Ever heard of Steve Eisman, a Harvard law graduate from New York, or Michael Burry, a physician from Califorinia? They are two of the investors featured in Michael Lewis’s book of 2010 The Big Short. Lewis tells how the pair and others made money from the crash of 2008.
Eisman, Burry et al earned stellar returns as the US subprime crisis morphed into a global financial crisis because they had ‘shorted’ securities linked to the US housing market. ‘Shorting’ describes taking bets that securities will decline in price. ‘Shorters’ sell something in the hope of buying it back at a lower price.
While shorting can be controversial to the extent it was banned in some spheres during the Global Financial Crisis, it’s a valid investment strategy. It allows investors to take advantage of negative views on securities, just as conventional or ‘long’ investing lets investors profit from positive views of securities.
A key attribute of shorting investment strategies is that returns are no longer linked to benchmarks. Short-selling and long-short funds have proliferated in the US and elsewhere since the 1960s because overall they have proved they can generate positive returns in all market conditions.
As such, they are regarded as alternative options to long-only investing in conventional asset classes such as bonds, cash, property and shares.
When fund managers are operating share funds paced against a benchmark such as the ASX 200 Index, they are successful if they outperform the index. While a manager might have starred by only copping half the decline of an index, investors still lose money. That’s why alternative strategies that seek to provide absolute returns are of interest.
A skilled alternative manager can help investor protect capital and diversify risk while offering decent returns above cash. A portion of an investor’s portfolio eking out positive returns year after year partially offsets the erratic returns of shares and the steadier, but sometimes falling, returns from bonds.
Alternative strategies come in more forms than short-selling and long-short approaches. The term covers global macro strategies that seek to exploit movements across currencies, industries and markets. Event-driven alternative approaches hope to capitalise on situations such as bankruptcies, takeovers, political changes and weather events. Arbitrage strategies try to earn returns from fleeting mis-pricings. Private-equity investing come under alternatives too as it seeks to earn positive returns from unlisted companies and untraded debt. Alternative strategies often use debt or derivatives to juice returns, though this boosts their risk too.
Alternative strategies are just like conventional long-only investing in that they are seeking to exploit the same short-term market inefficiencies – it’s just that they aim to do that in an unconventional way. Such strategies have served investors so well over time that Prequin, a UK-based consultancy for alternative investments, estimates there is now about US$14 trillion ($21.2 trillion) in alternative strategies. Australian investors could do worse that consider injecting alternatives into their portfolios.
To be sure, alternative strategies are unlikely to generate the stellar returns as shares sometimes can – perhaps an alternative strategy is doing well to reliably produce high single-digit returns whereas share markets can soar more than 20 per cent from time to time. Many alternative investments offer no regular income. They are often risky; there is no guarantee of a positive return. Some alternative strategies can be hard to fathom. There is no alternative benchmark against which to measure these strategies. You can’t easily judge the appeal of alternatives as a group.
But time has shown the worth of many alternative strategies operated by skilled fund managers. People write books about the best of them.