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The days of easy money with alternative investments are over

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Over the past few decades, institutional and affluent investors have increased their exposure to an asset class labelled as, for lack of a better term, alternative investments. Alternatives are defined not by what they are, but by what they are not: They are not equities, and they are not bonds or money market instruments – at least not the relatively easily tradeable assets found in the typical 60/40 portfolio.

When I was head of fixed income and alternative assets for a mid-sized investment counsel, my mandate was to analyze, recommend and manage any investments that our equity team believed were unworthy of the attention of their colossal intellects.

The alternative investments space contains many different types of products, several of which have nothing to do with each other. They include, but are not limited to, hedge funds, private equity, natural resources, real estate and infrastructure. These categories can contain numerous subcategories.

The best example of alternative investments is hedge funds, which can range from low-risk funds that actually hedge risk, to wildly risky funds that do no hedging but actually do the opposite: Leverage their investments with debt. The latter type of “hedge” fund uses the term to justify their large upfront fees, sometimes taking 10 per cent to 20 per cent of their clients’ returns. They promise to provide investors with attractive opportunities not found in more conventional markets, and some actually deliver on this grandiose promise.

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One advantage of alternatives is that they can have low correlations with conventional investments, thereby improving the risk/return profile of a portfolio.

But manager selection is more important in alternative assets, particularly private equity. Large publicly traded stocks will have dozens of analysts following every minutiae of their operations and financials, and hundreds of portfolio managers and thousands of individual investors watching them. They also have accurate stock charts which provide important insight. Their financial information is public.

That’s not the case for many alternative investments, where information is kept very private.

There are a lot fewer private debt specialists out there than equity managers. It does appear that the efficient market hypothesis – the idea that managers cannot outperform the market over the long run – applies less to alternative managers.

Yet, to an extent, part of the incremental value of alternatives is generated by one of their major drawbacks. They are not liquid. An investor may not be able to withdraw their funds quickly. In many cases, there may be a lock-up period for years.

In a relatively efficient market, assets are priced for risk. An important risk is liquidity and therefore alternatives should trade at a discount, or have a higher return relative to liquid assets like stocks and bonds. Since alternatives are not liquid and do not trade on an exchange on a second-by-second basis, managers enjoy a lot of discretion around pricing. To no sophisticated investor’s surprise, many managers will “smooth” out their asset values, meaning they underprice assets during positive periods and overprice them after a negative period. Therefore, some of these investments will appear less risky than they really are.

In general, alternative investments do provide decent returns. But they are too broad a category to assess as a group.

For instance, the HFRI index of hedge funds produced an annualized five-year return of 4.51 per cent over the past five years. That compares with a 9.25 per cent total return for the S&P 500.

According to the CAIA Association, a global investment body, over a 21-year period ending June 30, 2021, private-equity allocations by state pensions produced an 11-per-cent annualized return. That exceeds the 6.9-per-cent annualized return that otherwise would have been earned by investing in public stocks.

Use caution, however, when examining data for alternative asset returns. Their illiquidity and opaqueness can obscure the validity of the returns reported. During bear markets, private-equity and debt investors may be unaware of problems until it is too late. A great example of this in the Long-Term Capital Management debacle of 1998. This highly leveraged hedge fund, arguably the world’s most awe-inspiring alternative asset before its implosion, almost took down the financial system.

Today, an alternative investment using high levels of debt is playing with fire. That’s because those alternatives that are relying on credit to augment returns, or are debt-based to begin with, and are in a radically different world than the one that existed from the beginning of the financial crisis in 2008 to the end of the long-term bond bull market in 2021. The era of artificially low interest rates is over.

This sector will have the same problem with the new era of higher interest rates as commercial real estate: interest rates are no longer below inflation rates.

Up until 2021, we had a prolonged, unsustainable and maladaptive period when interest rates were below inflation and far too low relative to price pressures. This allowed many poor investment ideas to see the light of day. Professional investors happily gobbled up investments and funded the ideas of managers who would have been escorted out of the building before 2007.

When someone responsible for allocating capital to an investment project decides whether a vehicle is acceptable, they look at projected cash flows and assess if the return on capital is above the so-called hurdle rate. The hurdle rate is the minimum return demanded for an investment to receive capital. Loans are used to finance these investments. After all, if rates are 5 per cent and the annualized return of the vehicle is 3 per cent, adding risk would be irrational. However, if rates are artificially low at 0.5 per cent, a once-poor investment can look lucrative using leverage.

We are now in a period where rates will be more appropriate given inflation. This has been the case through much of human history. The 2008 to 2021 years were an anomaly.

Hurdle rates will be higher and alternative managers will have to pay more to borrow in real terms. Alternative investments, depending on the category and methodology of the manager, will remain appropriate investments. But the days of easy money are over, especially for those managers who relied on what is effectively central bank “subsidies” arising from low interest rates.

