We have all heard the adage (attributable to Woody Allen, believe it or not) that “80% of success is showing up.” There's showing up in the physical sense: showing up at the interview on time, showing up for your kid’s ballet recital, showing up at spin class with those special shoes that snap right into the bike. But in the financial markets— particularly during the six or so years including and following the 2009 recovery — there are plenty of folks who have gotten by just by showing up.

The Active vs. Passive Conundrum
Jack Bogle at Vanguard is widely credited with popularizing passive investing using index funds. Along with their sleek newer cousins, passive exchange-traded funds (ETFs), index funds offer a convenient and cost-effective way to participate in entire markets, as opposed to choosing specific securities. Given the propensity for markets to go up over long holding periods, passive funds can be a practical basic component of a broader investment strategy. Passive funds, however, are limited to the returns that a particular market provides and are guaranteed to experience all of that market's volatility. As such, they are the ultimate toolbox for the investor who does not want to risk doing worse than the market and is content not to do any better.

Deploy active managers in your portfolio, and you introduce the risk of human error. Choose your investment talent wisely, however, and you unleash the possibility of higher returns and a smoother ride when markets stumble. The best managers are masters of their craft. Some perceive trends years before they become widely apparent or uncover hidden clues in corporate balance sheets and legal documents. Others acquire unloved companies or properties and transform them into coveted assets.

Whatever their particular expertise, these elite practitioners hone repeatable processes that can translate into higher long-term returns for their investors.

It's Not Just About Returns
When seeking out the best managers, it is tempting simply to gravitate toward this year’s winners. The problem with emphasizing short-term returns is that they may have less to do with a manager’s skill than with his or her having shown up for the party in a particularly hot market segment. As you might imagine, strategies predicated on buoyant markets tend to suffer when the tide turns.

Some basic statistics, often reported on funds’ marketing documents or on paid subscription services like Morningstar and Lipper, can help investors separate productive stewards of capital from happy party-goers. Beta, for instance, measures the sensitivity of a fund's performance to the market's return.

A fund with a beta of 0.6 to the S&P 500 is expected to experience about 60% of the index’s up and down moves. A fund with a 1.5 beta is expected to be a time and a half as volatile as the index, and one with a 1.0 beta is expected to move roughly in line with the S&P.

In a vacuum, there is no inherent virtue to having a high, low, or medium beta. Some beta comes with the territory in traditional equity investing, since every stock’s price is influenced at least somewhat by the prevailing market climate. Instead of an absolute indicator of worthiness, beta should be viewed as an equalizer among managers, a handicap that gets discounted in evaluating the quality of a fund’s returns. When we take those raw returns, strip away the market's contribution and discount the fund’s sensitivity to the market, we arrive at alpha, the part of the performance attributable to manager skill. If all else is equal, when two portfolios perform similarly, the one that achieved this performance with a lower beta has the higher alpha and the more skilled portfolio manager. A fund with no alpha is the actively managed version of just showing up.

Alternative Investments and the Alpha Advantage
Among active managers, those that pursue alternative investment strategies have access to the most powerful methods for lowering beta and enhancing alpha. Some hedge funds, for example, pursue short selling strategies, which profit when specific stocks decline. As a result, these funds can have low or even negative beta to markets. Venture capital funds can participate in the exponential returns – largely alpha-driven – that are unique to seeing a start-up company through from idea phase to realization.

There are arguably as many different categories of alternative investments as there are investment managers, and the only commonality between their strategies is that they differ in some way from a long-only strategy of simply buying stocks or bonds. Complicating matters for investors, the very fuzziness of the alternative investment category— which is defined only by what it is not— has made it a catch-all for offerings of widely divergent character and quality.

Top Talent Will Not Be Tied Down
Discerning investors have access to a rich and varied pool of talented professionals. As consumers of active management, we should expect investment managers to produce alpha. We should also recognize that a manager's capacity to do so is determined not only by her ability but by the tools at her disposal. In a traditional mutual fund (aka '40 Act) construct, managers must observe restrictions including concentration limits, outright bans on asset types such as certain derivatives and limits on short selling. Expecting a star portfolio manager to perform without these tools is like asking Yo-Yo Ma to put down his Stradivarius and play a toy cello on his next tour: a non-starter. Similarly, the most talented investors generally gravitate toward conditions where they can express their convictions freely.
To be clear, the restrictions in mutual funds are there for investor protection, and there are certainly talented liquid alternative managers running strategies with impressive track records. However, for those investors who can understand the associated risks, can afford significant loss in this opportunistic segment of their portfolios and can earmark these assets for a long time horizon rather than relying upon them to meet immediate needs, there is much to be gained by utilizing the undiluted version, provided they approach manager selection with care.

Whether liquid or illiquid, public or private, alternative investments generally charge higher management fees than their long-only counterparts. When comparing actively managed investment options, investors should consider the potential net (after fees) returns available from each offering. Between the inexpensive ETFs covering just about any market index one might like to replicate and high-quality alternative investments providing returns that enhance or complement core exposures, investors have options. There’s no need to pay anyone just for showing up.

James Waldinger is CEO of Artivest, a tech-driven platform expanding access to alternative investments for high net worth investors.

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