The Way Smart Money Diversifies Risk

by: David Merkel November 29, 2008    
David Merkel

David Merkel

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I’m taking a brief break from “all crisis, all the time” writing. I’m backlogged on book reviews, and it is time to write some.

When I get a book on asset allocation, I suck in my gut and say, “Oh no, not another book that falls into the common traps of only relying on past history, and doesn’t consider structural factors….” I was surprised this time, and I have a book on asset allocation that I can wholeheartedly endorse.

In 'The Only Guide to Alternative Investments You'll Ever Need: The Way Smart Money Diversifies Risk,' Messrs. Swedroe and Kizer have distinguished between asset classes in sophisticated ways. With annuities, they classify immediate annuities as good, variable annuities as bad, and equity-indexed annuities as ugly. I could not have said it better.

They identify real traps for the retail investor: avoiding the structured product, that Wall Street tries to feed retail investors -- they always find new ways to cheat you, encouraging you to sell options that seem cheap, but are quite valuable.

They also describe areas of the asset markets that are less correlated with domestic stocks and bonds — Real Estate, TIPS, Stable Value (I would note that over a long period stable value and bonds do equally well), Commodities, International Stocks, and Immediate Annuities.

Assets that are hybrid between equity and debt tend not to offer much diversification to a balanced core portfolio, so junk bonds, convertible bonds, and preferred stock do not offer much of a diversification advantage. Similarly, Private Equity is highly correlated with public equity returns over an intermediate-to-long time horizon. (I would note that any of those asset classes may present relative valuation advantages at certain points in time, and that expert managers can add value, if you can find them. As for now, high yield is attractive, and there is value in busted convertibles trading for their fixed income value only.)

Hedge funds are difficult to consider as an asset class, as there is much variability across hedge fund types, and within each type of hedge fund. There are many difficulties with survivorship bias in analyzing the effectiveness of hedge funds as a group.

The book has several strengths:

  • How do the costs of an asset class affect performance? (e.g. Variable Annuities)
  • How do taxes affect performance? (e.g. covered calls)
  • How does complexity affect performance? (e.g. Structured products)
  • How do personal factors like age and risk averseness affect what products might work well?
  • How does inflation affect performance?

Now, this is only indirectly a book on asset allocation. It is not going to give you a set of procedures to tell you how to analyze your personal situation, the relative attractiveness of various classes at present, and the macroeconomic environment, and calculate a reasonable asset allocation for yourself, your DB plan, or endowment. But it will give you the necessary building blocks to see how each alternative asset class fits into an overall asset allocation.

Full disclosure: If anyone enters Amazon through my site and buys something, I get a small commission. Your costs are not increased. This is my equivalent of the “tip jar” and so, if you like what I write, and need to buy through Amazon, please enter Amazon through links on my site.

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This article has 11 comments:

  •  
    Nov 29 05:57 PM
    There is no denying that expenses are a definite drag on performance. However, if the "smart money" considers a variable annuity an asset class, no one should follow the "smart money." It couldn't be "that smart!"
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  •  
    Nov 29 07:30 PM
    I have a hard time believing that international stocks are an alternative asset. "Alternatives&quo... are things that don't fit neatly into the three traditional asset clases - equities, debt, and cash. I agree with Dan O'Leary's comment that variable annuties aren't an asset class. They are a very expensive way to invest in equities.

    Most commodities aren't really an asset class either. They're just factors in production. Precious metals ought to be the only commodities worthy of being called an asset class, as they have value independent of any goods made from them.
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  •  
    Nov 29 11:21 PM
    Sounds like an interesting read, but a little arcane. I would love to see more data on historic performance through the depression, what investments did best during those years.
    Reply | Link to Comment
  •  
    Nov 30 07:11 AM
    The way most "Smart Money" diversifies risk is to invest in a number of different assets including commodities, PE, hedge, currency, etc. They can pay multiple managers in various ways to help them gain access to exchanges or products around the world. A retail investor can do that in some part due to the ETF products now available and brokers such as IB, but we'll still lag on the information foodchain.
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  •  
    Nov 30 07:58 AM
    good review as always. Thank you for the idea, it is on my Christmas list
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  •  
    Nov 30 10:07 AM
    On International investments: if you read the book you will see that we don't really consider international equities as alternative asset class. Having said that, we know that most investors, even those that invest internationally, limit the investments to large caps. We show that to get the real benefits of international diversification you should invest in international small, small value and emerging market equities.

    On Variable Annuities: we don't call them an asset class (and hedge funds, venture capital and lots of other investments we discuss are not asset classes either). They are however investment vehicles. And the book is about alternative investments. We also show why basically they should be avoided.
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  •  
    Nov 30 05:11 PM
    Wow, a comment by one of the authors. I'm very impressed. I also appreciate the explanation, as I was feeling compelled to say something about the distinction between asset classes and investment vehicles.

    I would like to say, however, that I have personally experienced the benefits of variable annuities, in both the guaranteed income and guaranteed death benefit categories. If the only benefit to a variable annuity was the tax shelter, then the costs would certainly not be worth it, but there are many additional reasons for using them. Of course, the costs should still be weighed in comparison to the benefits, but many older investors are turning to these benefits today because of their need for lifetime income (without annuitization) and the desire to guarantee something to their heirs.
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  •  
    Nov 30 05:17 PM
    The "benefits" of the variable annuity cited are far more expensive than can be obtained by other means---obtained more efficiently.

    That is one of the things we do in the book. We show how while some investment might look okay, there are better ways to achieve the same result. Example, junk bonds are totally unnecessary and the higher expected returns are better obtained (for variety of reasons) by simply adding bit more equity risks (beta, size +/or value) and then using Treasuries or better TIPS.
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  •  
    Nov 30 05:20 PM
    BTW-Smart money doesn't pay active managers (or hedge funds,etc) to invest. Smart money uses passive investment vehicles like Vanguard index funds, ETFs, and DFA's passive asset class funds. The evidence on why is presented in this book and in my other six, for those interested.
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  •  
    Nov 30 05:35 PM
    I have found that 68 year old retirees who have some pension income and a portfolio worth about $1million don't like to bother with managing it themselves, nor do they like to "complicate" things by having to come up with their own ways of creating certain guarantees which pre-packaged investments offer them. Now, this may not make financial sense, upon which we may agree, but it makes emotional sense to the 68 year old. The companies that offer these guarantees understand this. They simplify what seems complicated to the investor, and this is why these companies keep making money, whether we like it or not.
    Reply | Link to Comment
  •  
    Nov 30 10:40 PM
    There comes an age when it may no longer be wise to fire up the computer in the morning and to do a bunch of trades over your first cup of coffee in the morning, particularly if Alzheimer's is staring you in the face.
    However, relinquishing control (and that is what you are doing) with packaged, structured, and heavily hyped investment products costs money on the one hand (which if you do no want or need, maybe your children or some worthy cause does) and a withdrawal (which is alright if necessary but hopefully not premature) from the management of your own financial affairs.
    But if you have a $million that you do not really need, given a more than adequate pension, might not real return bonds and so on be the best way to go until the spectre of Alzheimer's or whatever appears??
    Not able or not interested, by all means take the packaged, structured, defined beneficiary route. Or maybe gardening is more interesting and keeps cognitive functioning in top condition.
    Reply | Link to Comment
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