If you are a conservative investor, you may believe that alternative investments are strictly for other people. The most common misconception about alternative investments is that they are all high-risk/high-reward, useful only to the most aggressive investors. The truth is that alternative investments, when properly employed, may actually help lower the overall volatility in a portfolio. In many cases they are perfectly well suited for investors with lower risk tolerances.
To clear up the confusion, let’s start with some basics.
Traditional equity and fixed-income investments—basically, stocks and bonds—are key components of any well-diversified portfolio.
Equity investments are generally referred to as growth assets (capital appreciation) with an income-producing component (dividends). Fixed-income investments are considered income-producing assets (coupons) with a risk-reducing component (capital protection).
Often, during periods when equities perform poorly, fixed-income investments do well, and vice-versa. When both equity and fixed-income investments are included in a portfolio, the uncorrelated nature of the two ultimately leads to lower overall volatility through different market cycles and more stable returns over time.
The primary objective of an equity or fixed-income mutual fund manager is to outperform a “long only” market benchmark, such as the S&P 500, over multiple time periods, irrespective of how the benchmark itself performs. Because they seek positive “relative” performance vs. a benchmark, these managers are often constrained by the benchmark they track.
Alternative investments target positive “absolute” performance—a return that is largely independent and uncorrelated with the ups and downs of equity and fixed-income markets. Alternative investments have grown in popularity over the past 20 years, and now are used by both institutional and retail investors.
What are alternative investments?
At their most basic level, alternative investments (commonly just “alternatives”) are any investments outside of traditional long-only investments in stocks, bonds, or cash. In practice, alternatives can be broken into two categories.
The first category includes funds that use alternative strategies—meaning non-common investment techniques such as hedging, short-selling, or derivatives—to invest in traditional financial assets (equities and fixed-income). Examples include long/short equity, unconstrained fixed-income, managed futures, and global macro, to name a few.
The other category includes funds that invest in real assets. Real assets are tangible assets that have an intrinsic value due to their inherent qualities or properties. Examples include real estate, commodities, timber, and farmland.
How do you invest in Alternatives?
There are essentially two ways: private or public funds.
The most popular private funds are hedge funds. For years, they have been the most common way to invest in alternatives. They still account for the biggest chunk of the alternative universe.
Liquid alternatives (also called “alternative mutual funds”) are public mutual funds that specialize in alternative investments. They are relatively new. Often described as “hedge fund strategies in mutual fund wrappers”, they provide the same benefits as hedge funds while alleviating many of the complex investment and operational issues present in private funds. As the title “liquid alternatives” suggests, these investment vehicles aim to eliminate some drawbacks that can arise in hedge funds, such as requirements that investors keep their money in the fund for long periods of time.
Over the past two years, according to Hedge Fund Research Inc., liquid alternatives have gained more net inflows than hedge funds. At Trust Point, we have never had significant interest in hedge funds for reasons listed later in this article. Four years ago, however, as liquid alternatives started to gain some attention, we conducted our own research project. We liked what we found, and wrote about the topic in a 2011 edition of Worth magazine. Today the industry is growing faster than ever.
Are liquid alternatives safe?
Liquid alternatives are registered with the SEC under the Investment Company Act of 1940 (the “40 Act”). The term “liquid” indicates that investors have the ability to buy or sell the funds daily, while “alternative” means that the source of risk and return differs from traditional long-only equity or fixed-income investments.
By law, alternative mutual funds have to follow the same rules as other public mutual funds in the United States. The 40 Act has specific requirements to protect investors by constraining the fund manager on the use of leverage, short-selling, illiquid investments, and diversification.
What makes liquid alternatives attractive?
A survey conducted by Deutsche Bank in September 2014 highlighted the main reasons why liquid alternatives have become so popular relative to hedge funds. Increased liquidity topped the list of factors that investors found most attractive, followed by better regulatory oversight, lower fees, and increased transparency. Here is a breakdown:
- Liquidity (58%): As herds of investors rushed for the exit door during the 2008-2009 credit crisis, liquidity issues left many hedge fund investors anxious and frustrated. Back then and still today, many hedge funds still use “gates” or “lock-ups” to prevent investors from getting their money back quickly. In contrast, liquid alternatives allow investors to pull their money out at any time, just like normal mutual funds.
- Regulatory Oversight (16%): Regulation surrounding hedge funds is relatively light. That requires investors to have a high degree of faith in the track record and reputation of the hedge fund manager before risking their money. In contrast, heavier regulations for SEC-registered funds provide investors with additional safety and security.
- Fees (14%): Most hedge funds still charge “two and twenty,” which equates to 2% management fees on assets under management (regardless of performance) and 20% in performance or incentive fees. Liquid alternatives do not charge performance or incentive fees, and they often carry management fees below the 2% mark.
- Transparency (9%): Hedge funds generally offer little insight into portfolio holdings and transactions. Liquid alternatives, because of mutual fund regulations, have to meet the highest standard for transparency. A specific set of rules governs the quantity, quality, and timing of information that must be disclosed to investors.
Are all hedge fund strategies “packageable” in a mutual fund structure?
The requirements associated with SEC-registered funds make some alternative strategies unsuitable for alternative mutual funds. For example, merger-arbitrage strategies typically short the acquiring company and buy the target company. Based on the perceived probability of the deal closing within the timeframe announced, the manager will often use leverage (borrowed capital) to magnify returns. This strategy typically requires an ability to short and borrow beyond what the SEC allows in alternative mutual funds governed by the 40 Act.
However, a number of popular alternative strategies do work well in a liquid format. These include:
- Unconstrained fixed-income: This strategy allocates funds to different types of bonds with various degrees of interest-rate risk. The fund manager is not constrained to a market-cap weighted index, which often has large allocations to riskier or less attractive companies or sectors.
- Long/Short Equity: The idea is to buy the stock of attractive companies (bet on price going up) and sell short the stock of weak companies (bet on price going down) to generate returns with lower volatility than long-only equity strategies.
- Managed Futures: Commodities, currencies, and financial derivatives are traded based on signals from using trend-following models and complex proprietary trading systems.
- Global Macro: Based on economic and political shifts in trends, positions are taken in various asset classes globally.
Successful and reputable firms, such as AQR Capital Management, Loomis Sayles, and BlackRock all participate in liquid alternative fund structures. These world-class managers use classic hedge fund strategies to run alternative mutual funds. In fact, many alternative mutual funds today are liquid versions of time-tested hedge fund strategies that have been around for years.
The investment case for alternatives
Regardless of type, the addition of alternative investments may benefit a balanced portfolio through increased diversification, lower correlation to traditional asset classes, and lower volatility.
The concept of diversification is an important one. It is simply described by the adage about not putting all your eggs in one basket. While most investors use a combination of stocks, bonds, and cash to diversify their portfolios, adding alternatives into the mix can provide greater opportunities for differentiated risk/return portfolios.
Given their complex nature and risks, alternative investments are not suitable for all investors. They require a high level of understanding, rigorous due diligence, and constant monitoring. However, when vetted properly and included as a component of an overall asset-allocation plan, many alternatives have the potential to absorb shocks and reduce volatility in a way that can benefit even the most conservative investors.
Is now the time to try alternative investments?
Equity markets near all-time highs, interest rates close to generational lows, and very low yields on cash instruments imply that future expected returns from traditional investments may be disappointing compared with recent history. At the same time, the “great moderation” in global stock and fixed-income markets volatility of the last five-plus years may be approaching an end.
Trust Point offers a number of liquid alternative options for its Wealth Management clients. Now may be a good time to revisit your portfolio and ask your financial professional about alternative investments.