Contents Introduction 1 The Alternative Manifesto 2 Do Alternatives Work? 3 Major Alternative Strategies 4 Major Alternative Structures 5 Higher, Inflation-Protected Current Income (Job 1) 6 Broadening the Base for Risk Reduction (Job 2) 7 Long-Term Growth Enhancement (Job 3) 8 Purchase Power Protection (Job 4) 9 The Big Picture 10 At the Dealership Conclusion: It’s Time! Acknowledgments Glossary Resources About the Author Praise Credits Copyright About the Publisher Introduction We’ve been taught that the investing universe is made up of stocks, bonds, and maybe some real estate. But elite investors know those categories represent only a fraction of the real possibilities . . . and that by broadening their choices they can, and do, dramatically improve their total returns while simultaneously reducing their risks of big losses. That the rest of us didn’t even know about these “alternative investments” hardly mattered, because we couldn’t invest in them anyway. That has changed. Today nearly all investors should be expanding their investment horizons to profit from these new opportunities . . . and also to protect themselves from the inevitable next major market shock. That’s what this book is about. Admittedly, the vocabulary of this world is a bit odd, but the ideas are not difficult. Over my thirty-year tour of duty in alternatives—as a lawyer, investor, entrepreneur, and director of broker-dealer and asset management firms—I’ve constantly been amused by the way these relatively straightforward concepts are wrapped in such crazy lingo. After all, the original “alternative investors” were the European aristocracy who threw their art and gold into saddlebags, fled temporarily, and later returned to their timberlands. And somehow they managed all that without ever hearing a peep about reversion to the mean. Even the original hedge fund manager—Benjamin Graham, the hero of Warren Buffett, in fact—was just a classic value investor who recognized that simply buying cheap stocks while simultaneously shorting expensive ones would create profits regardless of overall market movement. If you’ve never had anyone explain to you exactly how “long/short” strategies work (you’re about to), it may seem marvelous and sound oxymoronic; but once you have, it’s pedestrian. And so it goes. The language and tactics may be unfamiliar, but the core ideas are vital. The “secrets” of alternatives, so effectively used by the world’s top investors for decades, are essential tools for anyone hoping to survive financially when more common options are volatile, limited, and unrewarding. Now, obviously, everyone approaches this topic with different financial needs and goals. Therefore, to make the book as useful as possible, it’s organized around the four essential jobs that investments can perform: Job 1: Generate greater income than typical fixed income instruments provide, with a focus on income that rises with inflation. Job 2: Reduce overall risk by diversifying into a radically broader set of strategies and assets, and by incorporating insurance against stock downturns. Job 3: Enhance long-term growth through opportunities with substantially more upside than traditional investments. Job 4: Protect purchasing power from inflation, currency devaluation, and crises. As we progress you’ll discover dozens of new strategies and asset classes, from royalty rights to global macro funds, and from start-up investing to timber. Certainly not every option will be suitable for all investors, but there is one common, ultimate goal: to maximize returns and mitigate risks. If you already know a bit about alternatives, you may be surprised to see that the content is not organized by subjects like “Private Equity” or “Real Assets” or “Hedge Funds.” Rest assured, they’re explained in full. But these labels are of little practical use to investors, not only because of extensive real-world overlap, but now also because the picture has been blurred by new mutual funds and ETFs* that deploy many of the same strategies. Instead, we’ll start with an overall explanation of why and how alternative strategies work (chapters 2 and 3), describe the vehicles in which you’ll find them (chapter 4), and then go in to more strategy-specific detail as we describe how investors of different financial status can fill those four jobs (chapters 5 to 8). The entire story is brought together in “The Big Picture,” chapter 9, with model portfolios tuned to different levels of wealth and liquidity, and also to the investor’s view of our long-term economic prospects (you’ll hear mine). Then you’ll get all the tools necessary to get to work, with a list of resources for help in finding opportunities, the key questions to ask before investing, and a glossary. OK. If you’re new to the subject, you might want to just pop right over to chapter 1 and dive in. Have fun! If you are already familiar with the topic, an investment professional, or just really curious about the book’s conceptual framework, stick around for a few more paragraphs. Perhaps you’re wondering how the contents relate to what you already know about the alternatives