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BULLS & BEARS: Alternative investments are the rage-so beware

December 4, 2006

Pension and endowment funds across the country, including some in Indiana, are stepping up to the alternative-investment craps table holding a pair of dice.

Should you care? Well, if you are a taxpayer, a pension beneficiary or a charitable contributor, your attention is required. The outcome of this massive reallocation of investment dollars may determine your future tax burden and the retirement security of millions of Americans.

Fiduciaries are in the process of executing an enormous shift of money away from stocks and bonds, and into hedge funds and private equity funds. As such, the future financial health of many retirement and charitable funds will, for example, be less dependent on the long-term performance of General Electric's stock.

Instead, the ability of these institutions to meet their contractual obligations might rely more on the short-term return of a pool of leveraged sub-prime mortgages, or perhaps on whether certain stock-index futures trade with lower-than-expected volatility over the next month. It also might depend on whether the public can continue to be persuaded to invest in recycled IPOs that are saddled with debt.

What is driving this seismic shift? Let's roll the dice and see. In a previous column, we described the phenomenon of the "institutional imperative," where investment committees and their consultants gravitate toward what has worked in the past. Feeding the current pattern of group-think is the high returns that Harvard University and other early adopters of alternative investing have scored over the past several years.

Armed with data showing mid-to-highteens historical returns, the well-compensated consultants are steering their institutional clients toward the hope of higher returns in alternative investments.

Ironically, this sea change is in response to the subpar returns earned by institutions from their last major asset allocation shift-which was the stampede into large-company growth stocks in the late 1990s.

But the results of that shift were miserable. The dollar return on an investment made in the S&P 500 index (a proxy for large-company growth stocks) at the end of 1999-almost seven years ago-is zilch, virtually zero.

Meanwhile, some independent-thinking people-some of them running hedge and private equity funds-were scooping up bargain securities at cents on the dollar. In fact, take a look at the performance of a small-company value mutual fund over the last seven years and you might be surprised to see annual returns in the high teens.

One might conclude from this that the returns touted by alternative-investing cheerleaders are not as stunning as the consultants might have you think. Investors would have done well merely by investing contrary to the institutional imperative at the time-selling large-company growth stocks and buying small-company value stocks.

Which brings us to today. The cascade of money from institutional investors flowing into alternative investments is strikingly reminiscent of the record cash flows into mutual funds in early 2000-literally weeks before the stock market peaked. The bargains that existed years ago have vanished, as their prices have risen to reflect their full values. As such, the high returns institutions are hoping for with this allocation shift will be disappointing-once again.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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