The Benefits of Alternative Strategies

This week’s Barron’s featured an article called “Just Don’t Lose It!” It was an interesting examination of how investors are nervous about the current and future state of the market. Even though January’s market returns were excellent, investors have a good memory of stock and economic gyrations going back to the collapse of 2008, and all the way to the wild up-and-down swings of the past year.

This was my topic several weeks ago when I wrote about how to invest like a hedge fund using alternative exchange-traded funds. The reason to use alternative strategies in your portfolio is to provide access to hedge fund-like non-correlated returns, which help to diversify your portfolio, reduce risk and improve your risk-adjusted returns.

I want to explore this topic through a very interesting Question & Answer session that I participated in this week. My firm, Rockledge Advisors, hosted a webinar called “The Long and the Short of It,” that addressed the benefits of alternatives such as the Long/Short and Absolute Return strategies.

The webinar was a success, with nearly 400 people in attendance. The participants were sophisticated investors who asked many good questions, and I’d like to share some of that Q&A here.

I bought a few long/short funds and they seemed to go nowhere. I was told that I have to hold more. What are we to do?

It is difficult to answer in specific without knowing which funds you are talking about. In general, there are several known issues with Long/Short funds underperforming. The first one is unfortunately bad business management, where a portfolio manager claims to have a non-correlated Long/Short strategy, but in fact, it is mostly a long strategy with some short hedging involved. Unfortunately, this happens more often than not and you really have to do good due diligence on the fund. The second point is that most Long/Short strategies are not designed to hit home runs. A typical Long/Short strategy is expected to hit many singles, often and consistently. So once again, it is hard to judge the Long/Short funds you are referring to without know what time frame and market cycles these strategies lived through.

How would you respond to questions about recent negative performance in some alternative funds?

Some alternative funds did underperform recently. Part of the answer is above, meaning that you have to see these strategies performing over several economic, business and market cycles before you can have a true comparison. Alternative funds are not a panacea or an answer for everything. A prudent investor who believes in delivering returns consistently and with appropriate risk tolerance should focus on portfolio diversification and include alternative funds as part of his or her overall portfolio allocation.

If capital preservation is the goal, why not cash?

Going into cash is always an option, but only if you know when to come out of cash. You are talking about market timing, which is not done well over any meaningful period.

When increasing an allocation to alternatives, what is an institution typically selling to increase the alternative allocation?

Typically, you should decrease proportionally your holdings in other asset classes. To be more specific, if you are using an equity absolute return strategy, the allocation should come out of the equity class. If you are using a fixed income absolute return strategy, the allocation should come out of fixed income class. Most recently, endowments have been decreasing exposure to equity asset class more than other classes.

How do alternative ETFs compare with the relevant HFRI index?

An HFRI index is an aggregate hedge-fund index that includes different hedge-fund strategies, such as Long/Short, Market Neutral, Merger Arbitrage, Macro, Short Only and others. An alternative ETF should be properly compared to the corresponding hedge-fund category within HFRI.

What do you think of using a higher allocation of alternatives, say 40%? Over time, will that allocation be too high and therefore be a drag on performance?

We believe that an investor should allocate 15% to 25% to alternative asset class products. The key is to diversify and find non-correlated strategies.

What is the best way to “lift the lid” on alternative strategies?

An alternative strategy wrapped in an ETF provides full transparency to the investor as holdings are published daily, thus the ETF is fully transparent. A wrapped alternative strategy offered through a mutual fund is only revealed once a quarter and there is no way of knowing if that position was the same through the quarter. A hedge fund will most likely never reveal its holdings.

Long term is good, but if over a 10-year period the strategy underperforms the S&P 500, how long can you expect investors to continue to look to the long term? Many would have been gone about the time when the value began to be proven.

A 10-year period is too long to wait for performance. In our experience, if the fund does not start to deliver within 18 to 24 months, its inclusion in your portfolio should be reassessed.

Is there a cost to borrowing or shorting a stock as rates are lower? Assuming margin rates are lower, creating a lower hurdle to beat.

Yes, but that is only part of the story. Short positions earn what is called a short stock rebate, because when you borrow, you sell security for cash and earn interest on that cash. So the higher the interest rates are, the higher interest you will earn by selling short that security.

What type of investments does an alternative ETF hold?

The portfolio holdings are fully transparent and can be seen on a daily basis on the website of the ETF issuer. That is the enormous benefit of investing in the ETF as opposed to a mutual fund or a hedge fund — the ETF holdings are fully transparent.

Please talk about different segments of alternatives in portfolios. I have read alternatives can be divided into risk control (equity and fixed income hedging) and return enhancement.

There are several categories within alternative strategies. If you look at the hedge-fund space, the alternative strategies can include Market Neutral, Long/Short, Merger Arbitrage, Short Only, Macro and others. Within this definition it can include both equity and fixed income. If you look at the broader definition of alternative strategies, you would also add commodities, real estate, private equity, etc.

When tracking an alternative strategy, what’s the best-correlated index to look at for the past performance comparison?

These strategies are designed to be non-correlated and should not be compared to an equity or a bond index. The alternative strategies should be compared to aggregated hedge-fund indices.

Do you eat your own cooking?

Yes, we eat our own cooking. All the principals own the fund, as well as our families.

We ended on a good note, with many thanks for the information provided. I was happy to see so many sophisticated investors. It confirmed for me what the Barron’s article suggested, that people are leveraging their experience and improving their batting averages by looking into alternative strategies, while lowering their risk though new and exciting alternative ETFs.