In our last article, we discussed the potential benefits of adding alternative assets to a strategically allocated portfolio, along with some of the difficulties that advisors may face in the process. In this posting, we will discuss one specific approach to constructing portfolios using alternatives.
As a reminder, we need to address the following set of questions: First, how much to allocate to alternatives in the overall portfolio? In addition, which sub-strategies should we include within the alternative sleeve, how should we combine them, and which managers should we use?
Analyzing Different Types of Alternative Strategies
To address these complex problems, we first need to group the investment strategies into similar approaches, or clusters, so we may compare and contrast them, and so we can meaningfully compare the strategies within each cluster. One of the more appealing techniques for grouping strategies is cluster analysis, a statistical technique that requires no preconceived notion of what each strategy does. Instead, this technique “clusters” similar strategies together based on their past performance.
Clustering allows us to examine and logically assign names to different types of alternative strategies. Three major clusters that tend to be the most effective in managing downside risk in a portfolio are market neutral, hedged equity/merger arbitrage and managed futures. They have the following key characteristics:
- Market neutral strategies, which seek to profit from both increasing and decreasing prices in a single market or numerous markets, often by investing both long and short;
- Hedged equity strategies, which attempt to capture potential stock upside while using active risk management techniques, such as short selling, to reduce the effect of market swings on long-term performance; and
- Managed futures strategies, which employ a trend-following approach implemented through futures trading, which in turn provides risk management tools that may not be available through direct equity investments.
The ideal portfolio construction process for including alternatives allows advisors to make informed choices in terms of trading off a portfolio’s downside protection in bad