Trends Watch: March 2, 2017

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks to Richard Jenkins, Founder & CEO, Stone Toro Investment Advisers. 

What is your outlook for the alternative investment industry?

Virtually every asset allocator I’ve met in the retail world has the same question: “How much do I need to allocate to alternatives?” The answer ultimately will drive the growth of the alternatives industry and determine the way these instruments are used. Unfortunately, the answer to this question requires a deep understanding of what alternatives do for the asset allocation process. A whole new world becomes available to the asset allocator when they are introduced to the process. All too often, the asset allocator does not have the knowledge on how to evaluate and include an alternative in their portfolios. They often fall back on what they know and use the same methods they have employed for many years. Retraining the asset allocators on new techniques for portfolio constructions will be the next step in driving growth in the alternative investment industry.

Certain forced changes are coming that will help spotlight alternatives as a solution for investors. For example, the increased correlation of fixed-income to stocks during periods of economic stress makes certain alternatives a good substitute to lower portfolio risk during these events. Also, as rising rates impact both stock multiples and bond returns, certain alternatives can become attractive substitutes for generating yield and hedging against interest rate risks. The industry can only grow once asset allocators learn to design asset allocation models to be less predictive, less correlated and less dependent on market growth. As they move towards these techniques, allocators will become less fearful of the individual investment risk of each portfolio component and better at managing the overall risk of the portfolio through effective and dependable non-correlation currently provided through alternatives.

Since 2009, most hedge fund indices have underperformed long-only stock indices. One might view this as the beginning of the end for alternatives, but new highs in total alternative investment AUM are being achieved even with this reduction in relative performance. This drop in average returns may be due to a shift in investors’ preference for certain types of alternatives. After experiencing highly volatile equity markets leading into the great recession, investors leaned towards lower-risk strategies. At the same time, investors have moved away from certain higher-risk strategies due to the fact many of these strategies just cannot produce pre-2007 returns in a low-interest, compressed-risk environment.

I expect that increased demand will not be the only change in the alternative investment industry. As the industry starts to reach maturity, I expect to see changes typical of a normal product lifecycle – consolidation in the number of players, price/fee compression, brand awareness, and public acceptance.

What is your outlook for the economy?

The excitement and anticipation of positive growth in GDP due to fiscal policy changes promised by the Trump administration have driven retail investors to rush into the equity markets. This new inflow to the markets will likely not last long. The economic challenges of these fiscal policy changes will start to set in and affect economic outcomes in unexpected ways. Like most equity market downturns in years past, the retail investor is late to the party and is left paying the bill when it ends.

The profits of many companies will likely drop in the short run while implementation of fiscal policy changes will bring added expense and reduced revenue opportunities. As this occurs, CFOs will look to put all bad news into one year.  This will drive earnings even lower to the point of creating loss years for many companies. The potential lower tax rates for company earnings in 2018 and beyond will give additional motivation to the CFO to take additional reserves this year in an effort to push income into future years. These and other factors will likely delay any real GDP growth to years beyond 2017.

What keeps you up at night?

The number one concern is China and number two is automation of the workforce.

Chinese aggression in the South China Sea could spark military responses by U.S. and Japan. This has the potential to create a military solution that involves many other nations. The Global Peace Index for 2016 found that peace deteriorated for the tenth year in a row. Increasing conflicts are driving the allocation of more and more world resources to these conflict areas. As nationalist attitudes rise, defending borders and settling old disputes become more likely. China’s aggression in the South China Sea is reflective of this posturing.

My second concern is the social and economic disruption that automation could bring. The rapid advance in automated solutions has the potential to be the most disruptive event since the industrial revolution in the latter half of the 1700s. Autonomous cars are just one example of this automation effort. A large section of the manual labor market has the potential of becoming obsolete. This automation revolution will be followed by the elimination of the educated worker. Consider this: The majority of the vehicles on the road could be autonomous in 10-20 years. Initial estimates are that this puts over 6 million driving and related jobs at risk with no reasonable substitute proposed.