Portfolio Diversification Now: How to Classify Liquid Alternatives

 

Our last column laid out the case for advisors to consider liquid alternative investment strategies. But before we can implement such strategies in a portfolio, we need to think about how to properly classify them and why. First, here’s a bit of history on this topic.

Alternative asset managers have historically believed that their strategies can’t or shouldn’t be categorized in the way that traditional strategies are. A traditional manager builds long, fundamentals-based portfolios. Alternatives managers, in contrast, were traders first; they built portfolios based on arbitrage opportunities when securities were temporarily mispriced and increasingly sought to expand their “tool box” of investing instruments to do so.

Given that alternative strategies depend on exploiting short-lived arbitrage opportunities, as well as new techniques and markets (leverage, shorting, futures trading, private equity and other illiquid securities), the talking point has been that we simply can’t group alternatives managers or strategies according to indexes and style boxes.

But for advisors, being able to classify alternative strategies is important because it provides a framework for evaluating their performance history. How else can you compare strategies, and choose between the ever-growing number of alternative strategies that are now available in liquid, transparent structures such as mutual funds and exchange-traded funds (ETFs)?

I’d suggest that it makes more sense to create peer groupings of like alternative investment portfolios based on sources of risk and underlying investments used. With an alternatives manager, there are essentially four possible outcomes for your investment: 

  1. The manager is good at selecting superior stocks and leveraging them appropriately but bad at shorting inferior stocks.
  2. The manager is good at shorting inferior stocks and leveraging them appropriately but bad at selecting superior stocks.
  3. The manager is good at both going long and short.
  4. The manager is not skilled at any of these tasks.

Managers in category 4 are easily identifiable and are generally not in business for very long. The difficulty lies in unmasking managers who hide behind their ability to conduct one aspect well. In order to do so, we break down equity-based alternative strategies into four subgroups so as to better

 

understand how managers intend to add value. These include the following:

  • Enhanced Equity: Managers have an expanded “tool box” at their disposal to enhance return potential through the use of leverage, options or shorting
  • Hedged Equity: Managers use an expanded “tool box” to protect them from negative equity market movements
  • Market-Neutral Equity: Managers intend to maintain a neutral equity exposure, rather than rely on their selection ability to generate performance
  • Negative Equity or Bear Market: Managers attempt to add value by selling stocks short, holding a net short position at all times.

With this classification system for equity-based alternatives, we can better evaluate the success of alternatives managers and understand the risks associated with each subgroup.

We’re now in a position to use alternatives in constructing a portfolio. In our next installment, we’ll discuss the various approaches for tackling such a task.

For more on Mike Henkel’s thinking, this time on retirement planning, read the Five Steps to a Successful Retirement Income Strategy, written by John Sullivan of Investment Advisor off AdvisorOne’s recent “Frontiers of Investing: Reliable Income for Clients in Retirement” webinar.

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