By
Elliott Orsillo
:
The global financial crisis of 2008 left a permanent mark on
many investors' psyche. It represented the second time in less than
a decade that wealth invested in the stock market was cut in half.
Many began to question the "buy-and-hold" philosophy and began to
turn to other "alternative" investment vehicles to generate more
consistent return streams. Another knock-on effect of the crisis
was that investors began to assign a very high premium to liquidity
in their investments. The widespread desire for liquid investment
vehicles combined with the demand for alternative investment
strategies created a tipping point in the market for certain
strategies to be launched as mutual funds or exchange traded
products (ETPs).
As our clients know, at Season Investments we put a lot of
emphasis on building portfolios that extend beyond just stocks and
bonds as part of our
Diversification 2.0
portfolio construction. Our philosophy is that additional assets
should be added to a portfolio to
complement
stocks and bonds in order to reduce risk and generating better
returns over full market cycles. Part of our portfolio includes
funds which would fall under the alternative label. The universe of
what is considered an alternative fund is vast and growing. Some of
the more popular ETPs in this space include [[QAI]], [[XVZ]],
[[WDTI]], [[CSMA]], [[PBP]], and [[ALT]]. It seems like any product
that doesn't fit nicely into a Morningstar style box is lumped into
the "alternatives" bucket. In practice, the vast majority of funds
that the industry defines as alternative would not qualify for
inclusion in our portfolios.
Three primary questions need to be answered when considering a
new investment in this space.
1 - How will this investment make me money? (EXPECTED
RETURN)
To answer this question we first have to understand the ins and
outs of the specific strategy being employed in order to determine
whether or not we expect the strategy to provide an acceptable
amount of return potential (we are typically looking for mid to
high single digit expected returns). We then analyze how this
strategy has performed throughout various market environments
historically. The liquid alternative space is relatively young
which means that many mutual funds and ETPs have limited published
track records. In some cases, fund managers can provide historical
returns dating back multiple years if not decades for their
underlying strategy. In general, the more historical returns a fund
can provide the better to see whether or not their strategy is
generating returns through multiple market environments. Not all
track records are created equal. Here are the various types we
commonly run into, in order of preference:
-
Live Returns:
the actual historical performance of the underlying manager and
strategy as implemented in the fund under due diligence or even
in a separate structure (i.e. a private partnership in which the
strategy has been run historically)
-
Model Returns:
audited returns which were tracked in real time for a paper
portfolio but were not applied to run actual capital
-
Back-tested Returns:
hypothetical returns of a historical strategy if it had applied
the same quantitative/rules based strategy as the fund currently
being managed
Having a live track record isn't always a prerequisite for
taking new managers under consideration as some funds may still
warrant the research because of a unique and compelling value
proposition. But in general, managers with live track records have
a one up on those that don't when deciding on how much to allocate
to each fund.
In the world of alternative investing, high management fees are
the norm so it is always important to look at returns that are
net
of all fees and expenses. Nobody likes paying high management fees
and everyone wants to get more for less. But the saying that "you
get what you pay for" can hold true in alternative investing just
like it does in the rest of the world. We think of expense ratios
and embedded fees as hurdles that managers have to clear. The
higher the hurdle, the better the manager will have to be and the
more evidence we will need to believe that they will clear it by an
adequate margin.
2 - How could this investment potentially lose me money?
((RISK))
Often times, investors will look at a single metric such as
volatility and draw a line in the sand as to which investments are
within their risk tolerance. The problem with this thinking is that
it totally ignores the expected return per unit of risk. It is
important to remember that risk at the portfolio level can be
dialed up or down by sizing the allocations to the individual
holdings. Therefore, risk should not only be understood on a
standalone basis, but more importantly it must be viewed within the
context of expected return. A good alternative manager will
constantly be striving to minimize the level of risk per unit of
expected return. In general we are looking for funds that offer the
return profile as described above with an overall risk level
significantly below that of the stock market.
There are a wide variety of metrics that we use to measure the
risk profile of any investment strategy. In addition to standard
measures such as standard deviation (volatility), we look at the
following:
-
Up/Down Volatility Ratio:
measures how large returns tend to be in up periods relative to
down periods
-
Sharpe & Sortino Ratios:
scores the "efficiency" of the strategy by measuring the
magnitude of excess return being produced in relation to the
amount of risk
-
Max Drawdown:
measures the maximum peak-to-trough loss that was ever incurred
over any period of time
-
Rolling 12-Month Batting Average:
measures the consistency of the strategy by showing what
percentage of rolling 12-month returns were positive
-
Skew:
handicaps the direction of "surprise" returns by measuring
whether the extreme outlier returns tend to be more heavily
weighted to the positive or the negative
These metrics provide additional insight into an alternative
strategies risk which goes beyond the simple measure of standard
deviation. Knowing where the volatility is concentrated (e.g. to
the upside or the downside) is often times more important than just
knowing whether or not an investment is volatile.
3 - How does this investment fit in with everything else
I own? (CORRELATION)
As stated earlier, the main goal of including alternative assets
in a portfolio is that they act as a complement to the other
assets. The best bang for the portfolio diversification buck occurs
when alternative assets have little to no correlation to the other
assets in the portfolio. We wrote about this in a recent
Insight
on
real estate investment trusts
. The key takeaway is that if a portfolio is constructed with a
bunch of highly correlated assets, meaning the same macro forces
are driving all the assets up and down together, than
diversification has not been achieved. In the same vein, if the
return stream of an alternative investment is highly correlated to
the returns of the broad based stock or bond market, then it isn't
providing much diversification benefit.
It is important to remember that correlation isn't always a bad
thing. Ideally one would want a high degree of correlation in
rising markets and no or negative correlation in falling ones. This
is exactly the goal of one
trend following manager
which we profiled in another
Insight
a couple weeks ago. For this reason it is important to not only
look at overall correlation but to also look at downside
correlation, which measures how correlated asset A (a theoretical
alternative fund) is to asset B (the stock or bond market) when
asset B is declining in value.
There are many things to take into account when considering a
new investment, and this list should not be considered exhaustive
by any means. However, answering these three questions is an
important place to start in understanding what benefit a particular
alternative strategy might have in an overall portfolio.
Original Source
Disclosure:
I am long [[XVZ]]. I wrote this article myself, and it expresses my
own opinions. I am not receiving compensation for it. I have no
business relationship with any company whose stock is mentioned in
this article.
Additional disclosure:
Transparency is one of the defining characteristics of our firm.
This information is not to be construed as an offer to sell or the
solicitation of an offer to buy any securities. It represents only
the opinions of Season Investments or its principals. Any views
expressed are provided for informational purposes only and should
not be construed as an offer, an endorsement, or inducement to
invest.
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