The good news for investors? In the era now upon us, bonds and dividend-oriented stocks are looking pretty good in comparison to the alternative investment space.

Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank’s main bond fund.

 

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Amazon Adds $2.75 Billion To Anthropic Investment, Sora Goes To Hollywood – Forbes

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Amazon invests $2.75 billion in Anthropic. This brings Amazon’s investment to $4 billion, as it follows its previous investment of $1.25 billion, which gave the company the option to invest the additional funds. This comes as Anthropic’s new Claude-3 chatbot outperforms ChatGPT- 4 in recent tests. Amazon has unique insight into Anthropic’s performance as it is one of the suite of AI models offered by AWS, which include most of Claude’s competitors.

Sora Goes To Hollywood. Everyone is reacting to a Bloomberg report that OpenAI will soon be meeting with studios and other Hollywood stakeholders to demonstrate the capabilities of the text-to-video generator and explore partnerships. OpenAI says unnamed “A list” directors are already using it.

Based in Toronto, shy kids are a multimedia production company who utilized Sora for the above short film about a man “who is literally filled with hot air.” His head, as you can see, is a yellow balloon. “We now have the ability to expand on stories we once thought impossible,” shares the trio made up of Walter Woodman, Sidney Leeder and Patrick Cederberg. Walter, who directed Air Head, said as great as Sora is at generating things that appear real, what excites us is its ability to make things that are totally surreal.

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Neuralink Shows Paralyzed Patient Playing Chess on a PC. Elon Musk’s brain-computer interface company shared a video of its first human patient, Noland Arbaugh, playing chess and Civilization VI using their brain implant. Arbaugh, who is paralyzed below the shoulders, described the experience as “just stare somewhere on the screen” to move the cursor. While some experts see this as a promising step, others emphasize that it’s still early days and the technology has limitations. Arbaugh acknowledged that there’s still work to be done, but the implant has already changed his life.

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Illuvium Labs Raises an additional $12 million for NFT Gaming Universe. Following an extensive three-and-a-half-year development journey and $60 million in funding, Illuvium Labs is on the cusp of unveiling its interoperable gaming universe. It will feature three interconnected titles designed to utilize the same NFTs seamlessly across all games, promising a first-of-its-kind experience. The influx of $12 million in Series A funding from esteemed firms like King River Capital, Arrington and Animoca will be allocated to developing new gaming titles within the Illuvium ecosystem.

Databricks’ DBRX claims the crown as best open-source LLM. It’s a list that includes Meta’s Llama 2 and Mistral’s Mixtral. Leading companies like OpenAI, Google, and Anthropic sell, or rent, their proprietary private models to enterprises and subscribers. DBRX was produced for just $10 million, orders of magnitude less than its competitors. On Monday, Wired reported that the company showed data proving its AI model’s reading comprehension, answers to general knowledge questions, and coding is superior to other open-source models that can be downloaded from Hugging Face and modified by users.

Shiba-Inu Metaverse leader steps down amid dispute over IP. Marcie Jastrow, the well-regarded Hollywood executive who led Technicolor’s XR efforts, has left the company. This led the company’s legions, known as the Shib Army, to speculate about malfeasance, which is easy to do, because Jastrow is the only person involved who is not anonymous, including Ship’s charismatic leader Shytoshi Kusama.

This live football experience was built by Immersiv.io to showcase how AR can transform the live sports broadcast and fan experience using the Apple Vision Pro. Immersiv.io worked with the Bundesliga (the German Football League) on the production. In a post on X, the company said. “This is a 3D reproduction of the live game integrating TRACAB Gen 6 live skeletal data of all players and the ball, complemented with real-time insights, offering the ultimate live tactical perspective of the game.”

SXSW 2024: XR That Makes You Go Wow. The XR competition was won by an AI experience, The Golden Key. This is the second year in a row that an XR experience did not take the immersive festival’s grand prize.

The second annual AI Film Festival is coming to Los Angeles on May 1, and New York May 9. Seats are limited, request to attend at http://aiff.com

This column, once called “This Week in XR,” is also a podcast hosted by author Charlie Fink, and Ted Schilowitz, former studio executive and co-founder of Red Camera, and Rony Abovitz, founder of Magic Leap. This week our guest is Liz Hyman, CEO of the XR Association. We can be found on Spotify, iTunes, and YouTube.

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Where Will Virtual Reality Take Us? (Jaron Lanier/New Yorker)

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FP Answers: What is a 'behavioural edge' in investing and how does it affect returns? – Financial Post

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Temperament is the unsung hero of investing success

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By Julie Cazzin with Felix Narhi

Q: What is a “behavioural edge” in investing? How does it potentially enhance returns? How can an investor develop it? — Giovanni

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FP Answers: Giovanni, the term behavioural edge is just another way of saying “temperament,” which refers to the habitual way a person behaves in each situation. For example, one person may be easygoing and relaxed while another is more likely to be impatient and assertive.

