Risk & Opportunity

A quarterly political and economic newsletter published by Michael Cuddehe

Q1 '02

Why Alternative Investments?

As anyone who has been paying attention can tell you, current opportunities in traditional investments are less than inspiring. While conditions in the near term are likely to improve somewhat over what we have seen for the last two years, that still leaves a lot to be desired. For an excellent review of the current traditional investment landscape I refer the reader to a March 17, 2002 L.A. Times article by Tom Petruno entitled Allocating Assets Gets Tougher For Investors. But this article focuses only on the surface level of current and prospective returns. What it does not delve into is the deeper political and economic trends, imbalances and excesses - the big risks - that are extant and which have direct bearing on the traditional investment arena.

The defining characteristic of all investment mediums today is pervasive risk. After an eighteen year bull market there are many excesses in the marketplace that need to be purged and an eighteen month bear market without even an "official" recession is not going to do the trick. Purification is the function of bear markets. It is a natural and necessary function and it never ceases to amaze me that this natural market cycle is looked upon with such fear and loathing. As investors we need to accept and work with the markets as they are, not as we would like them to be. We are in the early stages of a bear market that began with the dotcom sell-off. The Enron fiasco has ushered in a major round of purification, but it will not be the last. Stock market investors should beware of rosy but entirely unfounded predictions of a renewed bull market. Quoting Warren Buffet from the Berkshire Hathaway 2001 Annual Report, "Though Enron has become the symbol for shareholder abuse, there is no shortage of egregious conduct elsewhere in corporate America." This sentiment from the dean of value investors places the rampant and unabated greed in the executive suites in focus - a fundamental excess that needs to be purged.

There are also serious problems festering in the fixed income world. The agencies are currently carrying an enormous amount of leverage -- a problem that will eventually have to be dealt with and which is going to cost plenty. How will that inevitability impact real estate values, the cornerstone of the public's economic sense of well-being? For that matter real estate values have long been out of wack with rental values and dependent on inflation to make up the difference. This imbalance will not continue forever. When and how will it be resolved? And let's not even think about looking under the carpet in the muni marketplace. Most investors are also not paying much attention to our long-term dependence on foreign investors to fuel our capital markets, not to mention our continuing dependence on the volatile Middle East for our energy needs and our government's steadfast refusal to take measures to correct that dependence. These are just a few of the excesses that have built up during the good times. Any and all of these imbalances could impact us at any time. If we're lucky they will be resolved sequentially and not simultaneously.

Add to this toxic stew geopolitical instability and the fact that our current administration seems to be intent on pressing its own agenda regardless of anyone else's interests or concerns, upending the status quo globally. Policy issues aside, when you disrupt the status quo, persistently and globally, unexpected things are going to happen. And let's not forget the very real prospect of periodic acts of terrorism. As investors, it's not the known risks that we have planned for that are going to hurt us, it's the unexpected, the "rare events," that are the real risks that we need to be prepared for. This means structuring an investment portfolio that is properly diversified and sufficiently liquid to be able to sustain repeated shocks and hopefully profit from them as marketplace excesses are corrected and geopolitical events play themselves out.

Alternative investments provide an avenue to take the best that the investment world has to offer and to simultaneously hedge against the unexpected "rare event," which seems to be not so rare as statistical models would have us believe, especially these days. In an environment with pervasive risk throughout all sectors, a well-managed alternative investment strategy that employs aggressive risk management will provide vastly superior risk-adjusted returns over a traditional investment strategy.

Alternative investments are often painted by traditionalists as high risk strategies that are only for the most adventurous. While this characterization is true for some alternative strategies, it is a gross oversimplification and misrepresentative of the excellent risk adjusted returns available from alternative investments, which range from very tightly controlled, low volatility arbitrage strategies to more volatile directional strategies.

Furthermore, those sectors and strategies in which risk is an accepted and recognized part of the landscape have evolved systems, methods and strategies to manage that risk. Meanwhile those sectors and strategies that assume a stable underlying growth environment and which believe that they have limited risk have lagged in risk management and remain vulnerable to the so-called "rare event."

Putting aside the issue of pervasive risk, there are other reasons to favor alternative investments. Technological advances have created new opportunities and disruption to traditional models in every field, and the investment world is no exception. Alternative investment managers have embraced the opportunities presented by technological advances to create and deploy advanced systems for market research, statistical analysis and risk management and to utilize these systems to produce superior risk-adjusted returns all along the risk/return spectrum.

Finally, the foundation of good investment management is diversification. Alternative investment strategies support the optimum application of the principle of diversification, making available a broad range of strategies and mediums that are not readily available otherwise. For a somewhat more technical but very readable explanation of the value of diversification I refer the reader to an article archived on this site entitled Not All Apha is Created Equal by Jon Lukomnik.

For further reading and another perspective on this matter, I refer the reader to another article archived at this site entitled The End of the Benign Economy and the New Era for Managed Funds by Mark Rzepczynski.

For those who want to spend some time to gain a deeper understanding of the current global economic and political crisis, I refer the reader to a book entitled False Dawn by John Gray.

Copyright 2002, Cuddehe Capital Management, Inc.

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