By Jon Sundt
One of the principal legacies of the financial crisis of 2008 is an increased focus on liquidity, as investors seek flexibility in their quest to better manage portfolio risk-without giving up on performance. It is no surprise, then, that increasing numbers of financial advisors and their clients are turning to liquid alternative investments to help meet this challenge.
While alternative investments have historically been the exclusive province of institutional and high-net-worth investors, liquid alternatives offer hedge fund strategies within a mutual fund structure with daily liquidity, low investment minimums, no investor pre-qualifications and efficient tax reporting. Thus, they can help a broader range of investors access the traditional strengths of alternatives-including reduced portfolio volatility and asset-class correlations, as well as strong potential risk-adjusted returns.
Alternatives have been migrating to a broader investor base for some time, but that trend has gathered speed in the wake of the financial crisis. According to Morningstar Direct Fund Flows reports, assets in alternative mutual funds have increased 138% since October 2008, to $104 billion as of Jan. 12, 2012, while the ratio of alternative mutual fund assets to total mutual fund assets has risen from 0.84% to 1.25% during that same timeframe.
In designing a long-term investment strategy for their clients, however, financial advisors should keep in mind that some alternative investment strategies are better suited for a mutual fund structure than others. At Altegris, we believe that long/short equity, managed futures and global macro are particularly strong fits within a mutual fund framework, and that these strategies should comprise a core allocation for any investor seeking a diversified exposure to alternative investments.
Long/short equity, managed futures and global macro: The core of liquid alternative investments
For a strategy traditionally residing within the realm of hedge funds to be effective in a mutual fund format, it must meet some important criteria. It must be: a) liquid enough to support the daily liquidity of the broader mutual fund; and b) pursued successfully with reasonable levels of leverage.
Long/short equity typically entails a manager going long equities he or she expects to increase in value, while selling short equities he or she expects to decrease in value. Managed futures managers, in contrast, generally utilize proprietary, model-based trading systems to identify market trends and react to corresponding price movements in securities. Global macro is a highly discretionary strategy in which managers use fundamental or macroeconomic data to predict price movements.
Despite the obvious differences in approach, these three strategies share key similarities. All generally trade in highly liquid, centrally cleared instruments-publicly traded equities from around the world, in the case of long/short equity; and global exchange-traded stocks, bonds, currencies and commodities for both managed futures and macro.
All three also have the ability to go long and short, thus providing investors with the ability to generate returns in a variety of market environments. In addition, all can pursue their investment approaches with reasonable levels of leverage. Many of the best long/short equity managers, for example, have historically maintained gross leverage of less than 200%.
As a result, investors allocating to these strategies via liquid alternatives can enjoy some of the primary potential advantages of mutual funds-a high degree of transparency, the ability to quickly invest and redeem (thus aiding in actively rebalancing portfolios), and regulatory and board oversight-while also reaping the rewards of alternative investment exposure, including strong potential risk-adjusted returns and reduced volatility.
On the other hand, some strategies that are compelling in a hedge fund format do not necessarily translate as well to mutual funds. For example, some are not sufficiently liquid. Indeed, the lack of liquidity is a fundamental driver of investment returns for these strategies. This group includes virtually all forms of distressed securities investing, certain structured credit approaches and activist/special-situation strategies.
While these strategies can provide challenges within a daily liquidity mutual fund structure, they are more nimble than investments such as real estate, private equity, venture capital, timber and other hard assets, and infrastructure when considering them within a portfolio context.
Leverage is another key factor in evaluating whether an alternative investment strategy fits within a mutual fund format. Strategies such as relative value and statistical arbitrage can produce attractive risk-adjusted returns, yet they require leverage levels beyond what is allowable in a mutual fund structure in order to be effectively managed.
Therefore, it is important that advisors and their clients carefully consider the strategies involved when constructing an allocation to liquid alternatives.
Liquid alternatives offer strong risk-adjusted return potential and portfolio diversification benefits
Another enduring lesson of the financial crisis is how highly correlated markets can be-particularly in a downturn. Thus, the ability to generate returns that are uncorrelated to traditional asset classes is crucial both for weathering short-term market swings and meeting long-term investment objectives. While past performance is not indicative of future results, the table below illustrates the substantial difference between the risk-return characteristics of US bonds, US equities and our three core alternative investment strategies, as well as the potential diversification benefits of these approaches.
Alternatives of varying liquidity can play key roles in a well-diversified portfolio
While liquid alternative investments can deliver more transparency and liquidity than offered by hedge funds typically accessible via private placement, advisors should keep in mind that liquid and less-liquid alternative investments are not mutually exclusive within a well-diversified portfolio.
For investors with the appropriate levels of investable capital for whom alternative investments are suitable, allocating sufficiently to liquid alternatives can free them up to simultaneously pursue less-liquid hedge fund strategies offering higher risk-and potentially higher returns-by virtue of their longer investment horizons.
As a result, liquid alternatives and private placement alternative investments can work in tandem to position a portfolio to generate potentially strong risk-adjusted returns in both up and down markets.
Seeking an entrée to the premier hedge fund managers via a mutual fund format
With the universe of managers available via mutual funds expanding rapidly, the challenge for financial advisors is to identify and access the most talented investment professionals. That means there are clear benefits from partnering with firms such as Altegris who have built deep relationships with premier alternative investment managers globally, and can package those managers' strategies in a liquid format for a range of advisors and their clients.
We at Altegris believe that investors realize the full benefits of liquid alternatives only when they work with "the real deal": top-flight, experienced alternative investment managers with a robust infrastructure behind them, and the ability on a historical basis to deliver alpha. In order to facilitate these opportunities for investors, an advisor should blend top-down viewpoints with bottom-up analysis to identify the most compelling market opportunities for clients and the best-of-breed managers within each strategy.
A detailed assessment and multilayered due diligence process for each manager is also essential before an investment is approved. In a multi-manager portfolio, the advisor utilizes advanced return analysis and risk profiles to actively manage and rebalance the portfolio. Finally, the advisor should perform an ongoing evaluation of each manager in the portfolio-including constant investment review and risk monitoring.
By gaining exposure to premier alternative investment managers, in a liquid format, investors can infuse their portfolios with more flexibility, reduce correlations to stocks and bonds, and improve their risk-return profiles. Through the use of liquid alternatives, financial advisors can bring the best of both worlds-mutual funds and alternative investments-to their clients.
Jon Sundt is President and CEO of Altegris, which offers alternative investments via a suite of private funds, actively managed mutual funds and futures managed accounts to financial professionals and individual investors. Altegris and its affiliates are subsidiaries of Genworth Financial, Inc. and are affiliated with Genworth Financial Wealth Management, Inc.