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Putting All of Your “Alts” in One Basket?

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On a recent trip to Costco, I was reminded of the benefits of one-stop shopping. In the ever-growing metropolis of Denver, it’s more efficient to make one trip to a warehouse-style store. However, there are distinct downsides as well, not the least of which being that many patrons seem to lose their minds in these sensory overload tanks.

Aside from the frustration such encounters produce, I find I often end up with more than I need. How many dishes can one come up with to whittle down a 10-pound bag of kale? Many times a seemingly simple solution engenders unintended complexities.

Case in point: multistrategy funds. Over the 12-month period ending on Oct. 31, investors added almost $16 billion to multialternative funds, according to Morningstar. That brought total assets for the category to about $53 billion. It now ranks as the largest among those we consider to be true alternative strategies, surpassing long-short equity, which has assets of approximately $51 billion. Further, a study by Morningstar and Barron’s found multistrategy funds were a top current and future allocation because they “allow advisors to effectively outsource much of the responsibility for selecting and allocating among complex alternative strategies.”

The survey suggests that one of the reasons for multistrategy funds’ popularity is that many investors lack the time and experience to conduct proper due diligence. Perhaps more importantly, they may struggle to incorporate alternatives into an otherwise diversified portfolio of traditional assets in an effective manner. A corollary to this narrative is that many investors opt for multistrategy funds as their initial foray into the world of alternatives. But is that well reasoned?

Multistrategy funds can offer many benefits, but the apparent ease of getting your entire “alts” allocation in one place is not without its own pitfalls. There are numerous decisions to be made and resulting due diligence items to consider, among them, whether to select a single manager or a fund of funds approach. There are material differences in the level of transparency, fees, nimbleness, risk management and talent issues that all need to be vetted. Additionally, since most multistrategy funds have the latitude to shift capital rapidly, an investor needs to have some ability to gauge the impact on the risk exposures for the entire portfolio.

Our point: One stop shopping isn’t a panacea. For investors new to alternatives or who don’t have the time to consider all of the due diligence and portfolio construction issues, a simpler way to dip your toe into liquid alternatives may be to start with long-short equity. Not only is long-short equity the original hedge fund strategy, but it is highly intuitive. That is advantageous from both the client education and due diligence perspectives. Further, it is relatively easy to add to a portfolio of traditional assets without requiring a radical shift in the overall asset allocation and portfolio construction framework — meaning that long-short equity is equity. It delivers equity beta, albeit in a lessened form, and hopefully while providing additional sources of alpha. An allocation to long-short equity can be funded from equities.

Admittedly, long-short equity doesn’t offer much on the correlation front, but it does deliver on one of the main reasons for which investors seek out diversifying assets — volatility reduction. In fact, while long-short equity has a higher correlation to equities than does the typical multistrategy fund, the category actually held up better than multistrategy funds during the Great Financial Crisis (see table below).

Comparison of multistrategy funds during 2008-2009 financial crisis

The allure of a multistrategy fund is understandable given the many demands on advisors’ time, and the multistrategy solution seems to make even more sense when an allocation to “alternatives” likely makes up a small portion of a total portfolio, at least initially. However, as is often the case, what seems easy may be anything but. Long-short equity might be a better first step into alternatives.

— Read “Volatility Pushes IRA Investors Into Nontraded Alts” on ThinkAdvisor.