Trends Watch: December 13, 2018

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 with David Lifchitz, Owner, Lifel Group.

What is your outlook for alternatives?

There are many “alternative investments,” but I’m going to only talk about the ones that I know the best: hedge funds.

Hedge funds 20 years ago could provide nice returns to their investors by exploiting inefficiencies in the market of many asset classes, could ride trends which were more long-lasting… providing indeed a real diversification vs. traditional investments (i.e., long stocks and bonds).

But with floods of money poured into hedge funds leading to more competition among them for a decreasing “inefficiency pie” due to the raise of high frequency traders, their average returns have strongly diminished. Add on top of that ten years of Central Banks’ uninterrupted intervention in the markets leading to global markets raising straight up for ten years in a row (beside minor hiccups that were quickly erased) which made it very hard to “beat the market” after fees unless a fund used a lot of leverage. Thus today, most hedge fund strategies have become “beta in disguise”… and an expensive beta (call it long/short equity, merger-arb, you name it). The only hedge fund strategies that remain uncorrelated to the market are commodity trading advisors, global macro funds and volatility funds. But being uncorrelated to a raging ten-year bull market make these strategies quite unappealing to the average investor, focusing only on the short-term performance.

But now that this bull market is aging, that the Central Banks are reversing course (i.e., are raising rates), all asset classes are tanking at the same time, and “beta in disguise hedge funds” are tanking also, but on leverage, leading to the following observation: Hedge funds (as a whole) underperformed the market during the bull run and now they also underperform during corrections… which makes them look like a bad investment idea.

Therefore, to me, only hedge funds that will demonstrate their ability to provide a positive return during the upcoming stagnant-to-bear market will remain alive, while most others will see their assets under management shrink as investors will replace them with passive instruments to get market exposure. But at the same time, that will clean up the hedge fund market.

What is your outlook for the economy?

Unfortunately, not good….

Indeed, since the remedy to the 2008 crisis (initially a debt crisis) has been to add more, way more debt into the system, I feel like we are back in 2007 but on steroids. Very accommodative rates have pushed companies to binge on borrowed money, which has to be repaid at some time; but the demand for their products and services is slowing hard, so they are clogged with all that debt. Low to negative interest rates have kept zombie-companies alive, but if the Central Banks keep on raising rates, they will ignite a flurry of bankruptcy and a chain reaction in the global system.

On the other hand, a sub-zero rates environment cannot exist forever. So something has to give… and one way or the other it won’t end well.

What keeps you up at night?

Six years ago I would have told you, my new-born daughter… but today what keeps me up at night is the butterfly effect, where a meaningless event somewhere in the world could lead to a global crisis: The global economies are so interdependent and so indebted that a crisis could spread very quickly. There are also many butterflies out there: U.S. political gridlock, trade wars, Brexit and potential Italeave, Middle East issues, hard landing in China, FED misstep on rates….

But these are all potential triggers. The real issue is the markets “fake/apparent” liquidity. We have observed it many times since 2008 that liquidity dries up during crises. Crowded place, small doors… there will be many casualties. So if one wants to keep on dancing, he/she should dance close to the exit door….

That’s why I recommended my clients to hedge their portfolios: they may miss the next five points of upside, but won’t suffer the next 30 points down. “Better safe rather than sorry” has never been more appropriate as an investment strategy than in these days!