Alts Are the Answer

By Ben Warwick

July 28, 2014 at 08:00 PM

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Pity the diversified investor in 2013. Who needed international equities or fixed income or real estate when the stock market only traded to the upside? Not only were domestic stocks among the best performing asset classes last year, they also boasted minimal volatility, making them the no-pain, all-gain investment.

The first six months of 2014 looked like a repeat performance. So is it time to take money off the table or press one's bets? Based on the current macroeconomic climate, I believe there are three reasons why it makes sense to reduce equity beta in favor of a more all-weather portfolio. After making this case, I will show how a few forward-thinking advisors are using liquid alternatives to position their clients for a more challenging environment ahead.

Reason 1: The (Eventual) End of QE

In normal circumstances, the Federal Reserve controls the money supply by setting short-term interest rates. Short-term rates control the cost of loans, mortgages and the rates earned in savings accounts. When the economy is overheating, the Fed typically raises rates. That makes loans more expensive, which reduces the amount of money corporations are willing to borrow, thus dampening growth. Higher rates also encourage savings, since the amount of interest paid on CDs and other short-term instruments is higher.

When the economy sputters, the Fed lowers rates. This encourages spending instead of saving, and the amount of borrowing tends to increase. But when rates are very close to zero, the Fed's effect on the economy becomes limited. So the next tool is to directly inject the economy with fresh cash. Quantitative easing is this process, and is accomplished when the Fed buys assets (usually Treasury and mortgage debt) with new money it creates by increasing the size of its credit account. The result is lower yields on U.S. debt securities and reduced borrowing costs.

Since its inception in 2009, quantitative easing has been a huge driver of risk asset appreciation. Stock prices have more than doubled since the start of QE, while cash on corporate balance sheets has expanded dramatically. Although gains in the employment rate and the degree of economic growth have been disappointing to some, many economists believe that the Fed's strategy to lower rates prevented the global financial crisis of 2008-2009 from spreading. What no one knows is how the end of the policy will affect the capital markets.

Why the uncertainty? There are no examples from any time in history to use as a gauge for what may happen or how market participants may react to the eventual end of QE. Beyond the obvious effects of inflation or currency devaluation, the long-term result of this rather unorthodox economic policy is hard to pin down.

Reason 2: The Return of Volatility

Market volatility is at rock-bottom levels. While some think such complacency may herald a pullback, others see it as a part of the investment landscape that is here to stay.

Volatility measures the amount of dispersion of price movement for a given security or market index. It is usually expressed as the standard deviation of returns. Regardless of the time frame used, this metric is at historical lows. Theories abound over why volatility has dried up. Some cite the lack of trading volume, as many investors (large and small) have largely stayed out of equities since the global financial crisis (lower than normal volumes have also been blamed for a dramatic reduction in trading profits of Wall Street firms over the last year). Others point to the artificially low interest rate environment.

Volatility is used to calculate the Sharpe ratio, which measures the risk-adjusted return of assets. The current investing environment has propelled this measure to extreme levels.

The chart above shows that over the past 24 months, an investor has received nearly three units of return for every unit of risk. Even the most risk-managed strategies struggle to have a Sharpe ratio of 1. For an unmanaged equity index to be much above this number is highly unusual.

It's likely that today's low-volatility, high-return scenario will attract new money from those sidelined after the 2008 market rout. Since that time, investors have pulled a net $247 billion from equity mutual funds, according to the Investment Company Institute. Will their frustration culminate in a mad rush into stocks, only to end in a painful correction after all the retail money on the sidelines has been committed?

Reason 3: Stock Market Valuation

While there is little agreement on how pricey stocks are today, few analysts think the market is fundamentally undervalued. Indeed, most view stocks as the "best house in a bad neighborhood," thinking that money flows are attracted to asset classes that stand the best chance of generating a decent return. With yields so low, investment-grade credits are not attractive to many income-oriented investors. And with Europe and Japan printing money at a furious pace, the long-awaited end of monetary stimulus may not be as sudden as some expected last year.

Most bullish analysts pin their hopes on continued improvement in corporate health. As of July 11, FactSet projected that the companies in the S&P 500 will report year-over-year earnings growth of 4.6% in the second quarter of 2014.

After a shaky first quarter, GDP growth is expected to rise at about a 3% annualized rate, according to most estimates. Consumer spending is leading the way, rising 4.6% year-over-year, the highest rate since 2011, according to ICSC-Goldman. Business spending is also set to improve. According to the Philly Fed, nearly half of all firms expect to increase their total capital expenditures in the current year.

Even so, the current market is one that seems priced for perfection. If the U.S. economy keeps plodding along, and if geopolitical pressures stay at reasonable levels, and if rates stay low, stocks should continue performing. But that seems like a mighty narrow ledge upon which to pin one's hopes.

Participate in Upside, but Protect From Pullbacks

The current state of the markets isn't lost on the dozens of advisors with whom I have spoken. Many of them are using liquid alts in an attempt to reduce portfolio risk while generating the returns clients need to meet their objectives.

Mercer Treadwell is one example. A CFA who is chief investment officer of Broad Street Capital Advisors, a $700 million firm in Athens, Georgia, he sees his approach as a risk-driven way to ensure clients generate the cash flow they need.

"We try to remove the emotional burden of investing for our clients," Treadwell said. "Investors tend to make decisions that are not in their best long-term interests during extreme market stress. Reducing market exposure by using liquid alternatives is a great way to participate in the upside of equities, while giving some protection from market pullbacks. We may be giving up some upside, but in the process our risk profile is much more tenable."

