Using Alternatives to Boost Returns and Increase Diversification

Using Alternatives to Boost Returns and Increase Diversification

What many high-net-worth and institutional investors have discovered the hard way is that when you buy the cheapest investment strategies, you often get what you pay for.

Alternative investments were originally the sole province of institutions and the wealthiest of families, but in recent years access has been democratized as an increasing number of alternative strategies have been packaged in ’40 Act mutual funds. A primary reason advisors are including alternative strategies in their clients’ portfolio is that they broaden diversification and give investors a risk/return profile different from that provided by equities, bonds or cash.

Investment theory continues to evolve, and a contemporary approach starts with the idea that a fully diversified portfolio does not just hold long, unlevered positions. In order to realize the maximum benefit from a particular strategy the portfolio might also hold potentially levered positions, where more than 100% of the portfolio is invested, or it could be betting against a stock and hold short positions.

Although it is popular right now to call this diversified approach an alternative strategy, it has become so mainstream that an argument can be made that it is actually at the core of modern portfolio construction. Some investors look at alternative strategies as a seasonal play as in, “I think stocks are expensive right now, so I need some alternatives to reduce the risk,” or “We think stocks are very cheap and so need some alternatives to bring a new set of tools to the portfolio.” That kind of thinking can severely limit the investors’ chances of long term success by ignoring the benefits that alternative strategies can bring in any market environment. Investing by looking in the rear view mirror and chasing last year’s winners can be a dangerous game to play.

Generally speaking, most alternative strategies fall somewhere between stocks and bonds in the overall risk profile they bring to the portfolio. They almost universally have a lower volatility or a lower risk than an all equity portfolio and depending on the strategy they probably have higher risk than a bond portfolio. Over time these strategies also have, after adjusting for the higher risk level of stocks, been shown to have a higher return.

Most advisors look at alternatives as portfolio diversifiers because they don’t have a high correlation with stocks or bonds and fit somewhere between the two in terms of risk profile. It’s important to remember that the lack of correlation can mean different things at different points in the market cycle.

For example, the dominant asset class for the last few years has been large cap US stocks and by comparison virtually every other asset class appears to have underperformed, but most people aren’t investing only for today or for the next five or six years. The reason that diversification is important in portfolio construction is because investing is a long-term proposition, and it is performance over time that should be most important to investors.

A superficial look at returns would seem to indicate that US stocks have been a great place to park your money. However, closer examination reveals that even in the current environment, there’s a price to pay for this approach relative to a portfolio containing a good multi-strategy alternative. From the standpoint of absolute returns, US stocks have done better than other asset classes, but in terms of how they’ve done versus the risk in the portfolio, the best multi-strategy hedge fund managers, net of fees, have still done better.

Matt Brown is the founder and CEO and responsible for firm strategy, management and business development at the CAIS Group. He has worked at firms including Shearson Lehman Brothers, Smith Barney and Brownstone Advisors.

Getting What You Pay For

One of the most common misconceptions about investing in alternative strategies is that they have a higher entry point and a greater expense ratio than a traditional long-only strategy. That may be true, but investors should make their buying decisions based on the expected benefit to the portfolio, net of fees.

It’s much like when a traditional investor chooses to put money into an actively managed rather than an indexed fund. The investor has decided that, after deducting fees, the manager is likely to bring some insight to the process that over time will produce better results than the index fund.

Of course “better” is a subjective description and what it means depends on one’s outlook and what the strategy is expected to accomplish. When it comes to alternative investments a strategy may be chosen because of its return characteristics or risk reduction characteristics. These are skill sets that are more expensive to execute, but worth the cost, if after the fee of executing the strategy the investor reaps additional benefit. The question that needs to be answered is whether what the investor is getting in return is worth the extra expense. And that is something that needs to be addressed on a case by case basis by the investor and advisor together.

What many high-net-worth and institutional investors have discovered the hard way is that when you buy the cheapest investment strategies, you often get what you pay for. Investors, and their advisors, need to be very cognizant of what they are actually paying for, and this is with all investments, not just alternatives. If a particular strategy has been commoditized and available from a number of managers, then buying the least expensive makes a great deal of sense, but if there is a particular skill set or a specific role in the portfolio that must be addressed, then over the long run it is probably worth paying the premium.

Ultimately advisors, and their clients, are turning to alternative strategies because they provide an additional tool that can increase diversification and boost returns. After all, getting an acceptable return over the life of the portfolio is the reason for investing in the first place.

 

 

Matt Brown is the founder and CEO and responsible for firm strategy, management and business development at the CAIS Group. He has worked at firms including Shearson Lehman Brothers, Smith Barney and Brownstone Advisors.

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