Menu
Markets

The Alternatives Are Correlated

Mention “alternative asset” to the passive investor and a few will assume you’re talking about solar energy. A non-investor might think you’re talking about the name of some new gay nightclub (this was actually asked of me by someone who was not joking).

Mention it to a credited and/or professional investor and it will most likely conjure up images of expensive wine, paintings, classic cars, life settlements (“death bonds”), exotic options and derivatives, and even (as I learned just today) watches.

AltAssets_YES

And yet say the very same to a savvy (jaded?) contrarian investor and they will see the signalling of a market top, or perhaps even a warning sign for the next financial crisis.

An enigmatic term, for obscure investments… that is the easiest way to describe it I suppose.

The idea behind many alternative assets (other than making money, that is) is that diversification and non-correlation are keys to any modern portfolio. In order to protect from market turmoil, or overexposure in any single asset or market, an investor should spread their investment capital across a wide range of assets and markets to prevent massive bloodletting. As such, the more “non-correlated” the better.

Diversification makes a lot of sense, especially for mature investors. Throwing all your money at a single asset or market is not a prudent, or particularly savvy, investment strategy, much like keeping all of your cash tied up in your house (or under your pillow) for an extended period of time.

But diversification, like any strategy, does have its risks. Main among them is that it doesn’t actually matter because we live in a hyper-connected globalized world where everything is correlated.

Having some professional experience in the alternative asset world, I came to realize that the reality of a non-correlated world is that it’s mostly just not true.

The truth is, the more these funds and their managers stress that these assets are non-correlated to traditional assets and market places, the more the sales pitch seems disingenuous. Everything is connected. Everything. We see this time and again. If equity markets take a dive, or currency markets swing viciously, it sends shockwaves to every corner of the (free as well as not-so-free) world. Nothing is spared.

During the financial crisis of 2007–08, I worked for an alternative asset fund (which remains nameless due to the standard non-disclosure requirements I was asked to sign). As part of the sales team, it was our job to relay/convince/persuade potential clients on the viability, strength, and non-correlation that our fund and assets offered. It was an easy pitch with the help of some charts, key statistics, sunny future values, and “semi-cloudy” past performances (pro-forma returns). Moreover, once the “Great Recession” dug its teeth in, everything we had been saying seemed to be proven right. It was a great time within our team, and everyone felt a sense of pride and excitement at being on the right side of such an ugly market environment.

Little did most of us know (at least the sales team) what would happen in the months and years to follow when the market turmoil of the Great Recession worked its way through the system like a cancer, corrupting everything in its path. It starts out small, a blip on the radar, and then metastasizes into something severe before you even realize it.

That little blip was a red flag, but noone noticed. Confidence, hubris, and excitement clouded all judgement and blinded the path of the once “enlightened ones.”

No one knew, or at least dare say out loud, that once the money spigot was turned off, once fear crippled the once jubilant investment crowd, and once professionals actually started to pay attention to mark-to-market risks, that the whole alternative investment world would be turned on its head. The very concept of of non-correlation was chewed up and spit out.

Mark to market (MTM) is the difference between an asset’s book value (unrealized value) to its real market value. MTM is problematic for many paper alternative assets because the assets’ values are based on the current state of the market. For example, life settlements have serious issues when it comes to mark-to-market risks. A life settlement is an active insurance policy that has been sold on a secondary market. The problem, and I’m being exceptionally casual when I say this, is that an enforce insurance policy is not an actual asset. Rather, it is a liability until the insured passes. So what is the fair market value for a liability that has some sort of chance to become an asset in the future? Confusing? Yes. And also highly correlated to any economic cycle we may be in.

In addition, what about these “alternative assets” that don’t trade on public exchanges? How should a fund fairly value a 1966 Porsche 911 if the bottom falls out of the economy? Or a 2005 Bordeaux? Or a 1970’s classic Rolex Submariner? In a downward spiral, what is that bottle of great wine or expensive watch going to mean to someone else if each investor is experiencing the same crisis? Why would anything other than survival necessities increase or retain value?

The interesting and frightening thing about our new globalized and highly connected world, is that its globalized and highly connected. Non-correlation seems more likely a fallacy. During the financial crisis every market was chaotic—even gold, the highly touted “safe haven” asset, was headed south. Nothing was safe from the market turbulence during the peak of the crisis. If you didn’t feel like your portfolio was vulnerable and highly connected to what you were witnessing on a daily basis at the most dramatic time of the crisis, you must be kidding yourself now. The only people possibly not concerned were non-participants… but even that seems highly unlikely unless they were in an intoxicated coma.

In any event, investors—retail and professional—need to realize that non-correlation is now heresy in our newly integrated financial world. This connectedness is rapidly growing stronger each year, too. Technology is helping by closing gaps and slowly flattening out arbitrage (at least for those without high-frequency trading systems). When, for example, the next credit/debt crisis happens in Europe, North America, or Asia, you can be sure it will have similar devastating results on all asset classes worldwide. So investors (anyone, really) would benefit by understanding that the terms “alternative” or “non-correlated” do not exactly emphasize the reality or hold the same meaning they once did.

Investors should take a good, hard look at their portfolios. Instead of looking at them as a pie chart in pretty shades of pleasing colors, though, imagine them as a linear decline chart. Once one falls the others will also. Some faster, some slower, and some harder… but everything is heading towards the same inevitable conclusion the next time we have a more serious financial crisis. Or as Zero Hedge puts it, “On a long enough time line the survival rate for everyone drops to zero.”