Consuming Liquidity

by: Douglas Tengdin, CFA

What is a liquid alternative?

Coffee shop in Greenwich Village. Photo: Joe Mabel. Source: Wikimedia

Alternative investing is investing in something other than traditional stocks, bonds, and cash. It can include real estate, commodities, precious metals, or collectibles, like art and wine. Its appeal is their lack of correlation with the major asset classes. If these assets rise in price but zig when other things zag, they should be able to reduce a portfolio's risk while still contributing to its return.

That's how it's supposed to work, anyway. The problem is that alternatives are subject to the same biases and booms and busts as any other asset. In the middle of the last decade, many institutional investors added oil to their portfolios as prices climbed through 70, 100, and 125 dollars a barrel. There was concern that investors were buying up all the supplies and wouldn't leave enough for the economy to run smoothly. Goldman Sachs predicted prices would rise above $200/barrel. Oops!

Domestic crude oil prices. Source: Bloomberg

Those investments turned out to be correlated to most everything else during the financial crisis, and oil prices crashed. When oil prices recovered again, they spurred new productive technologies like fracking and directional drilling, and oil prices crashed again. Buying oil in 2007 turned out to be like buying gold in 1980: lots of risk, not much return. After everyone jumps on board, it's hard for the boat to leave the shore.

That's why I'm skeptical of the current craze over liquid alternatives - ETFs and mutual funds that invest in theoretically uncorrelated assets. Because no vehicle can be significantly different than its underlying investment. If the economy contracts, wine prices, old masters' art, gold and private equity will contract right along with it. Holding these assets in an ETF that trades on an exchange won't protect you when there's a rush for the exits.

At the end of the day, all investments depend on the underlying economy. There are really only three types of assets, each with its own claim on economic cash flow. Bonds have a senior claim on cash, stocks have the most subordinate claim, and real estate is somewhere in the middle - which is why real estate seems like a hybrid between stocks and bonds.

Each asset class represents a different seniority of claim, with a corresponding level of risk. Everything else is window dressing.