Alt Investments: More Need; More Choices

There’s more wind and more sail for alternatives, but choosing a course isn’t easy.

This year’s Alternative Investment Strategies conference highlighted the happy coincidence of a growing interest in alternatives and an increasing capacity to access them.

Investors see the need to look beyond equities, which have recovered from financial crisis troughs without the benefit of a solid recovery; and fixed income, where investors have tamped down interest rate exposure for years waiting for the rate hike that never seems to arrive.

This need for another set of choices is increasingly met by so-called liquid alternatives—strategies that reach beyond typical stock and bond exposure and offer the promise of easy entry and exit. Liquid alts contrast with more traditional alternative vehicles like hedge funds whose liquidity is hampered by lock-up periods and gates. The buzz on liquid alts is also powered by lower fees and greater transparency.

Still, hedge funds aren’t going away; nor should they, given their ability to capture illiquidity premiums from strategies like venture capital, where premature withdrawal of capital could doom both fellow investors and portfolio companies. And let’s face it, hedge funds’ gaudy fee structure, garnished with an unholy tax break on carried interest, offers massive incentive for managers to find success.

What’s In A Name?

In this fifth year of the conference, the exact definition of “alternatives” still doesn’t exist: The space rightly defies easy pigeonholing. At the coarsest level of asset allocation, alternatives likely means things other than equity and fixed income, and therefore could include simple long-only exposure to commodities and currencies, for example.

Yet even this crude definition flunks the test, since many alternative strategies rely on underlying exposure to equity or fixed income, such as equity market neutral, global macro and managed futures.

Practitioners at the conference even disagreed about whether alts should be considered a separate asset class. While semantic clarification is helpful in discussion and analysis, the question of “What is an alternative?” is best answered in the context of the investor’s unique allocation needs and performance goals, which I touch on a bit later.

Pie Slices

You’d expect purveyors of alternative vehicles to advocate large allocations to alternatives, and they do. Many suggested 20 percent or more, a scary number to many, if not most. Still, they have a point in that a 5 percent allocation to an alt strategy designed to deliver uncorrelated returns or to hedge tail risk may perform beautifully when needed most, yet still fail to move the dial in a portfolio context.

The logical follow-on is to do some rough stress-testing or scenario analysis of your portfolio and sprinkle or pour in some uncorrelated returns to see what the protection is, if that’s your goal. (I’ll run some numbers myself and post them in a future blog.)

One’s comfort level with alts; the time and ability to do the needed research; and investment policy constraints will also be limiting factors. Conviction in the available strategies also matters. One can accurately scope the need but lack confidence in the available solutions; in which case, a robust allocation wouldn’t make sense.

There’s also the question of allocating within the alternatives bucket. Allocating to more than one alt strategy makes sense. Risk and return profiles can be hard to assess, and investable track records are often short. Single-strategy trades might get crowded, meaning that lots of other folks might be doing the same thing your chosen strategy is doing in a crunch, with bad outcomes for all.

Lastly, one should consider where the allocation is coming from and what the specific goals are.

If you’re rebalancing from 2013 equity gains after letting them ride through Q1 and Q2 2014, or perhaps aiming to dampen equity volatility—the typical source of large drawdowns—then choices like long/short equity and MLPs, both of which retain some equity risk, might hold less appeal.

If the goal is to replace income from low-yielding bonds, again, consider the equity beta in income plays like covered calls: To allocate entirely from fixed income to this single alt strategy would effectively boost your equity risk.

If you’re aiming to reduce interest rate risk and allocating from fixed income, then be mindful of the embedded leverage or rate-sensitive margin costs in some yield-focused CEFs and mortgage REITs. Also watch out for “enhanced” derivatives-based strategies that make bets with collateral—bets that boost returns in good times but drag them down if rates spike.

Low rates cut both ways. Alts strategies that currently earn next to nothing from their collateral, such as managed futures, would get a tail wind from higher rates once they’ve arrived.

Without a doubt, choosing among and allocating to alternative investments isn’t easy. The good news is that, as the outlook for mainstream stocks and bonds remains clouded, investors have more choices than ever.

Contact Paul Britt at [email protected].