From the November 2015 issue of Investment Advisor • Subscribe!

The Dangers of Investing Complacency

Risk management isn't simply about judging the probability of a loss, but also the magnitude

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It's not enough to have a plan; you have to follow through. It's not enough to have a plan; you have to follow through.

Recently, I was hiking with my family in the mountains a couple of hours west of Denver. During the hike, we were crossing a stream, and in my attempt to help my daughter across, I slipped and came down hard on a pile of rocks. Upon inspection, it was only a surface-level injury and something that I could easily patch up with my first-aid kit — which was in my car about five miles away. I was prepared (I had thought to purchase a first-aid kit), but I had failed to actually put the kit in my backpack. Preparation without full implementation isn't particularly useful.

Of course, leaving my first-aid kit behind wasn't simply an oversight. It was likely a semi-conscious decision resulting from overconfidence, coupled perhaps with a lack of imagination. I’ve gone on more than 100 hikes in the mountains and I “never” get hurt, so ensuring my first-aid kit was in my pack wasn't front of mind.

And therein lies the point. When nothing bad has happened in recent memory, we get lulled into a false sense of security. Risk management is boring until it's not; just ask any security guard or TSA official. And risk management isn't simply judging the probability of a loss, but also the magnitude of a loss should one occur.

Six and a half years have now passed since the stock market bottomed out during the financial crisis. U.S. equities have annualized at between 17.5% for the largest companies (based on the Russell Top 200 Index) and 20.9% for mid-sized companies (based on the Russell Mid-Cap Index), with micro-cap and small-cap stocks falling in between. These outsized gains, along with our temporal distance from the pain felt during the crisis, have made it increasingly difficult to stay invested in risk-mitigating strategies.

Consider for a moment the flows to liquid alternatives over the past year.

12-Month Asset Flows Through September 2015 (Source: Morningstar)

Ten of the 12 categories experienced meaningful outflows over the past year. Clearly some of those outflows were redeployed into multi-alternative and managed futures funds, which have had strong inflows. This is likely the result of some investors opting for the one-stop shopping that multi-alternatives can offer (despite the potential pitfalls, which we’ll leave for another day). And while I’d like to think that managed futures have gained traction due to their undeniable diversification benefits, the truth is probably simpler: It's been the best-performing category among the group, and investors chase returns.

Even with healthy inflows to multi-alternative and managed futures, alternative funds experienced net outflows amounting to $4.6 billion over the past year. Based on anecdotal evidence, we’d hazard a guess that there are distinctly different groups of investors redeeming from single-strategy funds on one hand, and allocating to multi-alternative funds on the other. If so, it means that many investors have been throwing in the towel on alternative strategies at just the moment when markets are becoming “interesting.” Volatility, absent for many years, spiked in late August, and investors are being reminded of one of the reasons they pursued alternatives in the first place.

The good times can't last forever, and investors need to consider what changes are necessary to position themselves for success in the years to come. Risk management should be of primary concern given where equity valuations stand, the outlook for the global economy and the fact that interest rates remain at levels detrimental to savers and bond investors.

Investors should assess the risks in their portfolios, and explore strategies that have the flexibility to go both long and short. If the concern is equity market volatility, then long-short equity or equity-market-neutral strategies should be considered. If rising default rates in the bond market are worrisome, consider long-short credit strategies. If you are searching for a source of returns that has a low correlation to traditional assets, consider managed futures funds.

--- Read "Liquid Alts Sizzle in Volatile September" on ThinkAdvisor.

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