The Asian debt crisis (1997). The Russian debt default and the meltdown of Long Term Capital (1998). The tech stock implosion (2000). September 11th (2001). The credit crises (2008). These are a few of the trials and tribulations faced by investors over the fairly recent past. Couple those experiences with generationally low interest rates, and the resulting outlook for "safe" investments, i.e. bonds, and it's no wonder that investors of all sizes are gravitating toward anything "alternative."
What is properly deemed "alternative" may be in the eye of the beholder, and labels are largely irrelevant in any case. What is material is the additive benefit of an investment to the risk/return profile of a diversified portfolio. With an ever expanding list of managed products, from mutual funds, to hedge funds to ETFs, the questions that investors should consider are:
- Does the investment improve upon the opportunity set from which to generate returns, and is there a reasonably high probability that the opportunity set offers a positive expected return?
- Does the investment hedge out some/all of a particular risk already contained in the portfolio that either doesn't offer an adequate payoff or that the investor is overexposed to?
- Does the investment provide a return stream that is substantially different from the return streams to mainstream asset classes like domestic stocks and bonds, and thus provide true diversification benefits?
With these questions in mind, we address "alternatives." To begin, Prima Capital differentiates between alternative asset classes and alternative strategies. Alternative asset classes consist of anything beyond the traditional—i.e. domestic and international stocks and bonds, and cash. It is this set of asset classes that typically makes up the bulk of investor portfolios. Alternative asset classes that fulfill the above requirements consist of, among other things, emerging market equities and debt, floating rate and high yield debt, real estate, TIPS and commodities. We advocate the consideration of all of these asset classes for various reasons when constructing globally diversified portfolios.
However, our intention today is to shed light on alternative strategies rather than alternative asset classes. We view traditional strategies as long-only approaches to investing in either traditional or alternative asset classes. In contrast, alternative strategies invest in the very same asset classes, but they do so in conjunction with short positions, leverage, the use of derivatives and/or the investment in illiquid, non-public securities. Many such strategies have been launched in recent years in mutual fund vehicles, thus making them more accessible to mainstream investors.
The benefits of alternative strategies implemented within mutual fund vehicles are many, and include: improved transparency and liquidity, lower fees (usually), operational ease, and the avoidance of accredited investor rules. But those benefits come with a cost. Most of the alternative mutual funds that have been launched to date employ untested strategies, are run by unproven teams, and have fees that while lower than those charged by true hedge funds, are nevertheless too high. Further, the tool sets utilized by mutual fund managers are limited when compared with hedge fund managers (e.g. mutual funds must meet the 300% asset coverage requirement, or put differently, their ability to lever up trades is greatly limited).
