Author: David Andrew

I’ll Take a Chair with Three Legs over Two, Please

David Andrew

Ever since the great financial crisis of 2008, investing has been easy. Since January 1, 2009, the S&P 500 has returned 15.0% and the Bloomberg US Aggregate Bond Index has returned 4.2%, annualized. 1 Anyone holding a 50/50 portfolio of stocks and bonds during that time would have received an annualized return of 9.6%!

With the S&P 500 setting record highs and interest rates dropping to all-time lows, are recent returns likely to persist? Each year, JPMorgan publishes capital market assumptions designed to “aid investors with strategic asset allocation…over a 10- to 15-year investment horizon.”2 For 2021, JPMorgan is assuming a 4.1% return for U.S. large cap equities and a 2.1% return for U.S. Aggregate Bonds. These figures suggest that a 50/50 portfolio would return approximately 3.1%, annualized, over the next 10–15 years. That would be a huge disappointment when compared to the 9.6% realized since 2009. Would such a modest return even keep up with inflation? What should a wise investor do now?

In this paper, we examine the two traditional, investable asset classes and the need for a third true alternative asset class. Then we recommend that investors include hedge funds in their portfolio to further diversify the source of returns, adding stability to the portfolio and thus improving the portfolio’s risk-adjusted rate of return.

Investable Asset Classes

We can generalize the investment world as having two main asset classes—fixed income and equity— defined by the primary risk they take:

  • Fixed income (credit risk free) is an investment that earns a contractual rate of return depending solely on the lending period (i.e., the interest rate risk). Interest rate risk is tied to the duration of the contract, and returns typically increase as the duration increases (i.e., as interest rate risk increases).
  • Equity is the ownership of any residual value after all liabilities are repaid, and its return is tied primarily to market growth (i.e., the market risk).

All other factors being equal, if you anticipate market growth, equities should provide a positive rate of return. This makes sense, given that equities are nothing more than the leftovers. If the market grows and liabilities are fixed, then market growth leads to more leftovers. On the other hand, if you anticipate that the market will shrink, the contractual rate of return of fixed income should be more attractive.

Thus, traditional portfolios are composed of these two traditional asset classes, each providing a positive rate of return but performing better under different market conditions (i.e., growing markets versus receding markets). They have worked well together historically, but they may not provide the portfolio stability going forward. The problem in today’s market environment is that both asset classes have low expected future returns and may be correlated to one another due to artificially low interest rates.

In a world in which we use only these two investable asset classes, investment asset allocation is challenging under the current circumstances. For example, how can anyone allocate money to fixed income with an expected return of only 2.1% and significant downside risk if interest rates rise? Ideally, we would have a third option: an investable asset that derives its return from an alternative, uncorrelated source of risk. The addition of such an asset to the portfolio can improve the risk/return dynamic. We need an investment that is not highly correlated with interest rates or the equities markets, but rather has an independent return, a.k.a. an “alternative asset.”

Alternative Investments

It seems everyone is selling alternative investments these days, but what is an alternative?

  • An alternative is an asset or strategy that provides a return unexplained by the price movements of equities and fixed income (a.k.a. equity market returns, or “beta”). It is often the result of one’s ability to identify and capture mispricings in the market or securities (i.e., “alpha” risk).

To be a good diversifier, an alternative investment must generate its return from something other than interest rate risk or market risk. In the world of high finance, a return not explained by interest rates or equity returns is called “alpha.” Thus, the true benefit of an alternative asset is the unexplained return (alpha) it provides.

Many of the most commonly offered “alternatives” are nothing more than substitutes for their public and more liquid brethren. Private equity, for example, is nothing more than an equity investment in a non-publicly traded company. Do private equity returns produce alpha? Yes, investing in private companies has historically yielded greater returns than those predicted by the market risk factor. However, a significant portion of private equity returns are simply levered equity market returns. Thus, it is more accurate to include private equity as a replacement for some portion of the public equity allocation than to view it as a true alternative asset. The same can be said for private real estate, private lending, etc.

Few alternative investments generate mostly alpha returns. Fortunately, we have a valuable alternative for adding alpha to a portfolio: hedge funds.

