From the January 2014 issue of Investment Advisor • Subscribe!

Why Liquid Alts Are Good for Clients and Your Practice

Alternative funds' increasing approachability is helping meet clients' diversification needs

Alternative mutual funds are enjoying increased acceptance in the advisor community. And why not? In this new risk-on/risk-off era, finding diversification in long-only products is harder than ever. At the same time, bells and whistles like liquidity, transparency and (somewhat) lower fees have made alt funds increasingly approachable.

The message is resonating with advisors. According to Citigroup, assets in liquid alternative funds have surged from $95 billion in 2008 to over $300 billion last year. The bank estimates that by 2017, that number will swell to $1 trillion, or nearly one-third the size of the hedge fund industry. Your clients are also becoming increasingly hip to alts, as evidenced by the number of large firms, including Blackstone (the $200 billion firm with deep roots in private equity), that are now getting into the mutual fund side of the business.

It’s high time to do a deep dive on alt funds. We will examine why they should be considered in a portfolio; how to choose the most appropriate strategy for clients; and the attributes to look for when shopping for funds.

Everybody Wins

Although the popularity of liquid alts is hard to explain on the surface, these products bestow benefits to all parties. Alternative firms that previously raised money in limited partnerships can now access the retail market for assets. The ever-expanding number of fee-only advisors can use alt funds to reduce volatility in client portfolios, thereby smoothing out cash flow.

But the biggest potential winners in the liquid alts revolution are the clients. Simply put, true diversification is an increasingly scarce resource. Thanks to quantitative easing, capital markets move more in lock-step, confounding those that put their trust in the age-old belief that a stock/bond portfolio can cure all ills. When used properly, alternative funds can be the missing puzzle piece for even the most intelligently designed asset allocation.

To understand the solution, one must be mindful of the problem. The best way to think about the importance of diversification is to consider a tall building. Such structures are made to withstand high winds and even earthquakes, which explains why their upper floors tend to move a bit more than one might expect. Without this sway, the building may collapse.

The same is true with a portfolio. If client holdings are dominated by a single asset class, the result may be more comfortable returns with less variation (or wobble). But during periods of high volatility, such a construct is likely to experience severe losses, spooking investors out of their holdings at the worst possible time.

The two scenarios can be illustrated as shown in Figure 1. A rigid building (and its narrowly focused portfolio twin) can be represented as a distribution with a very narrow peak. When one makes the tip of the distribution pointier, it pulls the curve upward, which makes the tails of the distribution larger. That can make for some nasty surprises during volatile markets.

Traditionally, advisors have used fixed income as a diversification tool to control for equity risk, which makes sense for several reasons. After all, equity and debt sit against each other at the capital structure of a firm, with one usually benefitting at the expense of the other. Rising rates, however, add another component to this yin-and-yang-like relationship.

For starters, bond prices and interest rates move in opposite directions. A rising rate scenario roughly corresponds to swimming against the tide for bondholders. Even if a firm’s credit improves, the most likely direction is still lower. Additionally, since the Fed tends to move rates in multi-year waves either up or down, when interest rates change direction they tend to signal an economic environment that usually sticks around for a while.

That puts diversification-minded advisors in a quandary. If bonds head lower, investors won’t be getting the same volatility reduction benefits from fixed income as they have in the past. It is at this point that alternative investments may be the sharpest tools in the woodshed.

Owing to their unique return attribution, alt funds can address the myriad of return drivers that are not accessed in conventional equity and fixed income portfolios. (Disclosure: My firm is active in providing liquid alternatives in both mutual fund and ETF formats; see “The QES Approach.”)

This is something larger investors have known for years. Institutions and pensions have utilized hedge funds since the early 1990s. At that time, alt strategies were offering returns in the high single digits with about the same volatility as bonds—a compelling return/risk trade-off. But after the credit crisis in 2008, hedge fund performance became more earth-bound. Although the shine was off the penny, hedge funds were resurrected as portfolio diversifiers.