Treadwell tends to prefer multi-manager products. "Since funds of funds haven't been available in '40 Act form for very long, we tend to gravitate toward management teams that have a track record in hedge funds," he added.

Broad Street also has a healthy allocation to managed futures. In all, his firm has a 20% to 25% allocation to liquid alternatives. "Although there are some mandates that prevent us from using such funds, we find them quite useful in creating portfolios with the type of risk profile that clients are comfortable with."

Allen Gillespie, a CFA and partner at FinTrust Advisors in Greenville, South Carolina, links the increased acceptance of liquid alternatives to fears of another market meltdown. "We look at such investments in two distinct buckets. On the equity side, we use liquid alts for risk reduction. Strategies such as long-short equity, long commodities and managed futures tend to generate stock-like volatility, but can add valuable diversification and reduce overall portfolio risk," he said. "On the fixed income side," he said, "we use alternatives to increase return. This is where strategies such as convertible arbitrage, credit long-short and other debt-related methodologies can be used to increase return and lower duration risk compared to a traditional long-only bond portfolio."

FinTrust has developed a rigorous due diligence process for selecting liquid alt funds. For starters, the firm uses a number of performance spreads to determine the potential upside of a given strategy. "Returns in the commodity long-short space are typically equity-like, and we haven't seen that since the global financial crisis. Equity market neutral funds also fall into this category."

Gillespie keeps a keen eye on costs, including expenses like commissions and those associated with fund structure, such as swaps and other over-the-counter derivatives. He is also careful to understand what factors drive returns, "which is critical in giving us the conviction to stick with an investment through a performance shortfall."

Gillespie's experience as a fund manager earlier in his career has given him another perspective on judging when to invest. "I always ask about fund flows. Most of the time, flows are positive when the markets are overbought and negative when there are lots of opportunities. If you ask portfolio managers which way their flows should be going, they usually give pretty good insight."

Experience on the portfolio management side is also a driving factor behind Prism Advisory Group's use of alternatives. Jill Guess, a holder of the Chartered Alternative Investment Analyst (CAIA) designation and director of research for Newtown, Pennsylvania-based Prism, has six years' experience co-managing an in-house fund of hedge funds. This led to the creation of three discretionary mutual fund portfolios with significant allocations to liquid alts.

Like many practitioners, Guess stresses the need for rigorous due diligence in selecting such products. "Since alternative mutual funds are pretty new, I tend to look at the track record of earlier products, typically limited partnerships, which were run by the portfolio managers. This at least gives you an indication of their success managing the strategy historically. Then you've got to discern any limitations in implementing that strategy in a mutual fund format."

She continued, "I can't overemphasize the importance of reading the prospectus. This is a great place to find out what instruments are used in the portfolio, the structure of the fund and whether it will be run in a similar fashion to the firm's other products."

In Guess' mind, selecting liquid alts is much more difficult than a traditional manager search as they "tend to be newer, so there is less performance to consider. Advisors have to understand the return drivers, which in many cases are not obvious. This is very important in designing portfolios that can withstand the drawdowns equity markets will exhibit over time."

Like many advisors, Prism has a 20% to 25% allocation to liquid alternatives. Unlike other firms, it still uses hedge funds for some applications. "Strategies such as distressed debt are better captured in a limited partnership," she said, "but there are a number of liquid strategies that do a good job of trying to give that type of exposure."

Setting Expectations for Risk and Returns

For those advisors who approach risk with a more holistic view, liquid alternatives can fill a void left by traditional stock and bond investing. "Although we now live in a low interest rate environment—one that may be with us for some time—investors still need to make a return that meets their cash flow needs," said Chris Cabral, a CFA who's a vice president at Fiduciary Trust in Boston. The $11 billion firm is focused on educating its clients on how to manage their expectations within a given risk-reward framework.

"Many of our clients are taking regular withdrawals from their accounts, so at this point in their investing cycle a full allocation to equities may not be needed," Cabral said. "We are still constructive on stocks, but do not want to take more than the necessary amount of risk. Many areas of the fixed income market are overbought as well, so we limit how much duration and credit risk we take. Our process emphasizes truncating downside volatility in order to maximize the terminal value of our clients' portfolios."

A big part of the solution is liquid alts. Cabral chairs a committee on manager due diligence among the various strategies the firm uses to construct portfolios. "We consider liquid alts to be any strategy that generates a return stream unattainable in long-only public markets. This includes lower beta and non-directional strategies, as well as precious metals and global macro."

Cabral's team uses proprietary screens to filter potential candidates using rolling alpha, excess return and other quantitative inputs. "This gets us to a workable number for the next level of due diligence," he said, "which includes getting to know the management team, along with how and when their strategies perform. Fiduciary [Trust] prefers to work with experts in niche areas, rather than larger firms. We tend to foster close relationships with managers, and there is typically little turnover in our holdings. This allows us to determine when strategies will underperform and gives us staying power during difficult periods."

Cabral is a bit of a contrarian, preferring strategies that are sometimes out of favor. This includes managed futures, an asset class that has suffered in the current low-volatility environment. "Managed futures is neither portfolio insurance nor a hedge. It has a positive expected return, but it's non-correlated to our other holdings, which makes it a great diversifier. In particular, it is an asset class that is long volatility and should benefit from a return to a more normalized environment. The fact that no one wants to own it gives me additional confidence that this is the right thing to be buying.

"Last year was a great microcosm for judging the efficacy of liquid alternatives," Cabral concluded. "Stocks outperformed, bonds underperformed and liquid alt returns fell in the middle. The asset class performed admirably in 2013."

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