Thursday, December 20, 2018

Alternatives can provide diversification and downside protection if done right

Graphic: Pixabay/nattanan23

By Biagio Manieri, Guest Columnist

Today, with interest rates rising and volatility returning to stock prices as valuations seem somewhat stretched, some alternative strategies can provide investors with sources of return that are not correlated with traditional asset classes and that offer downside protection. But carving out an allocation to alternatives requires deep understanding and thorough due diligence. 

Advantages of Alternatives

Incorporating alternatives into a portfolio of traditional strategies broadens the universe of potential strategies and managers from which to select, which should lead to better returns over time. Going forward, publicly traded fixed-income returns will be challenged as rates rise and credit spreads possibly wid¬en. Alternative fixed-income strategies such as distressed credit, fixed-income arbitrage and other similar strategies may help returns. If certain segments of the equity market continue to propel higher and valuations become more stretched, strategies such as long/short equity, event-driven, activist strategies, etc., can add to returns and/or help reduce risk and volatility. 

Alternatives can improve the overall efficiency of the portfolio in various ways. One, alternative strategies that have low correlation with other investments in the portfolio help to reduce the overall risk of the portfolio. An example would be event-driven strategies that do not correlate highly with traditional long-only strategies. Another way that alternatives can lead to a more efficient portfolio is by enhancing the return of the portfolio or delivering a return stream that cannot be accessed via traditional strategies. 

Considerations for Investors

Questions that investors should always ask themselves include: What are my goals? What’s my risk profile? What are my liquidity needs? Then they should assess the current economic and market environment, and based on that analysis, construct a portfolio of strategies that are expected to meet those goals in the most efficient way possible. 

The biggest hurdle for most investors is access to top-performing funds. This matters because the dispersion of returns is very large in the alternatives space versus traditional funds. Another issue is the significant increase in the number of firms and assets under management, which we believe will result in lower performance for alternative strategies going forward. 

There is also the issue of how best to model alternative strategies for analytical and portfolio construction purposes. We cannot simply rely on quant models; we need to understand the underlying fundamentals of each strategy to decide when to include the strategy and how much to allocate to it. 

High fees make it much more difficult for any strategy to outperform. For us the important metric is net-of-fee performance: In addition, the calculation of carry needs to be well understood by investors. It is important to identify managers that align their incentive fees with the best interests of investors. 

Liquidity or illiquidity is also important. While some investors believe in an “illiquidity premium,” they typically do not include an “illiquidity cost” in their analysis. While it is debatable whether an “illiquidity premium” actually exists, the drawbacks of illiquidity are easier to show and should be taken into consideration when constructing portfolios.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of PFM Asset Management or TEXPERS.

Biagio Manieri
About the Author:
Biagio Manieri is managing director of PFM Asset Management. He has 32 years of experience in economics research, finance and fund management. Manieri, who was an investment officer with the Federal Reserve, serves as chief multi-asset class strategist, working with a team of analysts concentrating on the economy, capital markets, and investment management products.

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