Why Large Cap US Equities Should Beat Alternative Asset Classes

by: Toro posted on: April 16, 2007 | about stocks: IVV / IWB / JKD / SPY / VV / XLG

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An article in the Wall Street Journal Thursday highlighted the shift of institutional assets away from stocks and bonds into alternative asset classes:

Driven by the need to increase returns and meet long-term obligations, pension funds and endowments are shifting money into international stocks and hedge funds at the expense of U.S. stocks, says a new report.

The annual survey, released yesterday by consulting firm Greenwich Associates, says large U.S. institutional investors are placing increasing amounts of money in so-called alternative investments, which include hedge funds and private equity....

The research is based on interviews with more than 1000 pension funds, endowments and foundations, which together represent nearly $7.2 trillion in assets. It showed that last year on average these institutional investors reduced the percentage of their portfolios allocated to U.S. stocks by two percentage points to 44.7%.

In contrast, they increased the amount of money they dedicated to international stocks, hedge funds, private equity, and real estate. Their bond investments inched upward, but have declined in three of the past four years.

Greenwich said some large institutional investors are also giving their stock managers greater leeway to bet on a share's decline. The maneuver, known as short selling, involves borrowing shares, selling them, and then replacing them with shares bought later -- a profitable technique if the stock price falls.

The trend toward riskier investment strategies, and away from garden-variety stock and bond buying, looks set to continue. Forty-two percent of the public pension funds surveyed by Greenwich said they are planning to put significantly more money in hedge funds over the next two years. Last year, such investments represented an average of just 0.5% of their total investments. For corporate pension plans, the figure was 2.2%.

Unlike pension plans, endowments and foundations have moved far more quickly into hedge funds. Last year they had an average of 12.4% of their total assets in hedge funds, up from 9.4% in 2003.

This explains quite a bit, in my opinion.

With money pouring into their coffers, private equity has to buy something, otherwise they don't get paid.

Many hedge funds write options for income, dampening volatility. (Hedge funds are not an asset class, by the way.)

Flows out of equities explains why big cap stocks have lagged.

Flows into international equities explains why emerging markets have been doing well.

Of course, there are other reasons for the above, but pension funds, which control trillions of dollars, leave mighty large tracks, and large shifts obviously effect markets.

But because of those large tracks, alternative asset classes are becoming less desirable while vanilla stocks are becoming more desirable. If I had to bet on any of those for the next decade, US stocks would be near the top of my list while alternative investments and real estate would be at the bottom.

Commodities (also not an asset class) would be at the top of my list, or at least specific commodities would. Surprisingly, commodities was not on the table above. Pension funds have been increasing their allocation to commodities as well, which partly explains both the rise in so many commodity prices, but also at least partly explains shifts in commodity price curves that have historically been in backwardation, such as energy.

The flood of money into commodities demonstrates how large asset flows lower returns. Over the past three decades or so, the spot return of commodities has been 4%-5%, or at least it was until a few years ago. However, returns in commodities futures markets were around 12%. Because energy comprises a large portion the commodities market, and because energy has been in backwardation two-thirds of the time, investors in commodities futures have earned most of their return through the roll, or buying longer-dated futures then selling the contract as expiration drew near and prices rose up the futures curve.

Now, with so many more institutions allocating capital to commodities market, and everyone reading the same Goldman Sachs or Deutsche Bank studies, the demand for longer-dated futures has pushed future prices higher and price curves into contango, eliminating much of the return historically derived by passive commodity investors. Over the next decade, the return for commodities will be driven by the spot price , not the roll, which may detract from return.

The same will happen with private equity, hedge funds and real estate. The flow of funds into these alternative classes will decrease future returns as there aren't enough desirable investment opportunities to exploit given the supply of capital (at least without increasing leverage). Hedge fund returns are already falling. So are returns to real estate. We will see the same with private equity.

That is why I would take large-cap equities over any of these three.

Large Cap U.S. ETFs

SPDR S&P 500 ETF (SPY)
iShares S&P 500 Index Fund (IVV)
iShares Russell 1000 Index Fund (IWB)
iShares Morningstar Large Core Index Fund (JKD)
SPDR DJ Wilshire Large Cap ETF (ELR)
Vanguard Large-Cap ETF (VV)
Rydex Russell Top 50 ETF (XLG)