By Ian Morley*

I love that old adage that paraphrases as, “the future is the hardest thing to predict.” Unless of course like me you are a life long Tottenham Hotspur fan (for non-UK readers, a football team that plays in the English Premier League) and are familiar with the annual triumph of hope over experience. If Spurs were a cyclical agricultural stock they would go up only to come down, and have not been an evergreen since the 1960s.

But as we all know, nothing in life is certain apart from death and taxes and therefore, following the credit crunch and mass destruction of wealth that followed, we are now entering  a period of re-evaluating our approach to risk and return from our investments.

Risk has moved from a four letter word to a theological concept, with global regulators in a competitive rush to de-risk the market by applying capital levies across a wider range of financial institutions and a potential tidal wave of new rules to accompany them. Meanwhile, a few smart investors worked out that all asset classes had been de-risked simply by a price collapse approaching nearly 100% in some cases, and close to 50% or more for some major stock indices.

The investment decision was binary and simplistic. Fill your boots almost indiscriminately and expect either a dramatic rebound (lots of history to support this theory) or the end of the world (see Noah for details - Genesis, Chapters 6-9). That is why so many indices that do not have emotions, risk teams and views simply went straight back up while most active managers, traditional and alternative, lagged behind while they all  de-risked, messed about with the models, raised cash, worried and discussed Armageddon.

Traditional Alternatives (what a great oxymoron that phrase has become) did reasonably well but came out of it quite badly. The reasons are both clear and yet somewhat contradictory. The hedge fund and fund of fund pitch had become distorted and misheard.

What hedge funds actually do is lose less in bear markets and make less in bull markets. The net result is better risk-adjusted and absolute returns over time. The pitches, however, had wrongly morphed into: alternatives (read hedge funds) deliver absolute returns in all market conditions and are un-correlated with traditional assets like stocks and bonds. As investors hear the news they want to hear the sellers adjust the story to fit, as they like earning money by selling good news.

Now another little twist of distortion has occurred. In the last few years, institutional investment in alternatives had grown from a trickle to a flood, some of it direct but much of it filtered via consultants. Most investors and consultants feel comfortable with names and companies they have known for a long time. Similarly, they are generally more comfortable with investment ideas that feel safe and familiar - albeit with a new “absolute” name tag attached.

The confetti-like use of this newspeak resulted in almost every good, mediocre and bad fund manager quickly working out that it makes more sense to be paid 2 and 20 for an absolute fund than 30 basis points or less for a long-only version. As a result there was a huge expansion of long-only managers suddenly becoming long/short managers. Let’s forget for the moment that some of them wouldn’t know a short if they fell over it. Now the promise is the new absolute-return long/short fund managed by Ura Loser and Ima Winner.

As a result, a lot of investors bought the absolute-return offerings from the names they knew from the long-only world without doing much due diligence. Worse, most long/short strategies are by nature about 70% long and therefore highly correlated to the very stocks that they hoped to diversify from. To compound the problem, these investors ignored, because of fear, lack of knowledge (ignorance) or sometimes just prejudice many of the hedge fund strategies such as CTAs and global macro that are true risk diversifiers. As a consequence, they ended up with alternative portfolios which were in many cases no more than an extension to their existing traditional long-only portfolios and diversified in name but not fact.

Here comes the contradictory irony. When all this fell apart, they complained very loudly that the alternative part of their portfolio had not protected them from the rule that all correlations go to one during bear markets. A true own goal!

While the current pick up in demand for hedge funds and fund of funds is more talk than action the desire to change to real alternative, alternatives is palpable. Following a number of client meetings and virtual cry’s from the heart at some invitation-only investment conferences, the irreconcilable (can we please have transparency, liquidity, managed accounts, segregated custody, insurance, better regulation and higher returns with guarantees if available,  and without structures, leverage, gates, lockups… the list goes on) needs to be addressed.

Coming back to where we started about the future being hard to predict: parts of it are clearly not. You don’t have to buy the science for green energy, just feel the sentiment and measure the public support. Theses investments for credibility purposes  need  good stories attached to them , but clearly all forms of new energy (idiots growing bio fuels on arable land being a notable exception) make us all feel good about ourselves and the chance of making money as well.

Sadly, it’s not as easy as that. You need to do your homework. What technologies will work?  Who has a leading edge? How quickly will the Chinese or Indians make a commoditized version? On a global scale, is solar better than wind or tidal or geothermal? What if Malthus was right that as the global population grows exponentially, food only grows linearly? And then what happens when a billion middle-class Asians in 2050 all want to eat McDonald’s? If you don’t know, then how do you know that the people selling you these solutions are any more than a page ahead of you in New Scientist? The truth is you probably don’t! So, as always with investments, do your due diligence properly before buying into the best new alternative storyteller. Otherwise you may be doomed to repeat at leisure the false hope you had from the supposed alternatives that you
bought last time round.

*Ian Morley is the founder of Wentworth Hall Consultancy in London. A prominent figure in the hedge fund industry, he has advised the Bank of England and was the first chairman of the Alternative Investment Management Association.