“Liquid alternative funds are increasingly popular as rates rise and no one wants bonds anymore,” says Ben Warwick in typically straightforward (harsh) style.
The no-nonsense CEO of Denver-based alternative investment shop Quantitative Equity Strategies and ThinkAdvisor contributor argues that advisors are certainly more interested in the asset class as their clients catch on to the need for noncorrelated products and strategies. But how is it done; how does the advisor intelligently allocate these resources?
“Let’s back up and define what we mean by alternative investments in this instance,” he professorially begins. “Alternative investments are any nontraditional investment (not pure stocks or bonds). They are usually considered a portfolio diversifier instead of a return driver and are typically not highly correlated with equities or fixed income securities. They include hedged strategies, exotic beta, and other non-long-only products.”
With that out of the way, he goes on to make a strong case for aforementioned liquid alternatives, mainly delivered to retail clients in a mutual fund structure.
“The advantage, at least to the average retail client, is that fact that no K-1s are generated, they enjoy daily liquidity, more transparency, fees can be reasonable and usually there is no minimum net worth requirement,” he quickly ticks off.
Like nearly all investments, he adds. alternatives are typically evaluated based on the one factor that is not indicative of future results: their past results.
“Too often people try to sell them based off of performance indices that are not even investible,” he notes.
Warwick then mentions what he considers the three most important risks to any investment portfolio, and how alternatives can help manage each.
Interest rate risk— "Fixed income is especially susceptible to interest rate risk, and we seem to be witnessing in almost real time. Warwick recommends convertible bonds and managed futures during periods of rising interest rates. Precious metals, REITs and, of course, fixed income, are to be avoided."
Economic risk—"To minimize economic risk in a portfolio, consider 'deep-value' strategies to increase convexity in the equity allocation. 'Smart beta' products may be a good addition in the equity or alternatives allocation (in lieu of traditional active management). Long-only commodity products are to be avoided."
Volatility—"When dealing with volatility risk, look to investments that benefit from rising volatility. Avoid inverse funds, as there are better solutions, and rebalance more frequently."
“The best way to think about the importance of diversification is to consider a tall building,” he relates. “Such structures are made to withstand high winds and even earthquakes, although their upper floors tend to sway a bit more than some might expect. Without this ‘sway,’ the building may collapse. Without alternative investments, the portfolio might also.”
Of course, due diligence is critical, and Warwick concludes by listing two questions to make sure are answered.
“How will fees impact return expectations, and are there significant hidden charges? Also, the size of the fund, liquidity of underlying holdings are important considerations, and be aware of tax inefficiencies.”
Check out Buying the Shutdown—Searching for Alpha for October 2013 by Ben Warwick on ThinkAdvisor.