Hedge Funds

“Hedge fund” is the generic term applied to a private fund that produces returns via trading strategies or investments in securities. The basic characteristics of a hedge fund include the following:

  • A private partnership structure
  • A defined liquidity structure (usually quarterly)
  • A fee structure that includes a management fee (typically 1.0–2.0%) and an interest in the profits (typically 20%)

There are many hedge fund strategies, and their returns are derived from different proportions of market, interest rate, and alpha risk. Exhibit 1 briefly describes the most popular hedge fund strategies. Creating a true alternative asset class for a portfolio would require distilling a portfolio of alpha- generating strategies. This is easy to understand but difficult to do in practice, largely due to the common criticisms of hedge fund investing discussed below.

Criticisms of Hedge Funds

Hedge funds are subject to four common criticisms:

  • High fees
  • Complex structures
  • Lack of full investment transparency/attribution
  • Limited redemption availability

High fees are the most contentious argument against hedge fund investing. If you can inexpensively replicate the returns of hedge funds, then this argument holds weight. For example, many long/short equity hedge fund portfolios are net long equities resulting in returns driven primarily by equity market returns. It is certainly less expensive and easier to access market returns via an equity index fund or exchange-traded fund than via a hedge fund—but hedge funds provide a less expensive way to access alpha.

Research has shown that, on average, long-only equity managers underperform3,4,5 largely because they cannot generate excess returns after fees. Therefore, simply gaining exposure to the market return as inexpensively as possible is a preferred strategy for long-only equity investing. However, alpha returns are not market returns. Alpha returns are generated purely through the manager’s ability to generate returns not explained by the market. Thus, the fees paid to hedge fund managers should be compared only to the alpha they generate.

Consider this example: A hedge fund provides an 8.0% gross alpha return and charges a fee of 2.8%, thus netting a 5.2% alpha return. In this scenario, an investor is paying 2.8% for 5.2% of alpha, or roughly $1.00 for each $1.86 in alpha return. That math works.

Some may wonder, “Why would I pay 2.8% for a 5.2% net return when I can just invest in the SPY, earn 15%, and pay only 0.09% in fees?” But the logic is flawed as that analysis compares apples to oranges. The SPY doesn’t create any alpha return and is set up specifically to provide the equity market return.

To compare these two strategies, let’s assume SPY has a positive net alpha return of 0.01%. Using the same math as before, spending 0.09% to generate 0.01% of net alpha return means you pay $9.00 for each $1.00 of alpha return. In this example, we’re comparing apples to apples, and hedge funds appear less expensive than index funds. However, we must use hedge funds correctly for this to be a valid comparison.

The hedge fund world is broad and often opaque, leading us to the second criticism of hedge funds: their complexity. Indeed, hedge funds are complex, and understanding their trading strategies may require an advanced degree. This complexity may be a good argument against investing directly in hedge funds, but it is not a good argument against the hedge fund asset class. Professional management of a portfolio of hedge funds can provide the due diligence needed to mitigate the risk associated with the complexity of hedge funds. For this reason, many hedge fund investors rely on a professional allocator or a fund of funds to build a portfolio of hedge funds.

The third criticism of hedge funds focuses on their lack of transparency. Many hedge funds conceal their investments for competitive reasons, thus complicating oversight. However, large pools of capital are able to dictate terms around transparency and other factors, thereby receiving enough information to manage risk exposure. Such leverage is usually driven by the sophistication of the investor and the size of the investment (i.e., the larger the investment, the more likely the investor can dictate terms).

Limited liquidity is the fourth and final common criticism of hedge funds, but it is overcome through diversification. Redemption periods vary across funds and strategies; therefore, this risk can be managed by maintaining a fully diversified portfolio in which other sources of liquidity are available.

This review of the common criticisms of hedge funds reveals that a certain level of expertise and access is not only valuable but also required to build an effective, alpha-focused hedge fund portfolio.

The Best Way to Access Hedge Funds

The best way to access a diversified hedge fund portfolio is to secure the services of a professional to build a portfolio via direct investment (usually requiring a minimum of $50 million) or via a professionally managed fund of funds. A fund of funds is often criticized for layering fees on fees. However, professionals merit their fees; their ability to aggregate larger pools of capital and negotiate better terms may actually lower the cost of the underlying funds.

