Alternative investment options available to most investors present both challenges and opportunities. They can appear vexing partly because, to some investors, they are newly accessible in liquid vehicles. Many types, such as hedge fund strategies, have not been available to the typical investor until now. They are also increasingly popular: Assets in liquid alternative funds went from around $50 billion in 2006 to more than $300 billion in 2015, and the number of funds available increased almost fivefold, from 132 to more than 600 in the same time period (see Exhibit 1).
Alternatives are also complex and heterogeneous, in terms of the types of strategies alternative managers use and the classification of those types of strategies. The relatively recent availability of alternative strategies to retail investors — as liquid alternatives — has resulted in category mapping mayhem (see Exhibit 2). No less complex are the methods of adding them to a traditional portfolio.
What often gets lost when investors are sorting out all these distinctions is the reason they turned to alternatives in the first place. A better understanding of the role of alternatives in today’s economic environment — and in tomorrow’s — can help guide investors’ decisions as they weigh their options in the alternatives space.
What follows here is a guide to framing an informed alternatives discussion. It is intended to provide some much-needed perspective on the topic, to outline the principles of a successful alternatives allocation and to show how multi-alternatives in particular can help meet today’s diversification challenges.
As we move further away from the Great Recession, the traditional 60/40 portfolio faces headwinds that have not occurred for much, if any, of its existence. This much-used paradigm allocates 60% of a portfolio to equities and 40% to bonds, balancing over the long term the growth (and higher risk) associated with equities with the stability (and lower risk) associated with bonds. Yet a significant assumption within the 60/40 paradigm — historically strong bond returns with low volatility — is no longer realistic with low bond yields in the current environment. Modest inflation and an accommodative Federal Reserve partly account for lower yields, but a broader look shows yields have been in a secular decline since the early 1980s.
Lower bond yields, combined with a sustained low-interest-rate environment, should prompt investors to question whether a traditional 60/40 approach will continue to work. Our expectations are that even moderately risky balanced portfolios should expect returns more than 4% lower over the next 10 years compared to what a 60/40 portfolio delivered in the last 35 years. Investors will need to find a way to adapt.
Lessons from the origins of 60/40
An environment of lower returns for the traditional portfolio should prompt the question: Why expect this diversified portfolio, as it has been traditionally applied, to succeed? To answer that, it may be useful to take a quick look at the history of diversification and see what its origins may tell us about its applicability today.
Most accounts of the birth of modern portfolio diversification begin with Harry Markowitz’s 1952 paper Portfolio Selection, in which Markowitz argued that diversifying assets can help investors build portfolios with maximized expected returns for given levels of risk. Markowitz put science behind the wisdom of not putting all your eggs in one basket.
Roughly 20 years later, along came the Employee Retirement Income Security Act of 1974 (ERISA), which provides that anyone responsible for managing or advising assets in a retirement plan has fiduciary responsibility for their investment decisions or advice as to those assets. As fiduciaries, managers and advisers must act in the plan participants’ best interest. ERISA also requires fiduciaries to diversify investments and encourages managers of defined benefit plan assets to develop well-thought-out reasons for their allocation decisions. As a result, many institutional investors and consultants began to apply the science of Markowitz’s principles of diversification.
In this way ERISA served as a main catalyst for the widespread use of the balanced portfolio — and with relatively high interest rates and the help of a measurable decrease in the size of business cycle fluctuations between the mid-1980s and mid-2000s, it worked. It also succeeded because of relatively high bond yields, which in the last 30 years delivered 9%, nearly matching the 10.5% return from equities during that period.
Yet it worked so well that many investors may have difficulty understanding the reasons why it may not work today. Interest rates and yields have lowered slowly but significantly since the early post-ERISA days. The efficacy of independent central bank policy, thought by many to have contributed to the Great Moderation of business cycle volatility, now seems worth questioning. Few investors in the 2000s would have expected major central banks around the world to be moving to or considering negative interest rates, as some began to do as early as 2012. Perhaps more importantly, we believe continued divergence of central bank policies and China’s transition from a manufacturing-based economy to a service-based economy should create more volatility. It should be increasingly clear that traditional diversification is point dependent, and things have changed.
