Here is the second of a two-part guest article on alternatives by Bill Spitz, chief investment strategist, principal and director of Diversified Trust. It is based on the firm's latest white paper called The Evolution of Portfolio Management.

See part one here.

Why invest in alternatives?

Return

The first reason to consider an investment in the alternatives space is that many strategies have historically delivered higher returns than the traditional asset classes, and it is reasonable to expect them to continue to do so.  In the past 20 years a “traditional portfolio” (50 per cent US stocks/10 per cent international stocks/35 per cent bonds/5 per cent cash) had an annualized return of 7.8 per cent while alternatives showed greater returns – private equity at 15.5 per cent; real estate at 9.5 per cent; and hedge funds at 9.3 per cent.

Replacing a portion of the traditional asset classes with any or all of the three broad alternative categories would have materially enhanced return over this time frame.  Many of the alternative strategies require a lock-up of capital from one to as many as ten or more years, so any reasonable investor should demand an illiquidity premium in return for losing ready access to their funds. But, in addition to the illiquidity premium, there are several specific reasons as to why these strategies should deliver excess return.

First, some of them are relatively complex or simply not accessible to most investors which creates the opportunity to earn outsized returns for those with access and the necessary skills. Second, some strategies, such as leverage buyouts, real estate, and some hedge fund strategies, use leverage which magnifies returns on the upside although it has the same impact on the downside. Third, managers in some of these categories are able to gain what is known as an information advantage, a contrast to investors in the public markets (i.e. stock exchanges) where all investors basically have the same information due to insider trading laws and other regulations.  This should result in better decisions and a more accurate sense of valuation. Most important, managers in many of these categories can materially impact the returns they earn. Most stock and bond investors have little influence on the companies in which they own securities, and if dissatisfied, their only option is to sell.

Volatility and correlation

We strive to structure a portfolio for each client that meets the target rate of return with the lowest possible level of volatility or fluctuation as measured by a statistical term known as the standard deviation of return. The volatility of a portfolio is a function of the standard deviation of each of its components as well as the extent to which they move together. Therefore, in order to decrease the volatility of a portfolio, one must include individual asset classes with lower volatility and/or those that do not move in sync with one another.

Many of the alternative categories have lower volatility than stocks, and they tend to have low or even negative correlation with the traditional asset classes. Over the past 20 years, the standard deviation for US equities was 17 per cent and international equities 18.9 per cent.  Alternative categories were less volatile than stocks; private equity had a 16 per cent standard deviation, and hedge funds and real estate were particularly stable at 8 per cent and 4.6 per cent, respectively.  

The extent to which investments move in tandem is measured by a statistic known as the correlation coefficient which ranges between -1 and +1. A coefficient of -1 means that two investments move in exactly the opposite direction whereas +1 indicates they move in tandem. So, the goal in portfolio construction is to include investments that have low or even negative correlation with the other asset classes held.

When examining the correlation between alternative and traditional asset classes over the past 20 years, the correlation coefficient was 0.75 for US stocks versus private equity, 0.68 for US stocks versus hedge funds, 0.20 for US stocks versus real estate, -0.29 for US bonds versus private equity, -0.16 for US bonds versus hedge funds, and -0.09 for US bonds versus real estate.   It is evident the addition of the alternative categories to a traditional portfolio provided a diversification benefit because their correlations were less than one.  Real estate and private equity were particularly effective diversifiers versus stocks and bonds.

To tie together the discussion of volatility and correlation, one has historically been able to create a portfolio including alternative assets that had the same return as a traditional stock/bond mix with something like 25 per cent less volatility.   Inclusion of alternative investment strategies in a portfolio should either enhance return or lower volatility, and it may well accomplish both objectives.

Issues with alternatives

Illiquidity is the most significant issue with respect to some alternatives. Many of the alternative asset strategies require lengthy investments that are difficult and potentially expensive to exit - real estate and private equity funds typically have lives of six to eight and ten to 12  years, respectively, and many hedge funds entail a one year lock up and also require notice of three to six months to redeem. However, an alternative to hedge funds is specialized mutual funds that offer daily liquidity and have risk and return characteristics that are designed to achieve the same goals as hedge funds.

Second, there are a number of operational issues that make investing in alternatives more difficult than the traditional categories. Many top funds are simply not accessible to investors that do not have established relationships. Second, with respect to tax reporting, many of these strategies involve a K-1, and some alternative managers are unable to deliver them until after April 15 which requires the investor to file for a tax extension. Some alternative classes entail periodic cash calls and distributions which require each investor to have an active cash management program.

Third, alternative strategies are often complex and opaque, and some entail specific risks such as the use of leverage or derivatives. For example, many hedge funds are unwilling to provide their investors with a list of portfolio holdings. In the case of private equity and real estate, while there are regulatory guidelines, periodic valuations are influenced by the manager’s judgment so an investor really can’t assess the return on a fund until the end of its life. Finally, investors have very little say regarding the management of a fund including the opportunity to impose guidelines or restrictions on the manager.

Finally, manager fees are quite high. They generally include an annual base fee of 1-2 per cent of committed capital plus a share in the profits of the fund. The manager’s profit participation varies by strategy and manager, but is on the order of 20 per cent of profits after achieving a minimum rate of return that is known as the hurdle.

These drawbacks are certainly significant and need to be assessed in the case of each alternative strategy.

Looking ahead

Based on historical data, there has been a compelling case for alternatives which raises the question of whether we should expect similar future behavior. Some argue that alternative returns will not be as robust because non-traditional asset classes have been discovered by many investors. And while we acknowledge that the space is more crowded and there are many managers in each of the major categories, we believe:

• Alternative asset strategies should deliver superior returns as compared to the traditional asset classes, and their inclusion in a portfolio should enhance diversification;
• Even moderate incremental returns derived from alternatives will meaningfully impact overall portfolio returns;
• Dispersion across the manager universe provides an opportunity to further enhance returns through good manager selection; and
• Alternative asset classes deserve an allocation in the portfolios of investors with longer time horizons and the ability to give up some portfolio liquidity.

In order to successfully invest in alternative asset classes, we strongly recommend that experienced professionals with the requisite expertise, experience, and relationships be employed to manage this portion of a portfolio.