Given the forecasted low returns of stocks and bonds, the current market presents an opportune time to invest in hedge funds. When the two traditional asset classes are expected to provide low future returns, it makes sense to pursue hedge funds as a valuable alternative. Yet at the end of the day, it doesn’t matter how well the traditional asset classes are performing. Hedge fund performance is independent of them. Therefore, most qualified portfolios can benefit from the addition of well- selected, well-managed hedge funds.

Summary

Alternative assets represent a broad category of investments, and hedge funds are the best alternative for adding a truly unexplained source of return. Building a portfolio of hedge funds can distill the overall return primarily to “alpha”—a return not explained by interest rate or equity market risk. Adding alpha to a portfolio can further diversify the source of returns, adding stability and thus improving the portfolio’s risk-adjusted rate of return.

In today’s market environment with the S&P 500 setting record highs and interest rates dropping to all- time lows, adding an uncorrelated source of return in the form of hedge funds is not only prudent, but also necessary. Given the complexity of hedge funds, leveraging a professional is the best strategy for adding them to any investment portfolio.

Endnotes

  1. Annualized returns from January 1, 2009, through December 31, 2020.
  2. JPMorgan. (2021). Long-Term Capital Market Assumptions Matrices. Retrieved from https://am.jpmorgan.com/content/jpm-am-aem/emea/ch/en/adv/insights/portfolio- insights/ltcma/matrices.html.
  3. Jensen, Michael C. (1968). The Performance of Mutual Funds in the Period 1945-1964. Journal of Finance, 23, 389–416.
  4. Malkiel, Burton G. (1995). Returns from Investing in Equity Mutual Funds 1971 to 1991. Journal of Finance, 50, 549–572.
  5. Carhart, Mark M. (1997). On persistence in mutual fund performance. Journal of Finance, 52, 57–82.

Disclosures:
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell any security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An offer or solicitation of an investment in a private fund will be made only to accredited investors pursuant to a private placement memorandum and associated documents. There can be no guarantee that a client will achieve the intended investment returns or objectives. There are associated risks with all investments and those risks are described in the investment advisory agreement. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Past performance is no guarantee of future results. Autumn Lane Advisors, LLC is not a law firm, CPA firm, or insurance agency and does not provide legal advice, tax advice, or insurance products.

© 2020 Autumn Lane Advisors, LLC. All rights reserved. This material may not be reproduced, displayed, modified, or distributed without the express prior written permission of the copyright holder. Send email requests to info@autumnlanellc.com.

Autumn Lane Advisors Named to 2020 Financial Times 300 Top Registered Investment Advisers

David Andrew

Autumn Lane Advisors is pleased to announce it has been named to the 2020 edition of the Financial Times 300 Top Registered Investment Advisers. The list recognizes top independent RIA firms from across the U.S. 

This is the seventh annual FT 300 list, produced independently by Ignites Research, a division of Money-Media, Inc., on behalf of the Financial Times. Ignites Research provides business intelligence on investment management.

RIA firms applied for consideration, having met a minimum set of criteria. Applicants were then graded on six factors: assets under management (AUM); AUM growth rate; years in existence; advanced industry credentials of the firm’s advisers; online accessibility; and compliance records. There are no fees or other considerations required of RIAs that apply for the FT 300.

The final FT 300 represents an impressive cohort of elite RIA firms, as the median AUM of this year’s group is $1.9 billion. The FT 300 Top RIAs represent 39 different states and Washington, D.C.

Autumn Lane Advisors is a boutique wealth management firm that helps clients coordinate and manage their wealth with the objectivity, expertise and client experience associated with a family office. Serving as a fiduciary, Autumn Lane Advisors works exclusively for our clients.