landscape. So, for your convenience (meaning, so you can decide whether you actually want to read the book or not!), here’s a summary. The basic approach is an adaptation of the strategic asset allocation model that endowments have used for years, one that reflects two critical modifications. First, there’s great focus on liquidity and inflation-protected income. Second, it incorporates the latest analysis regarding portfolio construction, specifically regarding accumulation of risk premiums and avoidance of cross-asset class vulnerabilities. You might say the result is something of a “postendowment” model. Many of the terms used in the book will be familiar, but they’re used in a particular way and in a particular hierarchy. So here’s a digest. The conceptual starting point is that portfolios should be “panoramic” and “risk-tolerant.” Panoramic portfolios are highly diverse, taking advantage of all available assets classes and strategies for income and growth across broad-time horizons. One underlying theme is that, despite the obvious importance of liquidity, many high-net-worth investors and family offices are overlooking excellent long-term opportunities given the high illiquidity premiums the market is offering. The coequal principle is that the portfolio must be risk-tolerant. This has three aspects. First, most liquid securities should be held in strategies involving active risk management to protect against loss. Second, portfolios should house assets and strategies that produce “uncorrelated” returns, responding independently to different kinds of economic environments. One test of a risk-tolerant portfolio is whether it includes both “convergent” and “divergent” strategies. As creatures of modern portfolio theory, convergent strategies tend to do well in normal markets; but divergent strategies are superior during periods of higher volatility, probably because they are based on the very different dynamics of supply/demand and behavioral economics. Third, risk-tolerant portfolios should be “absolutely diversified,” with a focus on vulnerability diversification. This goes beyond “noncorrelation” and even beyond the concepts of convergent and divergent strategies in ensuring that the various investments are not all subject to a given systemic risk (e.g., another credit freeze), economic regime (e.g., inflation or deflation), or geopolitical event. Modern investors need modern tools. And they exist; it’s just that there’s been no reliable user’s guide. Now, I hope, there is. CHAPTER 1 The Alternative Manifesto Divide your portion to seven, or eight, for you do not know what misfortune may occur on earth. —KING SOLOMON, ECCLESIASTES 11:2 Yale’s endowment is up 100% over the past, extraordinarily difficult, decade. I won’t ask how you did. So, what’s up? Using all that IQ to pick great stocks? Hardly. The trick, in fact, is that mostly they aren’t picking stocks at all: in 2012, only 6% of Yale’s portfolio was in U.S. equities. Instead, fully half resided in things called “absolute return,” “private equity,” and “real assets” strategies. Another big chunk was in emerging markets. Those are the secret ingredients of an investing formula that is now widely followed by most other endowments, foundations, and the rest of the smartest money on the planet. The lesson is loud: in our ever more volatile and complex world, a long-only, domestic stock and bond portfolio is inadequate. Those traditional securities represent only a tiny sliver of the potential investment universe: many of the best opportunities are, simply, elsewhere. Even more to the point, the biggest key to long-term wealth is loss avoidance; and, as I bet you’ve noticed, traditional portfolios are subject to periodic, devastating, crashes. Until very recently, there wasn’t much typical investors could do to expand their horizons or limit their downsides. Not to diminish their spectacular results, but those institutional investors and their ultrawealthy friends have had an unfair advantage: access to strategies and vehicles that were both unknown and unavailable to the rest of us. That is changing extremely rapidly. Average investors are no longer stuck with the children’s menu of investment options. But what about the standard investing gospel, like our much-beloved 60/40 stock-bond portfolio? Are the old rules really passé? Well, in the most recent (and certainly not last) crisis, they provided about as much protection as a five- dollar umbrella in a hurricane, but you knew that. The real issue is that our bedrock principles actually have quite a poor long-term track record for safety and consistent returns. Let’s consider the three big rules that everyone’s been taught . . . but that are wrong. Mistake 1: A 60% Stock/40% Bond Portfolio Is Ideal. At first glance, the results of this standard allocation don’t look so horrible: a long-term average annual return of 4%. But this is a wonderful example of just how misleading statistics can be. The damning truth is such a portfolio suffered six collapses in the last century in which the losses exceeded 20% . . . utter disasters that each took more than a decade to recover from in real terms. There is no reason to expect this pattern to change. Another way to look at that long-term average: throw a dart at a list of the last hundred years, and pretend you had invested in whatever year it hits. The odds are nearly 25% that, a full decade later, such a position would have shown a loss. That sound like a conservative strategy to you? OK, but those bad periods aside, surely the rest of the time the returns have been great? Hardly. We’ve had eleven decades of experience with annually rebalanced 60/40 portfolios since 1900. In the majority of cases, seven out of those eleven, the average annual real return was less than 1%. Surprisingly, the current Mojave Desert of returns is absolutely historically normal.