By Any Other Name

A: If we call things like long-biased equity long/short funds and private equity equities instead of alternatives, it will look to these people like they are 90% invested in equities.

B: But they ARE invested 90% in equities.

One of the more dangerous things you can do in the markets is engage in self-deception. This is particularly true from a risk management perspective. A hill that I will die on is that much of what we call “alternative” investments are just equity investments by another name.

Nowhere is this more obvious than private equity. In what “bucket” of an asset allocation would you put a thinly traded, leveraged microcap stock that is no-bid for an extended period? There is no debate. It is an equity security. The economic risk exposures of the security are equity risks. Now, this is not a particularly liquid equity. But it is an equity security nonetheless.

Likewise, on the other end of the spectrum, a “defined outcome” S&P tracker with an options overlay is an equity strategy, exposed to equity risk. The addition of a mark-to-market volatility mitigating hedge does not transmute this into some kind of alternative strategy. It is just watered-down equity risk (with watered-down equity returns to match).

I have written about this kind of smoke and mirrors before.

Just because you have exposure to a bunch of different colored slices in a pie chart does not mean you have exposure to a bunch of differentiated sources of risk and return.

As I wrote in that post, I am NOT telling you that you shouldn’t be invested 90% in equities. That is a whole other debate. I am telling you to own your shots. Commit.

For most allocators and private investors, I suspect fiddling with phony-alternative, pseudo-equity strategies is akin to the golfer who is afraid to commit to an approach shot because of some windage. He is afraid of the wind so he clubs down. But because that club selection is driven by anxiety, he doesn’t hit as firm a shot as he normally would have. So he misses short and lands in a greenside bunker.

Don’t miss short! Get it past the hole!

There is an insidious thing that happens when you do not call things by their proper names. Things-as-they-are are gradually replaced with abstractions. This is what is happening with obvious absurdities such as private equity being pitched as “higher returns with less volatility.” From an economic risk perspective, the whole idea is nonsense. But as an abstraction bolstered by “statistics,” it is true.

Of course, I can reduce the volatility of my public equity portfolio, too. I will just mark it once a year, to my proprietary fair value estimates. My down capture will look great versus the S&P. My numbers will be audited and everything. Beautiful!

It is in periods of extreme dislocation that things behave as they are. This is when it becomes obvious that your long-biased equity hedge funds actually capture a decent amount of downside; and your high yield bonds behave a lot more like equities than you thought they would; and that bright hedgie who did a really good job of getting his net down at the start of the selloff keeps it flat into a massive rally… sorry… I digress…

The most egregious portfolio failures, in terms of both missed return targets and poor risk management, result from a failure (or even outright refusal) to see things as they are.

You can call your pie chart slices whatever you want. They can display all the colors of the rainbow. It does not change the underlying nature of the things they represent.

2 thoughts on “By Any Other Name

  1. Other than the large multistrats (Citadel, Millennium, etc.) where it seems like running a levered hedged portfolio plus incredible risk management creates alpha hard to argue. And rumor continues to be that absent the fed put they would have blown up.

    Unfortunately this is what LPs want. When asked if our long biased short duration HY credit fund would get hurt in an election sell off they are surprised when we say of course. Then they ask why we don’t sell down our risk and when we explain that we like the underwriting of our credits and the carry they provide but are happy to go higher cash/lower net but expect us to underperform if we do they absolutely don’t want that. It is a never end circle of frustration.

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