Alternative investing – deep dive portfolio construction thinking for financial advisers
Some great feedback on a previous AdviserVoice article has led Select Investment Partners’ Chief Operating Officer Alex Wise to address specific points provided by the AdviserVoice adviser community.
Alex writes his perspective from the position of a multi-asset investment firm that has incorporated some hedge funds and other alternative investments into its diversified portfolio construction since inception in 2002.
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There have been attempts over many years to classify alternative investments and hedge funds into defensive and growth categories. Why? Expediency is one reason – the primary purpose was to mirror existing industry terminology used to classify mainstream asset classes like shares and fixed interest.
Additionally some allocators placed hedge fund strategies into specific asset classes based on their return characteristics. Low risk (or more accurately “standard deviation”) funds were included as “fixed income” and higher standard deviation managers as “equity” irrespective of whether they invested in those asset classes! This made portfolio construction easier but failed to analyse the true characteristics of these investments – allowing the crazy situation of derivatives funds classified as fixed income. The problem was that these low or higher standard deviation hedge funds did not exhibit the same characteristics as equity or fixed income in many other ways and they shouldn’t have been sold (or bought) on that basis. It is not unreasonable however, where the advisor is more sophisticated, that long/short equity funds that are exposed to the market can be included in equity allocations as they exhibit the same characteristics based on many measures.
Unsurprisingly confusion remains. Which is why many expert investors and their consultants deal with the categorisation issue through the creation of a separate ‘alternatives’ allocation within a diversified portfolio – mostly made up of hedge funds. The existing asset classes within the portfolio are then proportionately reduced to take into account the inclusion of alternatives.
As discussed in previous articles, accessing alternatives requires specialist expertise. The skills required to realise the full benefits of alternative investments should always include:
- The ability to assess which opportunities are worth exploring further;
- The ability to perform the required due diligence;
- Experience and industry networks;
- The ability to discern which investments are appropriate for clients;
- The ability to access certain structures and offshore domiciled funds.
Alternative investments increase portfolio diversification. A diversified portfolio which includes assets with different risk and return profiles is difficult to build. A diversified portfolio helps reduce overall risk without necessarily impacting expected returns. A single manager fund exposes an investor to idiosyncratic risks associated with a single manager, for example key man risk of investing with a ‘name’ portfolio manager.
Alternative investments provide access to specialist investment opportunities. Some of the best opportunities are normally only available to sophisticated investors including large pension schemes or endowment managers. In turn most of these single managers are only available to wholesale investors. A diversified portfolio can provide access to these “best of generation” investment managers with high alpha potential.
Using a diversified portfolio materially reduces single manager investment risk. This is essential given the complexities that are involved in understanding and accessing some alternative investments.
Provided an adviser and the client have agreed on the diversification benefits of utilising alternatives, the most important question is sizing; how much should be allocated to alternatives?
Investment views on allocation weightings vary. Typically, a diversified portfolio can hold between 10 per cent and 35 per cent in alternative investments at any one time of which the largest part is likely to be hedge funds.
Hedge Fund Behaviour
Equity Funds
The term “hedge funds” comprises many different types of investment styles. As hedge funds invest differently (for example some invest in equities others in options) it’s not easy to group their returns as one. There is significant risk in looking backwards at how alternatives have performed in the past. Having said that, it is worth noting that during the GFC many hedge funds dropped in value as they were positioned to capture market upside or they were “net long the market”, however prior to the GFC these funds had performed very well.
Many lessons have been learnt from the GFC, in particular improvements in transparency and liquidity – meaning investors can “see through” into certain investments to ensure an understanding of the market risk or “beta” that they are exposed to. Additionally, the evolution of liquidity means many high quality equity hedge funds can be accessed on a daily basis – particularly those that are regulated in the US or Europe.
As stated above many investors classify long/short equity funds as “equity”, which really means “market risk” or beta. This allows investors to seek out outperforming funds “alpha” and the pay the premium for this skill. These are often mult-strategy funds that can invest across the spectrum.
The primary driver of these improvements is founded on allowing investors a clean exit in the event that the underlying investments fail to perform. For our firm, this means access to these strategies with the additional benefit of low fees. If equity markets perform poorly and these funds are net long these funds are likely to underperform historic NAV highs – but potentially outperform the index. In such an instance the enhanced structural aspects mean investors can go to cash quickly.
Market Neutral
Strategies such as market neutral (where the manager is long and short often in equal measures) should also outperform equities. These funds take advantage of small mispricing between similar or related securities and tend to use leverage to exploit small pricing inefficiencies.
Systematic Funds/ CTAs
Other hedge fund strategies such as systematic funds performed well in 2008; during this time our firm had exposure to systematic funds or “CTAs” that performed well. Many believe these strategies responded well to the volatility in the market. Evidence this year indicates that CTAs fail to perform in periods where equity markets are range bound and bonds underperform. Many had not expected that both bonds and equities would underperform at the same time and as such both CTAs and equities tended to underperform.
This adds complexity in considering the role of CTAs in a portfolio with many international investors remaining cautious that CTAs can provide portfolio protection in all circumstances where equity markets are flat or even falling.
Tail Risk Funds
Tail risk is the risk of outsized losses outside of the normal distribution of returns, some funds are structured to take profits from these outsize events (“tail risk funds”). During the GFC some strategies performed extremely well, for example tail risk funds which profited from volatility in markets. However, these funds tend to perform relatively poorly in a rising market; one of the tail risk funds held by our firm in 2008 made a triple digit return whilst equity markets collapsed. Many of these funds are also described as long volatility. Generally in a falling equities market, long volatility and tail risk strategies perform well.
Diversified Alternatives
As discussed above a diversified portfolio of alternatives reduces reliance on one particular asset class. It is rare to find an asset that outperforms in any scenario! Some managers can exhibit these characteristics and charge high fees to compensate for this rare skill. By investing in a diversified portfolio – in theory the fund should perform well versus a cash benchmark (or absolute return investing) – as opposed to benchmarking against the market. The range of hedge fund strategies is balanced with the objective of providing “all-weather” protection for investors. The allocations can also be rebalanced during the cycle to adjust the allocations to alpha and beta.
There is no guarantee cast iron or otherwise that investments will perform as expected. We all know that that past performance is not indicative of future returns. The alternative to looking backwards is looking forwards. Performance based on an expected set of worked events can of course be modelled although this is more of an art than a science as prescience has not been a widely bestowed gift since the days of the Hebrew prophets.
Summary
On the whole alternative investments can bring lower correlation with traditional asset classes. This means that when blended with mainstream investments they can help to smooth out an investor’s portfolio returns over time (particularly taking into account times of market dislocation).
Investing in a single hedge fund requires deep analysis on the investment strategy and how it can perform across a range of market scenarios. Where advisors choose one or two hedge funds there is a risk that those strategies can respond poorly at times when protection is needed. It’s also a big mistake to classify funds as equity or fixed income solely based on their standard deviation as an indicator of risk. A CTA for example has a considerable departure form traditional asset class thinking and is a million miles from fixed income in many respects.
Many institutional investors deal with this problem by building a diversified portfolio of alternatives assets with a target weighting often in excess of 10 per cent. They also use specialists to help build the portfolio.
Building a portfolio of alternative investment requires expertise in understanding complex investment strategies and the ability to undertake due diligence including business risk due diligence.
Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes.