According to Citibank, this reflected a growing concern in the institutional community about the risk concentration in their portfolios, which were typically 60% equities and 40% bonds. The failure of this allocation to offer any protection from the global financial crisis prompted many to believe such a configuration acted more like a 90%/10% portfolio, with 90% of the risk attributed to stocks and the rest to fixed income. Ironically, hedge funds’ role in making portfolios more resilient to idiosyncratic market events—even in the face of lower returns—is actually causing an increase in assets under management for this asset class.

Now, large investors have started embracing alternative mutual funds for the same liquidity benefits that have attracted high-net-worth clients. The alternatives industry has truly come full circle.

Let’s take a look at three aspects of prudently using alternative mutual funds in your clients’ portfolios.

Step 1: Picking the Right Alts Fund

Alternative funds may be great potential portfolio diversifiers, but few of them have long-term records. Instead of relying on past performance, which for these funds is typically shown pro forma (i.e., hypothetical or simulated), advisors should instead concentrate on fund expenses relative to the volatility of the fund’s strategy. Since a given level of volatility is a much easier metric to target than return, this selection criteria is more rational than past-performance-based measures such as Morningstar rankings.

The net expense ratio can be found in a fund’s prospectus or fact sheet. Fund companies typically limit expenses until sufficient assets have been raised in a specific fund to achieve economies of scale. Even so, most alternative funds have fees that exceed the 1.28% fee (according to Morningstar) charged by the average actively managed equity fund. Advisors must weigh the additional fees with the potential diversification benefit of alternative funds to determine what products should be included in client portfolios.

All things being equal, the best volatility-to-fee ratio is the highest for a given strategy. It doesn’t make sense to pay egregious fees for a low-volatility strategy like merger arbitrage, which in the best of years may produce gains in the mid to high single digits. Under that scenario, even if the fund performs as expected, investors will only retain a portion of the gains after expenses, but would be left holding the bag during a bad year.

It should also be noted that a fund’s expense ratio is not the only cost to consider. Trading costs, which can be especially high in multi-manager offerings, can be onerous. Funds that short securities have to pay to borrow them and are liable for dividends on that portion of the portfolio. Finally, there are margin costs for levered funds, even though borrowing in a ‘40 Act fund is restricted relative to levels seen in private partnerships.

One should include a good dose of common sense when using this rule of thumb. Although a volatility-to-fee ratio should be considered, choosing a fund that aims for shoot-the-lights-out performance could result in big disappointment.

Step 2: Picking Your Risk

Risk is like dark matter, the material that theoretically makes up a large portion of the total mass of the universe. Although it cannot be seen, scientists can observe its effect on celestial objects such as stars and planets. It is only when dark matter’s effect on certain forces is isolated that scientists are able to glean more information about this mysterious substance.

That’s how it is with risk. In order to determine just how a certain risk affects a portfolio, it must be isolated. So which risks are you most concerned about? Currency wars, falling equity markets and political uncertainty are but a few topics that are currently ruling the airwaves.

Rising interest rates are also a big worry, especially among those income-centric clients who don’t want to lose principal on their large bond portfolios. The key is to find investments that can actually benefit from rising rates, and to identify potential holdings that can generate income but have different return drivers.

This seemingly difficult task of finding investments that benefit from rising rates can be made much easier if it is parsed into specific steps.

Perhaps the most straightforward definition of rising and falling rate periods is the concept of a rate regime. A rising (or falling) rate regime consists of any period over which the most recent rate action on the federal funds target rate was an increase (or decrease). Since the Federal Reserve only changes its target rate on a periodic basis and because fed funds rate changes tend to occur in a series of multiple increases or decreases, these regimes can often last months or even years (see Figure 2: Understanding Rate Regimes. The data in the analysis can easily be obtained from the Web or a Bloomberg terminal).

Understanding rate regimes

The next step in the analysis is to determine the performance for various asset classes during rising and falling interest rate regimes. Figure 3 illustrates the results for seven different asset classes.