2020 Annual Letter – Interest Rates and Economic Risk

David Andrew

Executive Summary

  • Real interest rates are low and will stay low for the foreseeable future (think years);
  • COVID-19 has hijacked the year 2020, and the risk associated with it is real and still not quantifiable;
  • COVID-19 will be contained with a vaccine at some point, likely 12-14 months from now;
  • Upon the containment of COVID-19 and the resumption of normal economic activity, equity markets will snap back due to pent up demand and significant monetary stimulus.

2020 – The Year Ahead

We started writing this letter in January, and back then we were planning on discussing a recent academic paper about long-term real interest rates. You will have to take our word for it; the paper was riveting (all 123 pages of it). While we will still incorporate our thoughts on this academic study, the spread of COVID-19 and its impact (both socially and economically) has taken over the stage.

Today is March 8th, and there is still a lot of uncertainty regarding COVID-19. We will do our best in this paper to highlight facts from conjecture. However, investment is always based on both facts and the expectations of the future. If we could always invest with 100% conviction of the right answer, every investment would be risk-free… That is not reality; there are always unknowns. COVID-19 was an “unknown unknown” up until December of 2019. Now it is a “known unknown”, and we must take it into account.

2020 BC (Before COVID-19)

Prior to COVID-19, the market was doing just fine. Riding a wave of optimism following a stellar 2019, market talk centered around the US election. If you haven’t forgotten, the US is electing a President at the end of the year… Additionally, interest rates had seemed to find support, with the 10-year UST rate bottoming at around 1.6%. Historically speaking, 1.6% is rather low. Only a few times in history had the 10-year UST reached such levels. One would logically assume that rates would revert to their historical mean (i.e. going back up). However, a recent academic paper by Paul Schmelzing actually argues against this. Instead, Schmelzing, in his paper titled “Eight Centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311-2018” shows a trend decline of real rates between 0.6-1.8 basis points per year.
Having read this paper, we found ourselves wondering, what if the real risk-free interest rate did keep going down. How would this affect the construction of a diversified portfolio? The only reason to diversify is to obtain a different source of return, but what’s the point if that different return is zero? Finally, why would anyone buy bonds when their real return is effectively nothing or even negative?

2020 AC (After COVID-19)

The first report of a “pneumonia of unknown cause” in Wuhan, China was made to the WHO on December 31, 2019. On January 30th, 2020, the outbreak was declared a Public Health Emergency of International Concern. While the FED minutes from their January 28-29th meeting prominently discussed the emerging risk caused by the novel coronavirus, FED officials did not express a preference to provide additional policy accommodation and reaffirmed the FED’s intention to taper Treasury bill purchases. Now called COVID-19, the virus and its associated risk has finally started to impact the financial markets with the FED making an emergency 50 bps cut to the FED Funds Rate on March 3rd and the S&P 500 sliding 11.6% from 02/24 – 03/06.

COVID-19 is an unexpected risk that has taken over the headlines, financial markets, and our day-to-day lives. While the mortality rate of the virus seems relatively low, the ability for the virus to be spread via asymptomatic carriers makes it hard to contain. Currently, there is still much we do not understand about the virus. Thus, we would like to think about the possible outcomes in the form of scenarios:

  1. Best Case – media reports are overblown, and the virus is not nearly as bad as it seems. Morality rate is close to that of the seasonal flu, and warmer months slow its spread. In this case, China’s economy recovers without a respective rebound in the number of new infections. Financial markets return to normal by April or May. Global GDP growth is positive for 2020, and the S&P 500 gets back to 2,900 during the summer.
  2. Base Case – while dangerous, the mortality rate comes in around 1% (about 10x as lethal as the seasonal flu), with most deaths occurring to those over 70 years of age. Therapeutic drugs (such as Remdesivir) are found to reduce the severity of infection, providing a means to treat critical cases. Available therapies reduce panic and allow economic activity to return by the summer, albeit at a lower level than normal. A vaccine is discovered and produced by March 2021, with global economy returning to full capacity shortly thereafter. Global GDP growth is flat for the year, S&P 500 earnings fall to about $120 with the price finding support around 2,400-2,600 range.
  3. Bad Case – mortality rate is greater than 1%, and with no good means of treating the disease, the world must wait for a vaccine. In the meantime, “social distancing” becomes the prescribed method of reducing infection rates, and global economic activity grinds to a halt. S&P earnings give back a few years of growth shrinking to about $100 and multiples contract, causing the S&P 500 to fall to 1,600-2,000 range (about where we were 4-5 years ago).

