Alts Are the Answer

Treadwell tends to prefer multi-manager products. “Since funds of funds haven’t been available in ‘40 Act form for very long, we tend to gravitate toward management teams that have a track record in hedge funds,” he added.

Broad Street also has a healthy allocation to managed futures. In all, his firm has a 20% to 25% allocation to liquid alternatives. “Although there are some mandates that prevent us from using such funds, we find them quite useful in creating portfolios with the type of risk profile that clients are comfortable with.”

Allen Gillespie, a CFA and partner at FinTrust Advisors in Greenville, South Carolina, links the increased acceptance of liquid alternatives to fears of another market meltdown. “We look at such investments in two distinct buckets. On the equity side, we use liquid alts for risk reduction. Strategies such as long-short equity, long commodities and managed futures tend to generate stock-like volatility, but can add valuable diversification and reduce overall portfolio risk,” he said. “On the fixed income side,” he said, “we use alternatives to increase return. This is where strategies such as convertible arbitrage, credit long-short and other debt-related methodologies can be used to increase return and lower duration risk compared to a traditional long-only bond portfolio.” 

FinTrust has developed a rigorous due diligence process for selecting liquid alt funds. For starters, the firm uses a number of performance spreads to determine the potential upside of a given strategy. “Returns in the commodity long-short space are typically equity-like, and we haven’t seen that since the global financial crisis. Equity market neutral funds also fall into this category.”

Gillespie keeps a keen eye on costs, including expenses like commissions and those associated with fund structure, such as swaps and other over-the-counter derivatives. He is also careful to understand what factors drive returns, “which is critical in giving us the conviction to stick with an investment through a performance shortfall.”

Gillespie’s experience as a fund manager earlier in his career has given him another perspective on judging when to invest. “I always ask about fund flows. Most of the time, flows are positive when the markets are overbought and negative when there are lots of opportunities. If you ask portfolio managers which way their flows should be going, they usually give pretty good insight.”

Experience on the portfolio management side is also a driving factor behind Prism Advisory Group’s use of alternatives. Jill Guess, a holder of the Chartered Alternative Investment Analyst (CAIA) designation and director of research for Newtown, Pennsylvania-based Prism, has six years’ experience co-managing an in-house fund of hedge funds. This led to the creation of three discretionary mutual fund portfolios with significant allocations to liquid alts.

Like many practitioners, Guess stresses the need for rigorous due diligence in selecting such products. “Since alternative mutual funds are pretty new, I tend to look at the track record of earlier products, typically limited partnerships, which were run by the portfolio managers. This at least gives you an indication of their success managing the strategy historically. Then you’ve got to discern any limitations in implementing that strategy in a mutual fund format.”

She continued, “I can’t overemphasize the importance of reading the prospectus. This is a great place to find out what instruments are used in the portfolio, the structure of the fund and whether it will be run in a similar fashion to the firm’s other products.”

In Guess’ mind, selecting liquid alts is much more difficult than a traditional manager search as they “tend to be newer, so there is less performance to consider. Advisors have to understand the return drivers, which in many cases are not obvious. This is very important in designing portfolios that can withstand the drawdowns equity markets will exhibit over time.”

Like many advisors, Prism has a 20% to 25% allocation to liquid alternatives. Unlike other firms, it still uses hedge funds for some applications. “Strategies such as distressed debt are better captured in a limited partnership,” she said, “but there are a number of liquid strategies that do a good job of trying to give that type of exposure.”

Setting Expectations for Risk and Returns

For those advisors who approach risk with a more holistic view, liquid alternatives can fill a void left by traditional stock and bond investing. “Although we now live in a low interest rate environment—one that may be with us for some time—investors still need to make a return that meets their cash flow needs,” said Chris Cabral, a CFA who’s a vice president at Fiduciary Trust in Boston. The $11 billion firm is focused on educating its clients on how to manage their expectations within a given risk-reward framework.

“Many of our clients are taking regular withdrawals from their accounts, so at this point in their investing cycle a full allocation to equities may not be needed,” Cabral said. “We are still constructive on stocks, but do not want to take more than the necessary amount of risk. Many areas of the fixed income market are overbought as well, so we limit how much duration and credit risk we take. Our process emphasizes truncating downside volatility in order to maximize the terminal value of our clients’ portfolios.”

A big part of the solution is liquid alts. Cabral chairs a committee on manager due diligence among the various strategies the firm uses to construct portfolios. “We consider liquid alts to be any strategy that generates a return stream unattainable in long-only public markets. This includes lower beta and non-directional strategies, as well as precious metals and global macro.”

Cabral’s team uses proprietary screens to filter potential candidates using rolling alpha, excess return and other quantitative inputs. “This gets us to a workable number for the next level of due diligence,” he said, “which includes getting to know the management team, along with how and when their strategies perform. Fiduciary [Trust] prefers to work with experts in niche areas, rather than larger firms. We tend to foster close relationships with managers, and there is typically little turnover in our holdings. This allows us to determine when strategies will underperform and gives us staying power during difficult periods.”

Cabral is a bit of a contrarian, preferring strategies that are sometimes out of favor. This includes managed futures, an asset class that has suffered in the current low-volatility environment. “Managed futures is neither portfolio insurance nor a hedge. It has a positive expected return, but it’s non-correlated to our other holdings, which makes it a great diversifier. In particular, it is an asset class that is long volatility and should benefit from a return to a more normalized environment. The fact that no one wants to own it gives me additional confidence that this is the right thing to be buying.

“Last year was a great microcosm for judging the efficacy of liquid alternatives,” Cabral concluded. “Stocks outperformed, bonds underperformed and liquid alt returns fell in the middle. The asset class performed admirably in 2013.”