As Figure 3 shows, the return for stocks during periods of rising rates is similar to periods of falling rates. This is due to many factors, including the increasing latitude many companies have in raising the price of goods sold during inflationary periods. If rates were to rise, advisors may want to redirect portfolios toward growth stocks, which tend to appreciate more than their value-oriented counterparts during periods of increased economic growth accompanied by rising rates.

Asset class performance and rising or falling rates

The “Fixed Income” column in Figure 3 connotes the return of the Barclay’s Aggregate Bond index, the benchmark used for fixed income positions. As expected, the performance from this investment tends to suffer with rising rates.

Both managed futures and long-only commodity investments perform admirably as rates rise, since the prices of many raw materials tend to trend higher with inflation. Ironically, precious metals typically do better when rates are falling, due to the carrying cost nature of the investment. Real estate investment trusts (REITs) are mainly income-oriented investments and are not beneficial to own during rising rate periods.

Finally, consider the returns shown in the table of convertible bonds, which are fixed income securities that can be converted to stock under certain circumstances. Convertibles are sometimes referred to as a “hybrid” security, since they share characteristics of both equity and fixed income asset classes.

This methodology can be used to determine the behavior of various investments during almost any given economic scenario. Although we leave it to the reader to run this analysis, it should be obvious that advisors willing to put forth the effort should get a serious leg up on the competition.

Step 3: Picking the Perfect Pairing

It’s time to talk about that other elephant in the room—the vast amount of cash sitting in many clients’ portfolios—and how alternative funds can help advisors put more money to work.

According to a recent survey by BlackRock, the world’s largest investment firm, 48% of U.S. investors’ portfolios are in cash, with another 12% in CDs. Despite their lingering doubts about meeting future financial needs, most investors plan on either standing firm or increasing their cash holdings in the next 12 months.

An October poll by the American Association of Individual Investors puts their members’ cash holdings at about 17%, a smaller number than BlackRock’s, but much higher than what most advisors would recommend. Apparently, even the impressive performance of risk assets in 2013 has failed to quell investor angst about a repeat of the 2008 global financial crisis.

This scenario is hardly isolated to individual investors. Of the 400 professional investors at the Credit Suisse annual Megatrend Conference in New York on Oct. 18, nearly one-third held at least 30% of their clients’ assets in cash.

Cash-heavy investors have a few options. First, they can use their liquidity to increase market exposure if a big sell-off occurs. That’s a tough task, even for the most seasoned investors, and most simply don’t have the confidence to pull the trigger when everyone else is selling. Plus there’s a question of just when a stock market swoon might occur. If it happens 30% above current levels, that’s a lot of potential return to miss.

Another option is to simply jump head-first into the market, hoping that today’s high trading levels are the beginning of a longer-term up-trend. While that would certainly solve the excess cash issue in the fastest way, the strategy could run into issues if there was a sudden market sell-off. Would investors—think about your own clients—have enough poise to ride out the market doldrums, or would they simply throw in the towel and sell?

Alternative funds could be a part of the solution. If alt funds can be combined with traditional investments in such a way that more risk exposure could be created but without all the downside, that would give advisors a particularly useful third option.

For example, for clients who are nervous about the stock market’s resilience, an advisor could use excess cash to invest in an area of the market that he feels is the most interesting, like technology or an emerging-markets ETF. He could then offset that investment with an alt strategy that typically has a low or negative market correlation, like managed futures or some other macro strategy. Similar results could be had by simply investing in a lower beta asset class, like convertible bonds or a volatility-hedged equity strategy.

Although not exhaustive, Figure 4 may be useful in creating the perfect pairing of a specific alt strategy with the risk factor that advisors may wish to hedge out of the portfolio.

What risks worry you most?

The alts revolution is just beginning. With nearly 400 alternative funds available, this is an ideal time for advisors to become thought leaders in this new asset class. The benefits include differentiating one’s practice while improving client returns. Hopefully, this article will serve as a launching point for further analysis.

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Correction: Due to an editing error, the print version of this article mistakenly said REITs are "mainly income-oriented and are also beneficial to own during rising rate periods." REITs are not beneficial when rates are rising.

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