Page 21 - Investment Advisor - Jan/Feb 2021

ALTERNATIVE INVESTMENTS

By Josh Vail

Performance Dispersion Ups the Ante for

Alternatives Due Diligence

Advisors need to look inside the numbers to see where success, failure and

risk exist.

alling all due diligence wonks. folio’s key sources of risk. Through returns-
Get your coffee, your spread- based and holdings-based analysis, one can
Csheets, your performance data- identify: exposure to the equity risk premi-
bases and dig in. Your role has never um; exposure to other risk premia such as
been more important. size, value or momentum; and exposure to
Investment manager due diligence has sector and/or geographic concentrations.
always been a critical, if not underap- As with any strategy, it’s also impor-
preciated, value add in the advisor-cli- tant to measure the manager’s ability to
ent partnership. The advisors evaluating deliver alpha. With alternatives, however,
strategies are the sole guardians between if the strategy uses shorting, one should
millions of clients and thousands of man- ensure the strategy delivers alpha on
agers marketing to them. It’s never been both the short and long book. From what
an easy task, but it’s absolutely critical in Pick a poor stock fund, for example, we’ve seen, this is rare, but does exist.
the current market environment, especial- and the advisor and client will eventu- When conducting due diligence, ask
ly for alternative strategies. The reason: ally switch to a different stock fund. The managers to provide you the numbers
Performance dispersion in the alterna- asset allocation remains the same, how- that show the performance of the short
tives category has widened considerably. ever. But pick a poor-performing alterna- book. Make sure that you examine the
For both long/short equity and man- tives fund and a client might completely full historical numbers, not just the
aged futures funds, two of the more com- retrench from strategies they already are three-year or five-year (or whatever
mon alternatives strategies, performance less familiar with in the first place. time frame is on the fact sheet).
dispersion in 2020 has been considerably Whatever objective the advisor hoped Finally, 2020 has added an opportu-
wider than any of the previous five calen- to achieve with alternatives, whether nity for advisors to add another item
dar years. (For the purpose of this research, it’s outperformance or diversification, to the due diligence checklist: How did
we measured performance dispersion is now lost, and inevitably, the client’s they manage a crisis?
as the performance difference between switch away from alternatives probably Market upheaval in the spring pro-
strategies in the fifth and 95th percentile will come at the wrong time. vided a rare window to see how a team
of Morningstar’s category for long/short How can advisors avoid this outcome? navigated it. Did they panic and make
equity and managed futures funds.) Fund performance is never a guarantee, wholesale changes to the process? Did
Looking further back, dispersion for the but as manager selection becomes more they learn from it and make changes at
long/short equity category in 2020 was important in alternative categories, the margins? Or maybe their process
47.7%, compared to an average of 27.8% there are a few due diligence questions held up and they made no changes at
since the financial crisis through 2019. For that can help, including some new ones all. Then again, maybe the process failed
managed futures, dispersion was 27.3% in for the current environment. and they are too stubborn to adjust.
2020, compared to an average of 17.4% for First, address the manager’s invest- Whatever the response was, advisors
the full period since the crisis through 2019. ment philosophy: What inefficiencies should ask, and make sure they are com-
wan wei/Shutterstock a similarly wider range of outcomes. Poor do those inefficiencies exist, and why tional piece of the due diligence puzzle.
fortable with the answers. It’s an addi-
does the manager believe exist? Why
Wider performance dispersion means
should they reasonably persist? Finally,
outcomes in the alternatives space are
And for alternatives, it’s never been more
important to get due diligence right.
what is the manager’s definable edge in
troublesome, because the ramifications are
exploiting those inefficiencies?
usually larger than if a client is invested in
an under-performing stock or bond fund.
Second, advisors must identify the port-
Josh Vail, CAIA, is president of 361 Capital.
JANUARY/FEBRUARY 2021 INVESTMENT ADVISOR 19