More than three years have elapsed since the September 2008 collapse of Lehman Brothers triggered a global financial crisis that decimated many investors' portfolios. The across-the-board plunge in asset prices rattled investors' confidence in the long-held belief that diversifying among stocks, bonds, and cash would shield their portfolios from catastrophic losses.  

 

Unlike previous stock market declines, the market collapse of late 2008 and early 2009 featured extremely high correlations among many traditional asset classes, including domestic stocks, developed international stocks, emerging markets stocks, commodities, and certain types of bonds. For example, the market for corporate bonds, which had provided refuge during previous stock market corrections, plummeted and then froze. U.S. treasury bonds were one of the few asset classes that provided ballast to offset the stock market's losses.

 

Painful as it was, the 2008-2009 market collapse provided a fresh reminder that one of the keys to long-term investment success is to avoid large losses, even if it means sacrificing some gains on the upside. For long-term investors, an active allocation to alternative investments that seeks to limit downside risk may produce better risk-adjusted results than a traditional long-only, buy and hold strategy that features only stocks, bonds, and cash. This realization has given many investors a renewed appreciation for risk management. As a result, advisor interest in absolute return strategies and alternative investments is on the rise.

 

In an August 2011 survey of 500 financial advisors by Jefferson National Life Insurance, 68% reported increasing their use of alternative investments since 2008. Nearly a quarter (22%) indicate that their use has increased substantially. Six in 10 cited a desire to "address portfolio correlations" as a primary reason for investing in alternative assets, while 48% cited a desire for absolute returns. 

 

But what exactly constitutes "alternative investments?"  The term is defined  rather loosely in today's financial media, such that it can cover many different asset classes and investment strategies.  For example, alternative investments can include certain private partnerships or direct private investments in assets that tend to be relatively illiquid (private equity, oil and gas, real estate, timber, hedge funds, art). They can also include other liquid investment styles that focus on publicly traded securities and thus are available as open-end mutual funds and ETFs.  We refer to these as liquid alternatives, and these remain the core of our investment focus at Emerald. 

  

A Range of Investment Strategies and Styles...not an "Asset Class"

  

Using liquid alternative investments has become much more common among advisors, and the menu of options has increased dramatically.  However, they are not a "one-size-fits-all" solution. Liquid alternatives represent a broad collection of unique investment strategies that invest in a variety of asset classes, rather than one distinct asset class.  The same can be said for hedge funds - they do not represent an "asset class" but rather, a particular trading strategy.  Whether the vehicles are hedge funds or mutual funds,  lumping merger arbitrage, long/short, foreign currency and high yield (just to name a few specific investment styles) into a single asset class is at best inaccurate and at worst misleading.  They are distinct and have their own set of economic drivers, and as such, they may perform quite differently. 

 

It is important to understand not only the breadth of styles available, but also the differences among them and how they may perform in different market environments.  This takes extensive research, diligence and experience in the alternatives space.  It's not enough to simply make a choice based on a fund name, strategy, or reputation. Investors need to peek under the hood to fully understand the risks and rewards involved.

 

Perhaps this is why some investors have yet to embrace using alternatives in their practice.  Interestingly, while most advisors recognize the role that alternatives can play in a diversified portfolio, many individual investors remain reluctant to dip a toe in these waters. For example, in the Jefferson National survey, 51% of advisors said their clients were hesitant to allocate money to alternative investments. The primary reason, cited by 82% of advisors, was a lack of understanding among clients. 

  

Similarly, in a survey of 463 investors conducted by Natixis Global Asset Management, 47% said they were worried about losing money due to market volatility. Yet 40% of these investors say they have no interest in alternative investments or strategies. In addition, 70% indicated they understand alternative investments "only a little" or "not well at all." Forty percent said they had no knowledge of alternative investments and 69% said they need to learn more before investing in alternatives. With so many choices out there and more new products launching every month, the universe of liquid alternatives is growing larger and more complex.

 

At Emerald, we view the liquid alternative investment universe as multiple asset classes that each encompasses a particular set of investment/trading styles.  Most of these sub-styles are available through open-end funds, ETFs, closed-end funds and separately managed accounts.  When used properly, we believe these styles can reduce the impact of market volatility and limit downside losses in most market environments.  However, they each have their own approach and method of implementation.  That is why we believe it is critical to understand the nuances of each style and the associated risks and rewards, as no two are the same.

  

The following reflects how we view the liquid alternative world from a macro level and sets the framework for both our portfolio construction process and underlying security selection.  There are various investment styles that exist within each of these alternative classes and thus numerous ways to play that particular space using liquid vehicles:  

 

 

 

 

This may seem a bit complex and overwhelming, but it should not steer anyone away from evaluating the options that exist across these areas.

   

Embrace the Opportunity

 

In our view, investors' reluctance to invest in something they don't fully understand is an opportunity. In the late 1990s, many people eagerly piled into funds that focused on Internet and technology-focused stocks, only to be burned when the technology stock bubble burst. Similar boom and bust patterns have occurred in real estate and emerging markets funds.  As these examples demonstrate, sometimes a little knowledge in the hands of many people can create big problems for some investors and big openings for others.

 

To invest successfully in alternative investments certainly requires an extra layer of due diligence. For example, when sizing up merger arbitrage funds, it's important to understand that some funds may focus strictly on announced deals while others may speculate on potential transactions. Some may pursue cash-only deals versus stock deals, and some may use leverage while others will not. Similarly, an ETF focused on gold may invest in the stocks of gold miners, gold bullion, or a combination of the two. It's important to understand these nuances before you invest.

 

Whether evaluating an active fund manager or ETF, as part of the diligence and analysis process, we believe it's important to drill down as deeply as possible. The more information you can gather and digest, the more informed a decision you will be able to make.  We have strict criteria that must be met before we make any investment allocations, and this applies to any security under consideration.

 

While careful security selection plays an important role, tactical asset allocation is also critical.  Some studies show that asset allocation is the most important determinant.  We combine this empirical evidence with careful manager and security selection to create models that we hope will weather most market environments.  Particularly in today's volatile markets, we find it most prudent to diversify across multiple strategies and hedge with cash and/or short positions to mitigate risk, decrease volatility and smooth performance over time.  

 

Many firms lack the resources or the inclination to develop sufficient comfort with alternative strategies.  Given the complexity of certain investment styles and all the available products in the marketplace, this is not surprising. Many elect to outsource this function to a dedicated management team with expertise and experience in the alternatives space, while others may attempt to do it themselves. 

 

Whatever path is chosen, we believe that having a piece of an overall portfolio that is committed to liquid alternatives is a critical component to long-term portfolio stability, capital preservation and growth.  No one wants a repeat of 2008, or anything close to it.  There are an abundance of liquid alternative choices available, some of which have proven themselves through various market cycles and environments.  They have gone from Wall Street to Main Street for good reason.  Embrace the opportunity, and you and your clients may just sleep a bit better at night during these volatile times.

 

 

 

 

(c) Emerald Asset Advisors

www.emerald-eas.com