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Temperament is the unsung hero of investing success. Gaining insight about our innate emotional temperament and learning how to work with it gives investors an edge.

The common misconception is that you need a high level of intelligence to be a successful investor. No doubt, that can be helpful, but based on many years in the industry, I’ve seen it is not always the most important differentiator.

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Once someone has at least an average level of intelligence, it is temperament that often provides the investing edge in leading to better returns over the long term. “Investing is not a business where the guy with the 160 IQ beats the guy with the 130 IQ,” famed investor Warren Buffett has pointed out.

Having the right temperament can potentially enhance investment returns in several ways. An investor who is very reactive to external events is likely to fare poorly over the long term because, quite simply, the world is full of uncertainty and always will be. Markets are highly reactive, abetted by algorithmic trading and automatic rebalancing by exchange-traded funds. Individual investors should not be.

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Research shows that investors who trade frequently or try to time the market underperform. On the other hand, those investors who can remain calm and patient throughout market cycles do better because markets historically trend upwards. Hands down, being calm, cool and collected is the right temperament for an investor to have.

The concept of “homo economicus” — or economic man — describes a hypothetical person who consistently makes rational decisions. In real life, our decisions are coloured by our formative experiences, moods, external circumstances, what we ate for lunch and a host of other factors. These influences drive our behaviours, but they often operate below conscious awareness (even artificial-intelligence apps “hallucinate”).

Given that behaviour is some combination of cognitive and emotional inputs, an investor can create an edge by developing a disciplined investment process that overrides temperament, especially during highly volatile periods.

The term “active patience” means being clear about your investment principles and what you are looking for, and practicing active patience until the right opportunity arises.

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In contrast, regular patience is making an investment decision and sticking with it no matter what, even if it was the wrong decision. The latter approach is unlikely to bring financial success, which is the major goal of investing.

Active patience is what Buffett would call the “fat pitch,” which occurs when the market (occasionally) presents a very attractive opportunity. It is easy to spot a great opportunity and take full advantage of it when an investor has clear principles on what they are looking for.

Can we change our temperament? Recent studies show that personality traits and moods are subject to change, sometimes within the hour, so temperament may not be as fixed as we’ve been led to believe.

Becoming a better investor starts with self-knowledge — and lots of practice. The behavioural traits associated with good investment outcomes are patience, discipline, emotional control and risk awareness. It so happens, these qualities lead to good life outcomes, too. A calm temperament is the bedrock of making sound investment decisions.

Every investor must determine for themselves how to achieve greater equanimity and there is no shortage of books, videos and TikTok tutorials on that evergreen topic. I would also add the importance of staying humble.

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In investing, as in life, the learning never stops. Staying open to new information and having the courage to challenge our own and others’ beliefs and habitual behaviours are the keys to future success.

Felix Narhi is chief investment officer and portfolio manager at PenderFund Capital Management Ltd.

Bookmark our website and support our journalism: Don’t miss the business news you need to know — add financialpost.com to your bookmarks and sign up for our newsletters here.

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Lenders Rally After India’s Central Bank Eases Investment Curbs – BNN Bloomberg

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(Bloomberg) — Indian banks and shadow lenders rose Thursday after the country’s central bank eased capital requirements for a unique type of investment, a move that may free up more funds for loans.

The gains came after the Reserve Bank of India issued Wednesday modified rules on lenders’ required provisions for exposure to alternative investment funds, or AIFs, that invest in the lenders’ borrowers. Under the new policy, a lender needs to set aside capital only for the amount the AIF invested in the debtor company, and not the entire investment of the lender in the AIF.

Shares of Piramal Enterprises Ltd., which reported among the biggest provisions for such investments, closed 1% higher after rising as much as 6% during the day. A gauge of financial services firms climbed 1%, the most since March 1.

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Lenders led the rally in the broader market, with the NSE Nifty 50 Index registering its best day since beginning of the month.

The RBI’s softening stance came after industry players raised concerns over clarity and uniformity after it announced in December restrictions on lenders’ exposure to AIFs that hold stakes in their borrowers. The latest move will likely help firms including Piramal, HDFC Bank Ltd. and IIFL Finance Ltd. reverse some of their relevant provisions made previously, according to analysts at Citigroup Inc. and Jefferies Financial Group Inc.

Read more: India’s Crackdown on Financial Risks Puts Industry on Watch

“Select private banks and NBFCs like Piramal had provided for their entire AIF exposure during 3Q and could see some write-backs in 4Q if they decide to reverse the excess provision,” Jefferies analyst Bhaskar Basu wrote in a note.

Regulators introduced a flurry of new rules last year to prevent a buildup of financial stress at a time when India’s economy remained resilient in the face of rising interest rates, slowing global growth and unabated geopolitical tensions.

©2024 Bloomberg L.P.

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