It’s with good reason that alternative investments are becoming increasingly popular with retail investors. The asset class has been important to institutions for years, and it’s only right that a variety of alternatives are showing up as a ‘slice of the pie’ in traditional asset allocation models. That’s not to say, however, that amid the growing acceptance of alternative investments in modern asset allocation models, questions don’t remain as to how those strategies are best used. There are plenty of considerations to be sure, but establishing a framework for implementing alternative investments in a retail portfolio starts with the basic tenet that there is no ‘free lunch.’
Plenty of Choice
No matter how you look at it, investment return comes from taking on some kind of investment risk. In a traditional, diversified portfolio of stocks and bonds, the major sources of risk are essentially equity beta and interest rate. Alternatives, too, bring along risk, but the risk—and reward potential—differs greatly depending on the strategy. A wealth manager must identify the kind of risk a particular strategy brings, and diversify that risk across an investor’s portfolio.
How different are the strategies? Here are just a few examples…
- Merger-Arbitrage managers invest in the securities of companies in the midst of an acquisition or merger. Generally, the strategy makes money if the deal closes and loses money if it doesn’t. Obviously there is risk involved here, but the payoff has little to do with the direction of the stock market or interest rates.
- Managed Futures strategies are based on sophisticated trend models. A manager will buy and sell futures across multiple asset classes based on whether he or she can identify a directional trend in an asset class. Similar to Merger-Arbitrage, the payoff for a Managed Futures strategy is not contingent on whether the market goes up or down, but if the manager is right about the trend.
- Long/Short Equity strategies attempt to buy stocks that are attractive and sell those that are not. Generally, managers of these strategies will end up buying more than they short, leaving them with overall exposure to the equity markets. Long/Short Equity differs from the previous two examples in that the payoff is sensitive to the up and down movements of the stock market. In this way, long/short strategies have similar, albeit potentially less, risk exposure as long-only equity strategies.
They’re Called Alternatives for a Reason
So how does an advisor go about implementing any one or all of these strategies in a client’s portfolio? There is no exact answer, of course, but here are very distinct considerations, starting with the assumption that the composition a retail asset allocation model including alternatives would have of 50% equity, 30% fixed income, and 20% alternatives.
If alternatives are being added to equally reduce the equity beta and interest rate risks, then 20% of the allocation could be thought of as 10% “equity-replacing” alternatives and 10% “fixed income-replacing” alternatives. In this framework, the goal is to replace equity and fixed income investments with alternative strategies that can provide similar return and volatility levels without the same risk exposure.
A Merger Arbitrage strategy with low leverage and low volatility might make a good fixed income replacement. A well-run strategy could provide a volatility and return profile similar to bonds, but not contribute to further interest rate exposure in the overall portfolio. Similarly, a Managed Futures strategy might be plugged into the portfolio as an equity replacement because it provides a similar volatility and return profile to equities without being subject to swings in the stock market. A Long/Short Equity strategy, meanwhile, will not only offer similar return and volatility potential as equities, it will add to the equity beta exposure already present in the portfolio.
There are other alternative strategy types available in the marketplace, Convertible Arbitrage and Global Macro to name a couple, and they will expose portfolios to different risks, like liquidity and off-balance sheet leverage. An advisor will want to explore and understand the types of risks these alternatives bring to investors and determine if they are appropriate equity or fixed income replacements in a client’s portfolio.
Alternative Strategies Are Not Created Equal
One way or the other, the increasing popularity of alternatives means more portfolios are carving out space for a dedicated alternatives allocation. The best way we know to approach this task is to identify the existing risk exposures in a portfolio and select alternatives that have similar volatility and return profiles with non-correlated risks. It’s a good bet choosing alternatives within this framework will help reduce the overall volatility in the portfolio by diversifying its overall risk.
Author’s disclaimer: Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned.