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Portfolio > Alternative Investments

A Clear Path to Client Satisfaction: Add Alpha, Stay Invested

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In the next few years, a client’s evaluation of their advisor will boil down to the professional’s ability to do two things: add alpha and keep them invested. True, these have always been core components of an advisor’s role, but in the coming years they will take on added significance.

Why? It’s a function of a low-return environment, and the psychological roller coaster that is likely to unfold.

Let’s start with the low-return environment. There is good reason to believe that returns from both equities and fixed income will be lower in the coming years.

Equities rebounded quickly from the initial pandemic-induced sell-off. Lofty stock valuations do not reflect the economic reality of the highest unemployment level since the Great Depression. High unemployment levels likely mean a slow economic rebound, and lower returns from equity markets as earnings slowly recover. Investors can probably count on low returns from fixed income as well, which historically have been highly correlated to yields. Today’s historically low yields suggest that future fixed income returns may not be as compelling as they have been in the past for investors.

If low returns persist, clients should perceive an advisor’s ability to source incremental alpha as a greater value add than they would in a higher return environment.

Consider the math: If a passive, traditional stock and bond portfolio returns 15%, for example, and an advisor’s allocation decisions lead to a 16% return for the client, that 1% of extra return only adds 6.5% of total return (1%/15%).

But in an environment where market returns are only 5%, for example, an extra 1% of extra return makes up 20% of the total return. Suddenly, that alpha means a great deal.

Checked Emotions Will Matter More

Keeping investors’ emotional and behavioral impulses in check also has been a critical advisor role. This too could take on added importance. Admittedly, no one can accurately predict when volatility will ramp up. It’s the surprise element in markets that usually sparks it.

But there are plenty of events in the next few months that set the stage for potentially higher volatility including economic uncertainty, fears about an ongoing pandemic, geopolitical tensions and an upcoming U.S. election.

If March’s selloff and subsequent rebound has taught us anything, it’s that markets can react to bad news swiftly, and sharply, then recover almost as quickly. An investor who jumped to the sideline in early April would have done severe damage to his or her portfolio.

Given the potential for more volatility events, advisors will need to embrace the role of client psychologist again, and keep their clients invested. Clients will appreciate it as rebounds follow.

Alternative Strategies Essential

As advisors look for incremental alpha and seek to keep clients invested, alternative strategies can help achieve both goals.

To improve the risk-adjusted returns of a client’s portfolio, advisors either can rely on active equity and fixed income managers to produce alpha within their respective asset classes, or seek alternative strategies that are less correlated to traditional markets.

The skill of active managers has been spotty over the last decade, which suggests advisors may need to broaden their horizons to other asset classes that include alternatives.

Many alternative strategies also can dampen overall portfolio volatility, and, in turn, play a role in keeping clients invested through the market cycle because they don’t see their portfolio fall as far. Until recently, it had been quite some time since alternative strategies were tested in a volatile market.

But March provided a microcosm of how they can help portfolios — even just a simple 50/50 allocation to long/short equity and managed futures would have allowed investors to realize roughly a quarter of the market drawdown.

March’s performance is not surprising. Adding alpha and dampening drawdown have always been the hallmark of alternative strategies. For advisors, their use has never been more critical.

Josh Vail, CAIA, is president of 361 Capital.


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