There’s not a lot out there right now that’s enticing from a long-term returns perspective. The US stock market is priced to perfection and bonds are almost guaranteed to only beat inflation by 1 percent or less for the next 10 years. As a result, alternatives are often touted as a way to generate non-correlated returns that will help dampen the overall portfolio volatility in the current low-return regime. Larry Swedroe suggested the AQR Style Premia Alternative Fund, LENDX, which does alternative lending to small businesses along with consumer and student loans, SRRIX, a reinsurance fund, and AVRPX, which is a fund that sells volatility insurance across stocks, bonds, currencies and commodities.
I have a few objections to those potential sources of alternative returns:
- “Alternative Lending” is often predatory and focuses on high-risk borrowers, so hard pass.
- Given the likely increase in global warming related natural disasters it’s hard to get excited about taking on catastrophe risk.
- Since we have historically low volatility it’s not really a great time to pile into premium selling.
- AQR’s Style Premia Alternative fund isn’t exploiting any inefficiencies that the market doesn’t already know about and has likely priced accordingly.
So what opportunities are left for a non-institutional trader? Signalee is currently focusing on the following:
Emerging markets are the “cheapest” asset class if you look at research from GMO, Research Affiliates, and StarCapital (which you should!). But stop to think about which emerging markets you actually want to own. A lot of them are focused on resource extraction; a lot of them are terribly corrupt with significant rule of law issues; and a number of them have gone too far down the socialist continuum to where taxes and government are too much of a burden on local business [Note: before you misread this comment, I’m a big fan of social safety nets provided by the government. Capitalism is the best system for resource allocation and improving lives but only if you have a prudent government as a counterbalance to its worst excesses.]
While emerging markets are the cheapest, you have to be selective about which emerging markets you own. For Signalee, that means South Korea as the risk of war is overblown.
ex-US Developed Nations
Relying on GMO, Research Affiliates, and StarCapital’s research again, developed markets ex-US are projected to have the second best returns of all the equity classes. Since you generally don’t have the rule of law issues with developed nations that plague emerging markets and developed nations are called that because their economy is reasonably diversified, the only thing that is causing depressed prices for ex-US developed nations is more socialistic governments and aging demographics.
For us, since there aren’t as many surprises lurking in developed markets, we typically just own super-cheap market-cap indexes and use that as the basis for our core position trading.
US Real Estate
US real estate might seem like an odd core position to include in a rising interest rate environment. And for the YTD period an owner of VNQ would be sitting on an ~10 percent loss without any opportunities to trade around it to reduce the total loss. But two factors argue for its inclusion:
- An improving economic situation typically causes rents to rise enough to offset the pressure from increasing interest rates.
- A simple estimate for long-term real estate returns is simply to take the dividend yield and add the rate of inflation (this assumes GDP is positive over the long-term). So the real return of real estate is the dividend yield. For VNQ that yield is currently 4.4 percent, which is better than most alternative options.
The only caveat to REIT holdings is that too severe of a depression can cause massive losses in a core position given its inherent leverage. As long as you maintain dry powder to trade around the ups and downs then it’s less of a problem.
Commodities probably won’t be as long a holding as the other three core positions listed above since they’re typically mean reverting. Some people have even argued that the real return of commodities is zero. While that’s a little oversimplistic, it’s an easy mental place to start from. So the question becomes why do I have commodities as a core position and how do I expect to make money from it?
Commodities are sensitive to the economic cycle and since the entire world is in expansion mode, the demand for commodities is increasing, which is why you’re seeing prices increase. Owning commodities in an expansionary economic environment is the first and easiest way to make money. Of course, this requires selling them before the economic expansion ends to keep the money.
The second way to make money is to buy ETFs that are structured to take advantage of contango. One research paper estimated that 2/3rd of the total return for commodities over any given period comes from contango. [Note: Contango is a situation where the forward price of a commodity futures contract is above the spot price. To calculate a forward futures price you take the spot price and then do some nifty calculations that includes the cost of financing the purchase, storage, shrinkage, and any other costs particular to that commodity. Normal markets operate in contango because it minimizes arbitrage opportunities.]
The third way to profit from commodities is to periodically rebalance a portfolio as it inevitably goes through the cycles. We’re not looking to have a permanent commodity sleeve in the portfolio but we are looking to take advantage of the global economic expansion and to trade around it as it fluctuates.
Never go all in
While the above four core positions are pretty diversified, it’s not a complete portfolio. Since it’s not a complete portfolio a trader should never go all in on just the above. The four core positions I’ve listed represent good opportunities for long-term value and even better opportunities to trade around. So always keep some dry powder for when the short-term price movements put the odds of trading around the core in your favor.