* That gaudy 4% average annual return is explained by just four absolutely exceptional decades: the ’20s and ’50s (postwar periods), and the ’80s and ’90s (the end of yet another war, this time cold; and our unrepeatable debt accumulation, which we’re now working off). So unless you think we’re on the cusp of another historically anomalous growth period, 60/40 is not the way to go. At least, not without a camel. Even that history doesn’t relate the whole scary story. The bond bubble that’s been expanding for decades makes the “safe” component of a 60/40 portfolio into a potential hand grenade. The last period in which Treasury bond valuations were comparable to today’s was followed by forty-five years of negative real returns. Forgetting history, it’s simple common sense that the Fed’s ferociously loose monetary policy makes inflation, and a major tumble in bond prices, highly likely at some point. And, no, it won’t work to simply hold the bonds to maturity so you get all your principal back, because those dollars will have, by definition, then lost major purchasing power. That’s precisely what bonds are supposed to protect. Mistake 2: Stock Diversification Equals Safety. The standard method of “diversification” involves spreading stock selections across the “nine buckets.” Those are defined by a matrix with “small, medium, and large” down the side, and “growth, blend, and value” across the top. Fill up all the buckets, and you’re good to go. But, as you know, the crash emptied all nine at once. Well, maybe we should have included foreign equities, too? Not a terrible idea, certainly, but that won’t get you the sort of diversification that yields safety. That idea may have helped when world markets sang in different keys; today, however, they have fulfilled the ardent wishes of that famous old Coke commercial, and learned to sing in perfect harmony. Well, then, what about diversification across asset classes? That’s headed in the right direction, but is still not enough; my guess is that in the Great Recession your home value didn’t exactly cushion your stock losses. Merely spreading dollars around, even among apparently many different assets or strategies, does not necessarily provide the safety we need. A key reason is that some assets are inherently more volatile than others, so that dollar weighting does not equal risk weighting. For example, the long-term performance of a 60/40 stock/bond portfolio mimics a stock-only portfolio nearly perfectly: 95% of the combined volatility is driven by stocks alone. Bonds do almost nothing to balance out stock performance. The crash was so devastating for a different reason, though. It turns out that apparently diverse asset categories can share an unnoticed Achilles’ heel (often, leverage). Forgive the trite example, but different financial assets can be taken out by a single risk in much the same way that different telecommunications systems—phone, television, and the Internet—all bit the dust in Hurricane Sandy for “triple play” customers who relied on a single wire for all three. The way to address this sort of risk is by emphasizing “uncorrelated” income streams and “absolute diversification” in the portfolio. We’ll dive into this later, but meantime here’s an interesting fact to hold you over: the biggest timberland owner in New Zealand happens to be . . . Harvard. Now, we’re not exactly suggesting that you start buying trees on the other side of the planet (yet), but good modern investors will certainly adopt radically broader portfolios in aiming for safety. Mistake 3: Buy and Hold [insert asset class here] Always Wins in the Long Run. No parent trying to pay tuition from a devastated college fund needs to hear what’s wrong with this idea. Nor do folks who once thought real estate “can’t go down, because they aren’t making any more of it” . . . as this is written, fully one-fifth of all U.S. homes remain substantially less valuable than the mortgage on them. Maybe the Fed’s desperate attempts to engineer inflation to fix this problem will eventually work, but those homeowners will never recover what they toss away each month on the underwater mortgage. Stubbornly holding on to assets as they head south can just kill you. The cruel math of losses means that a 50% loss—from $100 to $50—requires a 100% gain —from $50 to $100—to break even. It’s simply unrealistic to expect people with