February 14, 2011

Risk and Return: Mutual Fund 'Alternatives' of All Stripes

Adding alternatives to portfolios to improve their risk/return profile is getting easier with the proliferation of 'alternative strategies' offered as mutual funds.

The Asian debt crisis (1997). The Russian debt default and the meltdown of Long Term Capital (1998). The tech stock implosion (2000).  September 11th (2001). The credit crises (2008). These are a few of the trials and tribulations faced by investors over the fairly recent past. Couple those experiences with generationally low interest rates, and the resulting outlook for “safe” investments, i.e. bonds, and it’s no wonder that investors of all sizes are gravitating toward anything “alternative.”

What is properly deemed “alternative” may be in the eye of the beholder, and labels are largely irrelevant in any case. What is material is the additive benefit of an investment to the risk/return profile of a diversified portfolio. With an ever expanding list of managed products, from mutual funds, to hedge funds to ETFs, the questions that investors should consider are:

  • Does the investment improve upon the opportunity set from which to generate returns, and is there a reasonably high probability that the opportunity set offers a positive expected return?
  • Does the investment hedge out some/all of a particular risk already contained in the portfolio that either doesn’t offer an adequate payoff or that the investor is overexposed to?
  • Does the investment provide a return stream that is substantially different from the return streams to mainstream asset classes like domestic stocks and bonds, and thus provide true diversification benefits?

With these questions in mind, we address “alternatives.” To begin, Prima Capital differentiates between alternative asset classes and alternative strategies. Alternative asset classes consist of anything beyond the traditional—i.e. domestic and international stocks and bonds, and cash. It is this set of asset classes that typically makes up the bulk of investor portfolios. Alternative asset classes that fulfill the above requirements consist of, among other things, emerging market equities and debt, floating rate and high yield debt, real estate, TIPS and commodities. We advocate the consideration of all of these asset classes for various reasons when constructing globally diversified portfolios. 

However, our intention today is to shed light on alternative strategies rather than alternative asset classes. We view traditional strategies as long-only approaches to investing in either traditional or alternative asset classes. In contrast, alternative strategies invest in the very same asset classes, but they do so in conjunction with short positions, leverage, the use of derivatives and/or the investment in illiquid, non-public securities. Many such strategies have been launched in recent years in mutual fund vehicles, thus making them more accessible to mainstream investors.

The benefits of alternative strategies implemented within mutual fund vehicles are many, and include: improved transparency and liquidity, lower fees (usually), operational ease, and the avoidance of accredited investor rules. But those benefits come with a cost. Most of the alternative mutual funds that have been launched to date employ untested strategies, are run by unproven teams, and have fees that while lower than those charged by true hedge funds, are nevertheless too high. Further, the tool sets utilized by mutual fund managers are limited when compared with hedge fund managers (e.g. mutual funds must meet the 300% asset coverage requirement, or put differently, their ability to lever up trades is greatly limited).

Managed Futures Mutual Funds

Because of those limitations, there are certainly strategies that have no place in the mutual fund world. However, we are of the belief that many alternative strategies can be successfully managed in mutual fund form. One area of particular interest to us today is managed futures. Managed futures strategies are typically trend following, and take both long and short positions across currency, commodity, fixed income and equity markets. There are at least nine managed futures mutual funds in existence at this time, varying greatly in quality and approach (i.e. from single manager/single strategy to fund-of-funds). Considering our general criteria for investments outlined above, we would argue that managed futures certainly meet the first and third criteria, and may also meet our second criteria, depending on the net exposures of a fund (although it would be a mistake to assume in advance that a managed futures strategy will hedge away risks contained elsewhere in a diversified portfolio at the moment that such a hedge is actually needed).

Additional Alternatives in Mutual Funds

Other strategies that we believe can be successfully run in mutual fund vehicles include long/short equity, merger arbitrage, convertible arbitrage, market neutral, global macro and certain fixed income arbitrage strategies. But before readers rush to utilize such funds, we’d point out that the added complexity of these investment strategies necessitates a more robust due diligence approach than traditional strategies require. While the value of due diligence in the realm of alternatives is most often framed around the need to ensure against fraud and operational risks, we’d argue that the total dollar amount of money lost or left on the table due to sub-par management and high fees far exceeds the dollars lost to fraud or operational problems.

We are encouraged by the growth of alternative mutual funds, as the benefits to such strategies, return enhancement (especially relative to fixed income), downside protection (primarily relative to equities) and differentiated return streams that offer true diversification will help investors to weather future financial market storms. While we have been advocates of hedge fund-of-funds for high-net-worth investors, despite their obvious drawbacks (e.g. high fees, operational complexity and the difficulty of identifying what is true alpha and what is beta), we speculate that alternative mutual funds may reduce the need for such vehicles in the future. But as is always the case, investment quality is paramount, and only a solid due diligence effort can make such a distinction. 

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