Stein and DeMuth, The Little Book of Alternative Investments

I’m quickly becoming addicted to Wiley’s “Little Book” series. Its most recent addition is The Little Book of Alternative Investments: Reaping Rewards by Daring to Be Different by Ben Stein and Phil DeMuth. With the breeziest of styles the authors transform a topic that is somewhat shopworn into one that belongs on display in a (financial) store window.

The authors believe that an investor should start with a couple of low-cost broad market index funds, such as VTI, VEU, and BND, and then exploit market anomalies to make adjustments at the margins. Here are three such anomalies: (1) value stocks outperform growth stocks, (2) small cap stocks do better than large cap stocks, and (3) low beta stocks “perform better than expected on a risk-adjusted basis.” (p. 22) The authors suggest some mutual funds that capture these anomalies.

And then it’s on to alternative investments, not all of which are attractive. Take collectibles, for instance. The problem is that you always pay retail and you normally end up selling wholesale; you’re buying high and selling low. The authors criticize PBS’s Antiques Roadshow, which “gives viewers a misleading impression of the easy money to be made trafficking in collectibles. Their appraisers always tell people the insurance value or the replacement value of the gewgaw they have hauled in, or what it might fetch in some ideal auction before expenses…. What they don’t say is what they, the knowledgeable dealer, would pay for it in cash money right there and then on the spot, or what we might call the actual value.”

And, the authors continue, although “it’s always fun to watch the delight on the face of somebody who paid $250 for a painting in 1950 when he discovers that it’s supposedly worth $5,000 today … [w]hat this scenario doesn’t show is the opportunity cost: If he’d just put that same $250 in the stock market in 1950, he’d have $130,000 today.” (pp. 43-44) So, scrap collectibles as a good investment idea.

Joining collectibles in the scrap heap are private equity, buy/write funds, structured products, 130/30 funds, and precious metals. Let’s look at just two rejects. Why discard buy/write funds? Many buy/write funds hold a stock index and then sell covered calls against it, a strategy that “delivers nearly all the downside of equities with the upside clipped off.” Others add out-of-the-money puts to the mix, thereby collaring the portfolio. But the authors “were able to simulate the total returns of a buy/write fund from 1994 to 2010 almost to the penny just by putting half [their] money in the S&P 500 index fund and keeping the rest in T-bills. In other words, if you want to control risk, you don’t have to pay fund managers extra money to do it for you this way.” (pp. 56-57)

The case for owning gold is iffy; it “depends entirely on the start and stop dates we choose to make the argument. During certain date ranges, picked after the fact, gold adds a Midas touch. During others—and especially over the long haul—it sits there like lead.” Faced with goldbugs who claim that there are special reasons to own gold now, the authors pull out the ultimate weapon—Warren Buffett, who recently told the authors: “You have a choice. On the one hand, you can have all the gold in the world. It fits into a cube of metal about the size of a large McMansion. Or, you can have all the farm land in the United States. Plus, you can own 10 Exxon Mobils. Plus, you can have one trillion dollars of walking-around money. Which would you choose? Which is likely to be the more productive long-term investment?” (p. 64)

Having rejected several possibilities, the authors turn to the alternative investments a person should consider adding to his portfolio. First of all, commodities and REITs. And, the ultimate alternative investments, hedge funds or “hedge fund pigs in mutual fund blankets.”

The authors give an uncommonly clear account of the desirable alternatives, especially hedge funds. I have shot my wad in this review by focusing on what to avoid whereas the authors rightly reverse this: they spend most of the book explaining what to buy. They describe ten basic hedge fund strategies and then point readers in the direction of mutual funds that try to capture these strategies. They even suggest a way to set up a “do it yourself” mini-portfolio that “has a low beta, a low volatility, and a low correlation to the market’s volatility” and that would be “a satellite to the rest of your holdings.” (p. 186)

All in all, this is a great little book for investors who are trying to improve their asset allocation. Lots of meat and fun to read.