How Should Advisors Evaluate Alternative Strategies?
Because modern portfolio theory emphasizes the value of holding instruments having low cross-correlations, we’ve heard many advisors describe the search for alternative investments as a search for assets with low correlations to either equities or bonds. This leads advisors too often to consider nontraditional assets over alternative strategies. We believe that perspective is too narrow and misses the larger point. It is our opinion that clients primarily desire reasonable returns with low volatility, and that there are many ways to achieve that goal.
We believe advisors can build portfolios using liquid alternative strategies as part of the core allocation, but to do so, should evaluate alternative strategies as follows:
Discover Primary Market in Which the Strategy Seeks Exposure
In our view, advisors should always identify the primary market driving returns in any alternative strategy. We believe most alternative strategies, whether in hedge fund form or mutual fund form, attempt to create portfolios using various asset mixes or hedging techniques to achieve a similar result as combining assets having low correlations. The resulting portfolios (funds) may exhibit a relatively high correlation to an underlying asset class, but with less volatility and without too great a loss of total return. For instance, effective long/short equity strategies promising lower volatility than holding un-hedged equities often will have relatively high correlations to un-hedged equities, and, in our view, should.
Understand the Liquidity of the Underlying Assets Used in the Strategy
One of the biggest challenges to advisors seeking to employ alternative strategies will be assessing the ‘true’ liquidity of a fund. We believe advisors need to do more than depend on the 15% limitation on illiquid assets held by mutual funds to assess liquidity. At a minimum, we believe advisors need to regularly review the quarterly filings made by the managers of alternative strategies and determine if they understand the risks of the portfolio holdings. If an advisor wouldn’t buy the underlying assets in a liquid portfolio, we don’t believe a daily net asset value and redemption feature create the liquidity most advisors seek.
Confirm Targeted Upside and Downside Participation with Primary Market
We believe advisors should understand the targeted upside and downside participation of the strategy with the returns of the primary asset class. We believe some sort of upside/downside benchmarks or targets will become key features in the classification of liquid alternatives in the future. If the manager of an alternative strategy defines lower return volatility as a primary goal of the strategy, we believe advisors can assess whether the target participation meets their clients’ expectations. If upside returns instead depend on some leverage, we think that advisors should be aware of the manager’s view regarding limits on leverage and not leave this solely to the limits imposed by the ’40 Act. A manager might be conforming to the letter of the ’40 Act by purchasing leveraged ETFs, for instance, but the advisor will have more difficulty measuring return attribution.
Identify Sources of Growth and Protection
The source of growth in a manager’s strategy might simply be the investment in an underlying asset class, or it might be the result of selling options. In our view, advisors need to understand where the manager will seek portfolio growth (or income). In addition, we believe advisors need to understand whether protection is a stated goal, and assess how likely the protection will work given their market view. Protection might be the result of buying options (which can be very expensive), short selling (which can pose other risks), or the addition of other protection assets or cash reserves. We believe the advisor needs to be aware that the goals of protection involve risks that might adversely impact the portfolio. Protection, like return, cannot be guaranteed.
Understand Use of Derivatives
Because of the inherent leverage of swap contracts, futures contracts, options on futures and options on securities, we believe advisors should fully understand how managers stop the risk of loss when mangers employ these instruments. In particular, the use of derivatives opens wide a range of potential outcomes, good and bad. We believe advisors should also determine whether managers use derivatives in a systematic manner that can be modeled by the advisor. If not, the fund manager who chooses derivatives tactically, or infrequently, poses a greater burden to the advisor who needs to frame expectations for the product in a dialogue with the advisor’s clients. We believe the use of derivatives can leave advisors guessing about the effective leverage and targeted upside/downside of the alternative strategy if the fund manager uses derivatives in an ad hoc fashion.
Summary
In our view, advisors are being inundated with varying approaches to managing client assets. To summarize, we believe if advisors can answer the following questions when evaluating liquid alternatives, they will have a strong framework by which to choose among the many choices now being presented to advisors and their clients.
- 1) What is the primary market in which the strategy sources returns?
- 2) How liquid are the underlying assets employed by the asset manager?
- 3) Does the asset manager articulate a targeted participation with the primary source of market beta?
- 4) Does the strategy target growth, protection, or both?
- 5) Does the strategy rely on derivatives, levered ETFs or exchange-traded notes?
It is our opinion that advisors will choose alternative investments because they believe such allocations will improve the clients’ outcome, including reducing behavioral risk. We also believe neither client nor advisor wants to be surprised by the outcome or performance of an alternative strategy.
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