These are just three simplified ways to think about what might happen. Obviously, the Bad Case (and hopefully most unlikely case) is a disaster. We do not think this will happen, but we at least need to recognize it as a risk. The Best Case would be a welcomed surprise. The Base Case is what we think will happen. It is based on the discussions, conference calls, and research we have participated and reviewed including contributions from:

  • Luciana Borio – Vice President of In-Q-Tel and Former Director of Medial and Biodefense Preparedness Policy National Security Council (2017-19)
  • Barry Bloom – Joan L. and Julius H. Jacobson Research Professor of Public Health Harvard T.H. Chan School of Public Health
  • Eric Feigl-ding – Visiting Scientist of Epidemiology and Health Economics at Harvard T.H. Chan School of Public Health

While these people have impressive resumes and experience, all three at one point or another said “I don’t know” or some similar phrase. No one knows exactly how bad this virus is, and that is why the world is practicing/preaching the only known defense: social distancing/isolation. Unfortunately, the act of limiting our interaction with others dramatically slows the economy. This fact is showing up in the financial markets as investors rerate stocks (i.e. they are paying lower multiples for future earnings).

Lower growth leads to lower interest rates. This is because interest rates are basically the cost of money. If you have lower growth, there are fewer opportunities requiring capital. Thus, the competition to borrow money is less, and lenders must lower rates in order to encourage borrowing. The downward trend of yields is further exacerbated by investors fleeing to safety assets (i.e. increasing the supply of available capital for lending). This concept brings us back to original discussion before COVID-19. Going forward, a zero (or even negative) real risk-free rate makes sense, and the downward trend of the real risk-free rate also makes sense. If you think of the storing and protecting of your money as a service, then you should be willing to pay for it. A risk-free security does just this; it stores your money and gives it back to you. For years, people were actually paid to receive this service through a positive real interest rate. However, with improvements in liquidity and information, we believe “riskfree” has become less risky. For example, do you think the US Government today is less risky to lend money to than the Italian Government of 14th Century or the British Crown in the 15th and 16th Centuries? Back then, those governments were the “risk-free” borrowers. We would argue that the ability to monitor governments and the liquidity provided by the financial markets have effectively lowered the risk associated with such borrowers.

We bring this up to highlight an outcome we believe will occur after COVID-19 is under control. While we believe interest rates will rebound, we believe that the real risk-free rate will remain at or near zero. Thus, the interest rate that people commonly discuss, the UST 10 year, will reflect nothing more than the expected inflation rate during the term of the loan. And if inflation is low, expect nominal interest rates to remain low.

So, we are saving our money to invest in equities. As panic selling subsides, and cooler (healthier) heads prevail, equities will rerate back up. The monetary easing that many central banks will provide over the coming months will amplify this rerating. Additionally, the hit to S&P 500 earnings is transitory. It will go away, and the pent-up demand of millions of former “social distancing practitioners” will hit the stores, restaurants, theatres and airports near you. So, if there is a silver-lining to this note, it is that the equity markets will come back, and when they do it will happen quickly!

Sincerely,

David E. Andrew
Partner
Autumn Lane Advisors, LLC

DISCLOSURES
This information is provided, on a confidential basis, for informational purposes only and does not constitute an offer or solicitation to buy or sell an interest in Autumn Lane Partners, LP (the “Fund”) or any other security. It is intended solely for the named recipient, who, by accepting it, agrees to keep this information confidential. An investment in the Fund is speculative and involves substantial risks. Additional information regarding the Fund including fees, expenses and risks of investment, is contained in the offering memorandum and related documents and should be carefully reviewed. An offer or solicitation of an investment in the Fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents. Interests in the Fund can only be purchased by investors meeting all the requirements of the Fund. There can be no guarantee that the Fund will achieve its investment objectives. The information contained in this material does not purport to be complete, is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. In preparing this document, Autumn Lane Advisors, LLC has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission. Send email requests to info@autumnlanellc.com.