From the March 2017 issue of Investment Advisor • Subscribe!

Back to Basics: The Utility of Alternatives

Yes, equities have had eight strong years, but they are a blunt instrument

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Another year has passed, and with it, investors booked double-digit gains on their U.S. equity positions, marking the eighth consecutive year of positive returns for the Russell 1000 Index. Further, equities have continued their upward march thus far in 2017, on hopes that our new president will be able to effect positive change relating to corporate taxes and overly burdensome regulations, among other things. With equities again in the limelight, investors could be forgiven for questioning the role of alternative strategies. But it is exactly at these moments when investors must give careful consideration to the various tools that can be employed in a diversified portfolio.

In the following table, we present various risk, return and beta measures associated with all the major hedge fund strategies, many of which are now available in mutual fund form. The window of time selected was based on the longest common time frame for these indexes, and includes multiple market cycles.

Risk, return, beta measures for hedge fund strategies

Note that while each strategy has a fairly unique signature, there are undeniable commonalities. This is a function of the fact that there are only four broad asset classes: equities, bonds, commodities and currencies. No matter how you invest in these asset classes — through long-only or long/short strategies, directly or via derivative exposure — you will have exposure to common risk factors. The benefit of using alternative strategies is that they allow you to better dial in the specific exposures that you want to either magnify or minimize.

Long-only equity is the workhorse of most portfolios and has been quite effective over time, but it is a blunt instrument. When it is working well, that blunt instrument appears to be the only tool that investors need. However, as we are all painfully aware given the two major bear markets since 2000, there are times when that blunt instrument fails spectacularly.

We are often asked our opinion regarding asset allocation, portfolio construction and risk management when incorporating alternative strategies into portfolios. Our first question is always, “What are you trying to achieve? Do you have a specific view on the economy or markets that you want to take advantage of? Do you have a return target, either absolute or relative, that you are trying to reach? Or do you have, let's call it a maximum pain threshold, a particular dollar amount that you absolutely couldn't bear to see evaporate, even if only temporarily?”

With a particular goal in mind, the merits of each asset class can be more easily determined. Alternatives allow investors to add to their equity, credit or interest rate exposure, for example, in ways that reduce timing risks, that allow for more precise exposure to sub-factors like quality, volatility or value, and that can dramatically truncate the downside when blunt instruments stop working.

We believe that an aging bull market replete with uncertainties surrounding the direction of the country is the impetus to take full advantage of alternatives by incorporating meaningful exposure to such strategies, consistent with client goals.

--- Read Advisors Expect Politics to Drive Volatility in 2017: Atomix Survey on ThinkAdvisor.

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