Diversification amid rising volatility
Weighing market exposure and active skill
Understanding how today’s challenges for the diversified portfolio differ from yesterday’s can help guide a responsible alternatives allocation. First, what are the options? By doing nothing, an investor may risk missing his or her objectives. Tilting the portfolio to higher-returning assets may capture higher returns, but it will also increase risk. Allocating to illiquid assets to capture the liquidity premium may also capture higher returns, but at the cost of lower liquidity.
Assuming that lower returns, greater risk or reduced liquidity are unsatisfactory options, a plan to find new sources of return should involve choosing from a spectrum of alternative options. A good alternative option should give the portfolio either a higher return for the same amount of risk or the same return for a lower amount of risk. Yet even distinguishing among strategies and identifying their sources of return and risk is challenging. The categorization of alternative strategies can be confusing. Hedge Fund Research lists four broad categories and 37 subcategories (plus four types of funds of funds); these do not always square with Morningstar’s system of categories (see Exhibit 2). Investors may not know what they’re getting.
To meet today’s diversification challenges, investors will need to distinguish liquid alternative strategies that rely on new market exposure, such as volatility and frontier markets, and those that rely on manager skill, such as market neutral, 130/30, long/short equity and macro strategies. Here it is important to note that many “new market exposures” may already appear in investors’ portfolios —
REITs and commodities are two common examples. The difficulty of finding truly new exposures, then, encourages a longer look at active management, where sources of return and risk are less dependent on market movement.
Higher stakes in manager selection
Key considerations when choosing a single active manager will involve identifying the investment strategy, its fit within a portfolio and its behavior in different market cycles. We must also ask: Can this manager deliver on its stated objectives? Is the strategy easy to understand, or is it a more nuanced style?
Distinguishing and then choosing active alternative managers remains complex and research intensive. Given a range of options, simply choosing the manager with the highest performance may not mean you have the manager with the most skill. Consider two managers with different levels of market exposure. Manager A has a beta of 0.8, while Manager B has a beta of 0.2. Suppose the market rises by 10% and Manager A returns 6% and Manager B returns 5%.
Judging solely from their returns, you might think Manager A is the more skilled manager. But with a beta of 0.8, with no effect from skill, Manager A should have returned 8%. Manager A’s skill actually generated a 2% loss. Manager B, on the other hand, received only a 2% return from the market, and the remaining 3% is the return from Manager B’s skill. This is a simplified example. Now imagine the managers differing not only in their level of beta, but also in the source of their beta — for the source varies from manager to manager — as well as their alpha or skill.
Manager selection in the alternatives space is arguably more difficult than in traditional long-only strategies because the stakes are higher. This is because the dispersions of both returns and levels of market exposure among alternative managers are greater than those in traditional long-only managers. Exhibit 7 shows the dispersion of returns among several strategies. The spread between top and bottom deciles of returns among traditional large blend managers is 469 basis points. Compare that to the return dispersion of 860 basis points among long/short equity managers. Missing on a long/short equity manager pick risks leaving much more on the table in terms of return.
Perhaps more importantly, such dispersion among alternative managers suggests diverse sources of alpha: Alternative managers generate alpha using very different skill sets. Trying to forecast future returns for these asset classes is even more difficult. Similarly, Exhibit 8 shows the dispersion of beta among the same categories, suggesting alternative managers are managing their risk profiles in very different ways — by region, market or currency, for example.
Due diligence that demystifies
The due diligence process in such an environment should take into account the above sources of differentiation among managers. It should understand the structural differences across managers and strategies and in doing so understand the alpha achieved and the beta relied upon. Moreover, it must often do so when there are no clear benchmarks to rely on. Active and informed due diligence of alternative managers should look at strategy, performance, risk management, organization and structure, among other items. We’ve outlined some of the key ingredients of a due diligence analysis that will lead to such an understanding below.
