Managing Fear, Maintaining Your Edge

The term “portfolio octane” is often used when discussing alternative investments. Because of their volatility, your clients’ individual behaviors must be taken into account. Would wide swings cause them to act irrationally and exit before they should or possibly invest more when they should not? Ask clients if they are willing to accept greater volatility of returns for the potential “octane” addition.

The Mixed Play Option

On the other hand, since the 1997 repeal of the IRS rule that prohibited mutual funds from shorting, strategies involving a more mixed play on everyday asset classes have only recently become available to the affluent. The objective of these “hedge fund-like” mutual funds is usually to generate positive returns regardless of the market’s direction and gyrations.

This is called “absolute return,” because the return is not relative to a specific benchmark, such as the S&P 500. The focus is to make money in all types of markets–including when the “traditional” markets are down. That’s because absolute-return strategies seek to create value by eliminating the daily effects of market swings by using one or more strategies.

By and large, you can divide these many strategies into two groups: Return Enhancers and Diversifiers.

Return enhancers. These investments aim for outsized, upside returns, often through a number of fairly sophisticated investment strategies, including long/short equity, going long on stocks whose value is expected to increase and short-selling other stocks whose value is expected to decline or investing in derivatives (hybrid securities, such as crude oil futures, whose value is pegged to an underlying investment, such as crude oil prices).

Because these types of investments may equate to an extremely bumpy ride on the way to returns, your clients’ risk tolerance must be considered. Although the allocation to alternatives would not be a majority share of clients’ portfolios, would severe swings on their statements make them act irrationally?

Diversifiers. The objective of these investments is to help provide more protection against downside risks without losing the benefit of your clients’ exposure to equities. Diversifiers stress capital protection. The goal is to retain an equivalent return on an existing portfolio, but reduce volatility by adding investments that do not fluctuate in tandem with other core investments, such as a broad stock market index fund. Unlike return enhancers, these funds are not designed to be hot funds.

At JPMorgan Asset Management, we believe that including diversifiers as part of core portfolios is a must, especially, with the democratization of investing. Why? To quote Benjamin Graham, “The investor’s chief problem–and even his worse enemy–is likely to be himself.” The purpose of diversifiers is to make the ride smoother, with the hope of protecting your client from emotional whims that volatility tends to cause (i.e., irrational behavior).

Adding diversifiers to portfolios helps to preserve capital and provide a steady stream of returns that do not run parallel to the market cycles. The end result is that your clients benefit from having access to a more predictable capital base at any point in time. Diversifiers can help prevent you and your clients from suffering “statement shock” in down markets.

Market volatility is currently at historic lows. Are your clients getting too complacent with the current investment environment and/or their portfolios? Will they suffer severe statement shock as the markets’ volatility returns to “norm”? To minimize emotional reactions in the future, incorporating diversifiers into your clients’ asset allocation mix may make sense today.

However, it is essential to educate your clients and manage their expectations. Your clients must understand that, with diversifiers, they are not trying to beat the S&P 500 Index. Instead, they are trying to increase the likelihood of their success by decreasing the potential for portfolio gyrations. If their expectations are not managed correctly, there is a good chance that some investors may jump out of diversifiers when, for example, the stock market soars, and shift to a long-only, broad-based market fund in an effort to chase returns.

Know thy manager

Like any active strategy, it is critically important to know the reputation, investing style, and performance record of the portfolio manager. Conduct your due diligence; go back to the “4Ps” people, process, philosophy, and performance. The good news is that these hedge fund-like mutual funds are much more transparent than their hedge fund cousins.

With springtime nearing, take the time to reflect and renew. Are your clients’ portfolios providing them with the upside strength and downside protection they may need and demand in the future? If not, right now is the time to discuss the appropriateness of incorporating alternatives into your clients’ asset allocations.