best funds and managers anywhere and a skilled
research team to stay on top of the funds they work with. You can access their expertise by going
to www.nicolawealth.com and clicking on “Meet With Us” to fill in the form. They will shortly
get back to you. You can email them at tactics@nicolawealth.com or you can just pick up the
phone and call 1-800-219-8032.
Your hoping to help you understand alternatives analyst,
John Mauldin
You should request, read and thoroughly examine the offering memorandum for
a hedge fund prior to making an investment. Consult with your personal tax,
legal and investment advisers prior to making an investment in a hedge fund.
Important Disclosures
John Mauldin is the President of Millennium Wave Advisors, LLC (MWA) which is an investment
advisory firm registered with multiple states. John Mauldin is a registered representative of
Millennium Wave Securities, LLC, (MWS) a FINRA registered broker-dealer. MWS is also a
Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the
CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC
and MWS LLC. All material presented herein is believed to be reliable but we cannot attest to its
accuracy. Investment recommendations may change and readers are urged to check with their
investment
counselors
before
making
any
investment
decisions.
Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs
at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above.
Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents
only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for
accredited investors who have registered with Millennium Wave Investments and Altegris
Investments at www.accreditedinvestor.ws or directly related websites and have been so registered
for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and
subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their
professional investment counselors. Investors should discuss any investment with their personal
investment counsel. Information about specific funds is only available to those who have had
substantive conversations with representatives of either Millennium Wave Investments or Altegris
Investments or both to determine their suitability to receive information on private investment
offerings. The Accredited Investor News is provided on a confidential basis, and subscribers to the
Accredited Investor News are not to send this letter to anyone other than their professional
investment counselors.
Millennium Wave Investments cooperates in the consulting on and marketing of private
investment offerings with other independent firms such as Altegris Investments; Absolute Return
Partners, LLP; and Plexus Asset Management. Funds recommended by Mauldin may pay a
portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and
thus with Mauldin. Clients of Nicola Wealth Management (NWM) pay a management fee to
NWM. 1/3 of fees received from clients recommended to NWM by MWS are shared with MWS
and thus with Mauldin. Any views expressed herein are provided for information purposes only
and should not be construed in any way as an offer, an endorsement, or inducement to invest with
any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services
or making an investment in a fund, investors must read and examine thoroughly the respective
disclosure document or offering memorandum. Since these firms and Mauldin receive fees from
the funds they recommend/market, they only recommend/market products with which they have
been able to negotiate fee arrangements.
FEE NOTICE FOR US PERSONS: Millennium Wave Investments and Altegris Investments are
independent firms that cooperate in the consulting on and marketing of private investment
offerings. Altegris Investments, Inc., a registered broker-dealer in La Jolla, California receives a
placement agent fee from hedge funds that if offers, including hedge funds mentioned in the Eletter, if any. Such fees may include a portion of the advisory and performance fees charged by
the hedge fund manager. Altegris will remit a third or other substantial percentage of those fees
to Mr. Mauldin’s firm, Millennium Wave Securities, LLC, a FINRA registered broker dealer with
which Mr. Mauldin is a registered representative.
Since Altegris and Mr. Mauldin receive fees from the funds they recommend/market, they only
recommend/market products with which they have been able to negotiate fee arrangements.
PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS
AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED
FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE
FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT
SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE
INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS,
CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR
VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX
STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION,
ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL
FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING
INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE
INVESTMENT MANAGER.
Past results are not indicative of future results. There is risk of loss as well as the opportunity for gain
when investing in managed funds. When considering alternative investments, including hedge funds, you
should consider various risks including, but not limited to, the risks summarized below.
Hedge funds are speculative and may use leverage. As a result, their returns may be volatile.
You may lose all or portion of your investment in a hedge fund.
Hedge funds are not subject to the same regulatory requirements as mutual funds
Hedge funds may involve complex tax structures and delays in distributing important tax
information; hedge funds are not required to provide periodic pricing or valuation information to
investors.
With respect to single manager hedge funds, the manager has total trading authority and in many
cases the underlying investments are not transparent and are known only to the investment
manager. The use of a single manager could mean a lack of diversification and higher risk. With
respect to funds of hedge funds, the fund's manager has complete discretion to invest in various
sub-funds without disclosure thereof. Because of this lack of transparency, there is no way for
you to monitor the specific investments made by the fund or to know whether the sub-fund
investments are consistent with the fund's historic investment philosophy or risk levels.
There is generally no secondary market for hedge fund interests. Transfers of interests are subject
to limitations, i.e., the investment interests are often illiquid. The manager may deny a request to
transfer if it determines that the transfer may result in adverse legal or tax consequences for the
fund.
Hedge funds are subject to substantial expenses (high fees) that must be offset by trading profits
and other income in order to be profitable. With respect to funds of hedge funds, because the fund
invests in other funds and fees are charged at both the fund and sub-fund level, the overall fees
you will pay will be higher than that you would pay by investing directly in the sub-funds. In
addition, each sub-fund may charge an incentive fee on new profits regardless of whether the
overall operations of the fund are profitable.
A substantial portion of a hedge fund's trades may take place on foreign exchanges that may not
offer the same regulatory protection as U.S. exchanges.