Seeking Alpha

2 Speed Vs. 2 Directions: Old Better Than New - Weekly Blog # 566

by: Mike Lipper, CFA
Summary

Investment survival and successful investing are often in conflict. This age-old quandary is facing us now. We instinctively know that losing money does not promote successful investing.

This thinking is captured in the first two great rules of investing: Don't lose money and Don't forget the first rule.

Unfortunately, the modern solution to this puzzle, Alternative Strategies, doesn't work most of the time.

Investment survival and successful investing are often in conflict. This age-old quandary is facing us now. We instinctively know that losing money does not promote successful investing. This thinking is captured in the first two great rules of investing: Don't lose money and Don't forget the first rule. Unfortunately, the modern solution to this puzzle, Alternative Strategies, doesn't work most of the time.

According to the latest data from Refinitiv (owner of Lipper data), there are 1507 mutual funds investing in 8 different types of alternative strategies, with assets of $239 billion. Similar strategies are followed by numerous hedge funds. The Investment Company Institute (ICI), the mutual fund trade association, has 5 categories of alternatives.

Within the ICI roster of alternative categories, the range of liquid assets is between 42% and 14%. The asset composition of alternatives includes liquid assets (cash or short-term debt) and two or more active groups of risk and debt related investments. The managers of these funds use liquid assets to cushion the periodic volatility of their more active investments, with the cushion theoretically improving the alternative portfolio's relative ranking vs. active investment funds.

While this will produce a slower speed of decline, it is rare that these strategies produce better rates of return over time. Even though cash was the only major asset class to generate a gain in 2018, it is extremely rare for the same long-shot horse to win two races in a row as a long shot. (One of my lessons from racetrack handicapping)

Starting at least in the 19th century, trustees of wealth used a balanced approach, often owning both stocks and bonds. Many early US mutual funds were balanced funds. They followed what appeared to be a sound strategy, as stocks and bonds moved in the opposite direction (two-way street) most of the time.

The reason for this divergence is that bonds generally increase in value when stocks appear to be risky. This yin-yang relationship is less true today, as the movement of interest rates is driving both equities and debt.

The 757 balanced funds with assets of $485 billion gained +7.31% on average in 2019, better than the averages for all alternative asset categories. This was also true for the 5 years through this past Thursday, where balanced funds averaged a return of +5.08%.

Only one of the alternative categories slightly beat balanced funds for the past 52 weeks, +3.05% vs. +2.51%. I suspect the reason for the balanced funds' superior performance was that on average they only have 6.07% invested in liquid assets, compared with the 42%-14% mentioned above.

Short And Long-Term Observations

Short Term

The American Association of Individual Investors (AAII) weekly sample survey of its members are now reporting that 42% are bullish compared to 20% being bearish. This is a very volatile time series and often a negative indicator.

Long Term

Since 1926, the annualized total reinvested return for the S&P 500 has been +10.1% and the Russell 2000 +11.9%. These factoids deserve a couple of ancillary observations. For a long period of time, the equal-weighted S&P 500 performed better than the more popular market-weighted version, suggesting there may be more relative market risk in the popular FAANG shares.

The better performance of the Russell 2000 suggests that the acquisition of its companies has overcome the drag of its component companies with losses. The shrinkage of the number of attractive small companies has led to managers like T. Rowe Price and Longleaf closing their small company funds. This could have the impact of raising the prices of some small-caps due to a perceived shortage.

Question Of The Week:

What level of decline do you think you can tolerate without making material changes?

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.