It’s with good reason that alternative investments are becoming increasingly popular with retail investors. The asset class has been important to institutions for years, and it’s only right that a variety of alternatives are showing up as a ‘slice of the pie’ in traditional asset allocation models. That’s not to say, however, that amid the growing acceptance of alternative investments in modern asset allocation models, questions don’t remain as to how those strategies are best used. There are plenty of considerations to be sure, but establishing a framework for implementing alternative investments in a retail portfolio starts with the basic tenet that there is no ‘free lunch.’
Plenty of Choice
No matter how you look at it, investment return comes from taking on some kind of investment risk. In a traditional, diversified portfolio of stocks and bonds, the major sources of risk are essentially equity beta and interest rate. Alternatives, too, bring along risk, but the risk—and reward potential—differs greatly depending on the strategy. A wealth manager must identify the kind of risk a particular strategy brings, and diversify that risk across an investor’s portfolio.
How different are the strategies? Here are just a few examples…
- Merger-Arbitrage managers invest in the securities of companies in the midst of an acquisition or merger. Generally, the strategy makes money if the deal closes and loses money if it doesn’t. Obviously there is risk involved here, but the payoff has little to do with the direction of the stock market or interest rates.
- Managed Futures strategies are based on sophisticated trend models. A manager will buy and sell futures across multiple asset classes based on whether he or she can identify a directional trend in an asset class. Similar to Merger-Arbitrage, the payoff for a Managed Futures strategy is not contingent on whether the market goes up or down, but if the manager is right about the trend.
- Long/Short Equity strategies attempt to buy stocks that are attractive and sell those that are not. Generally, managers of these strategies will end up buying more than they short, leaving them with overall exposure to the equity markets. Long/Short Equity differs from the previous two examples in that the payoff is sensitive to the up and down movements of the stock market. In this way, long/short strategies have similar, albeit potentially less, risk exposure as long-only equity strategies.
They’re Called Alternatives for a Reason
So how does an advisor go about implementing any one or all of these strategies in a client’s portfolio? There is no exact answer, of course, but here are very distinct considerations, starting with the assumption that the composition a retail asset allocation model including alternatives would have of 50% equity, 30% fixed income, and 20% alternatives.
If alternatives are being added to equally reduce the equity beta and interest rate risks, then 20% of the allocation could be thought of as 10% “equity-replacing” alternatives and 10% “fixed income-replacing” alternatives. In this framework, the goal is to replace equity and fixed income investments with alternative strategies that can provide similar return and volatility levels without the same risk exposure.