If you have been thinking about adding alternative investments to your clients’ portfolios, it’s important to step back and analyze the various types of investments available to you—which, despite being lumped together in the same category, have become increasingly varied.
To better understand alternative assets, they can be divided into two separate categories:
- 1) Long positions in nontraditional assets such as commodities, precious and industrial metals, art, jewelry, timberland, farmland, commercial real estate, currencies; and
- 2) Investments in alternative strategies in which the returns of traditional and/or nontraditional assets are re-shaped by combining long and short positions, hedging and/or alpha generation with the use of options and other derivatives, and leverage.
Nontraditional Assets
The nontraditional asset categories above have been available to investors for years, but are mostly illiquid and sparingly used by individual investors (with the exception of gold and real estate) because of the difficulty moving funds in and out of such investments. We acknowledge the growing attempts to offer more liquid instruments with market exposure to these assets but we believe those efforts will be limited. Other than foreign exchange held for investment, we think nontraditional assets will ultimately represent a small portion of the overall allocation to alternative investments because the supply available in investable form seems too limited to absorb any significant shift away from stocks or bonds.
Below is a partial list of nontraditional assets:
- Commodities
- Real Estate
- Collectibles
- Venture Capital, Private Equity and Other Illiquid Venture Funding
- Direct Investment in Infrastructure Projects
- Foreign Currency Held for Investment
Given the demand for liquidity, transparency and ease of settlement, there are limited amounts of nontraditional, investable assets available to a broad client base other than foreign exchange. Whereas the supply of land, for example, is fixed, the supply of currencies seems virtually inexhaustible. Modern central banking has become a dominant participant in world market activity and so investors can easily participate in the currency market to source returns not tied directly to stocks or bonds. This should lead to foreign currency based alternative strategies becoming a more important part of the alternative landscape.
Alternative Strategies
The growth of alternative strategies is more than likely to outpace the use of nontraditional assets in portfolio construction in the coming decade. When managers choose to employ shorting, leverage, derivatives and hedging techniques, a very wide range of possible outcomes is potentially available using a very large supply of core assets. There are two primary investment structures for alternative strategies:
- 1) Hedge funds
- 2) Mutual funds and exchange-traded funds (ETFs) employing alternative strategies
Many advisors may assume the distinction between the two structures for alternative strategies (hedge fund vs. mutual fund) is driven by the availability of daily liquidity (redemption). Today that might be the case, as hedge funds have not typically offered daily liquidity whereas mutual funds are most often structured to offer daily subscription and redemption. In the not-too-distant future, however, quite a few hedge funds are likely to offer daily liquidity, and the primary distinction between a hedge fund with daily liquidity and a mutual fund will be the leverage employed by the hedge fund manager.
There are other advantages to the mutual fund structure for delivering alternative strategies. In our opinion, the recent launch of a wide array of liquid alternative strategies in mutual fund form addresses four concerns many advisors have voiced to us about hedge funds:
- 1) Limits on leverage employed by mutual fund managers as compared to hedge fund managers;
- 2) Limits on amounts of illiquid underlying investments held by a mutual fund as compared to a hedge fund, along with diversification requirements for mutual funds;
- 3) As previously mentioned, mutual funds most often offer daily pricing and redemption while hedge funds typically have less frequent redemption opportunities (and which may be further subject to the manager’s right to limit the amount of total withdrawals to a stated percentage of the fund’s net assets, i.e., ‘gating’);
- 4) Absence of performance incentive fees in the majority of mutual funds.
Not all hedge fund strategies can be easily ported to the mutual fund structure, particularly those dependent upon leverage. However, a few hedge fund strategies can possibly be launched as mutual funds, and as a result, actively managed mutual fund strategies may more and more resemble hedge fund strategies. For example, many hedge fund strategies use highly liquid exchange-traded funds (ETFs) as core holdings or for short positions. Many hedge funds employ options. All of these can be part of an alternative mutual fund strategy.
However, advisors should be aware of the potential pitfalls of investing in liquid alternative strategies. Whereas hedge funds have been around for quite a number of years, and as a result, many hedge funds have long performance records over a range of market conditions, there is a limited history of operations for most alternative mutual funds and little evidence of their performance during severe market corrections. Further, given the limits on leverage within a mutual fund, it may not be easy to rely on a hedge fund’s track record to arrive at an estimate of future performance for an alternative mutual fund.
In addition, while the typical mutual fund can not charge performance fees, the annual management fees charged by managers of alternative strategies are likely to be higher than the typical mutual fund holding a collection of long-only assets.
Finally, the use of derivatives such as levered ETFs, futures and options can introduce risks the investor and advisor may find difficult to assess. Even adding a small amount of leverage can create larger fluctuations in returns than might be expected in a traditional mutual fund.
Liquid Alternative Mutual Funds
The array of alternative strategies offered in mutual fund form is wide and growing. A partial list of these strategies is listed below:
- Long/Short Equity
- Option-Based Long/Short Equity
- Volatility Strategies
- Equity Market-Neutral
- Unconstrained Fixed Income
- Managed Futures
- Multi-alternatives
- Tactical Allocation
- Risk Parity
Most of these strategies are in our guide to alternative investments available at our knowledge center http://www.larkinpoint.com/guidebook-for-financial-professionals.html
DISCLOSURE
Larkin Point Investment Advisors LLC (“Larkin Point”) is an investment advisor registered with the U.S Securities and Exchange Commission. Registration with the U.S Securities and Exchange Commission does not constitute an endorsement of the firm by the Commission, nor does it indicate that Larkin Point has attained a particular level of skill or ability. Larkin Point is not a registered broker-dealer in the United States. Larkin Point is not registered under the laws of any foreign jurisdiction and this report shall not be deemed a solicitation of any investors or clients in contravention of any such foreign laws and regulations.
The statements and material appearing in this report have been prepared, except as otherwise noted, by Larkin Point, contain confidential or privileged information, and should not be read, copied or otherwise used by any other persons.
This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein.
(c) Larkin Point Investment Advisors LLC