Portfolio construction: Putting it all together
Building a portfolio with the results of such due diligence requires creating the right blend of unique and complementary managers in a particular category as well as the right blend of strategies. Our research indicates that searching for alpha across many different markets leads to better outcomes. Doing so offers diversification benefits, as opportunity sets in different markets vary significantly over time. Some environments might be more conducive to long/short equity strategies, others to different types of macro strategies, for example.
Decisions regarding the number and styles of strategies in an alternatives allocation should be made from the perspective of the total portfolio. That is, they should take into account the size and role of the alternatives allocation as well as the types of traditional managers in the portfolio.
We believe that, when used within a larger portfolio as a diversifying allocation, a portfolio of liquid alternatives managers should be fairly concentrated, with roughly six to 10 underlying managers (this number may be higher in strategies outside the liquid alternatives universe). The key is to avoid diluting the contribution of any individual manager to the portfolio by using too many managers, thereby giving each only a small allocation. At the same time, too much concentration undercuts the diversification benefits alternative investments are designed to deliver in the first place. A 10% allocation to eight managers, given an equal weighting, would provide each manager roughly 1.25%. This would be enough to make a difference yet not enough to have a materially negative impact on the total portfolio.
A multi-alternative approach
A multi-alternative fund can offer access to a concentrated portfolio of alternative managers. A multi-alternative fund combines frontend due diligence, portfolio construction and management, and risk oversight, all performed by experienced, professional managers. It also helps answer key questions any allocation to multiple managers necessarily poses:
- Will the minimum investment for each strategy create a hindrance for building a diversified portfolio?
- How do all of the strategies correlate with one another?
- What is the right time frame and process for rebalancing the portfolio?
- How much time and what resources are necessary to fully research and understand multiple complex investment strategies?
- What is the appropriate risk management philosophy?
- How should overall portfolio and individual positioning be monitored?
Moreover, the built-in diversification of multi-alternative approaches helps answer the fundamental question that began the search process in the first place: Is the portfolio diversified by manager and strategy? An alternative allocation that combines expertise on manager research, asset allocation, portfolio construction and risk management should offer a flexible, portfolio-ready option.
Post-crisis returns have done little to motivate changes to the 60/40 paradigm of the balanced portfolio. But in a continuing low-rate environment, there are indications that this paradigm, which has seen investors through the last 35 years, will face challenges. While there are other approaches to addressing the low-rate environment, allocating to alternatives is an appropriate option for many investors. Multi-alternatives in particular can help meet today’s diversification challenges by offering easy access to the resources needed to:
- Separate market exposure from manager skill
- Identify the appropriate style of manager skill
- Screen a large number of managers across several qualitative, quantitative and risk-related factors
- Create an effective blend of managers
- Manage the blend from a total portfolio perspective
- Achieve portfolio breadth, differentiation and complementarity
Index definitions: S&P 500® is an unmanaged index of large-cap common stocks. Barclays U.S. Aggregate Bond Index is an index that covers the U.S. investment-grade fixed-rate bond market, including government and credit securities, agency mortgage pass through securities, asset-backed securities and commercial mortgage-based securities. To qualify for inclusion, a bond or security must have at least one year to final maturity and be rated Baa3 or better, dollar denominated, non-convertible, fixed rate and publicly issued. Investments cannot be made in an index.
Additional definitions: Beta is a measure of a portfolio’s volatility. Statistically, beta is the covariance of the portfolio in relation to the market. A beta of 1.00 implies perfect historical correlation of movement with the market. A higher beta manager will rise and fall more rapidly than the market, whereas a lower beta manager will rise and fall slower. Alpha is the incremental return of a manager when the market is stationary. In other words, it is the extra return due to non-market factors. This risk-adjusted factor takes into account both the performance of the market as a whole and the volatility of the manager.
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