3 Questions For Alternative Investments

By
A A A
Share |

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:

  1. 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)
  2. Model Returns: audited returns which were tracked in real time for a paper portfolio but were not applied to run actual capital
  3. 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:

  1. Up/Down Volatility Ratio: measures how large returns tend to be in up periods relative to down periods
  2. 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
  3. Max Drawdown: measures the maximum peak-to-trough loss that was ever incurred over any period of time
  4. Rolling 12-Month Batting Average: measures the consistency of the strategy by showing what percentage of rolling 12-month returns were positive
  5. 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.

See also An Options Play On A Bullish Wal-Mart Stores on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: ALT , CSMA , PBP , QAI , WDTI

SeekingAlpha

SeekingAlpha

More from SeekingAlpha:

Related Videos

Tiny Homes With Big Appeal
Tiny Homes With Big Appeal          

Stocks

Referenced

Most Active by Volume

270,887,127
    $93.89 unch
225,243,115
  • $40.93 ▼ 2.74%
135,900,109
  • $47.52 ▲ 1.80%
89,467,924
  • $5.35 ▼ 1.11%
85,105,358
  • $16.95 ▼ 0.53%
80,748,539
  • $39.80 ▼ 4.21%
68,491,586
  • $3.57 ▼ 1.79%
62,097,356
  • $100.96 ▼ 0.82%
As of 9/19/2014, 04:15 PM

Find a Credit Card

Select a credit card product by:
Select an offer:
Search
Data Provided by BankRate.com