New Insights on the Role of Alternative Investments in High-Net-Worth Portfolios
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The use and general opinion of alternative investments has fluctuated wildly since they became popular with high net-worth (HNW) investors in the early 1990s. In the early years (1995–2003), investors accessed alternatives primarily through “absolute return” strategies,1 hedged equity strategies and commodity trading advisor (CTA or managed futures) strategies. Most HNW investors sought exposure to alternative investments via multi-manager funds-of-funds (FoFs), which provided access, lower investment minimums, diversification, asset allocation and risk management in exchange for an additional layer of fees.
Many investors deployed alternative investments at the implementation stage rather than the allocation stage of portfolio construction, carving out some portion of their fixed-income allocations for absolute-return strategies and some smaller portion of their equity allocations for hedged-equity and CTA strategies. During the tech bubble and subsequent bear market of 2000–2003, these strategies performed well and helped offset the dramatic drawdowns suffered by most equity portfolios.
Life was good.
Success begets imitation, and demand for alternative investments increased dramatically from 2003 to 2008 ,2 new funds proliferated and strategies became increasingly specialized and granular. Many investors grew more confident in alternative investments and — rather than viewing them as surrogates for equity or fixed-income assets — began to include alternative investment asset classes at the allocation stage of portfolio construction. Other investors moved from FoFs to single-manager, single-strategy funds. The primary access vehicle for these strategies, whether single strategy or FoF, remained limited partnerships (LPs), also broadly referred to as “hedge funds.”3
The objective of alternative investing for many investors during this period shifted away from portfolio diversification toward portfolio alpha generation. Interest rates and volatility were low, credit was easily accessible and both equity and fixed-income assets enjoyed relative bull markets. In this “green grass and high tides” environment, many investors forgot or ignored liquidity risk, increasingly excessive leverage, counterparty and fraud risk and many other forms of investment risk not captured by standard deviation.
The subsequent events and impact of late 2008 and early 2009 are well known: The credit markets imploded, liquidity evaporated, all correlations (except Treasury securities and CTAs) went to one and the markets crashed. CTAs generated positive performance in 2008, and hedged equity mitigated a portion of the downside movement in equities, but absolute-return strategies absolutely failed to meet investor expectations. Absolute-return strategies posted double-digit losses — less than the global equity markets but negative nonetheless. Worse, many of them faced enormous and untenable redemption requests that highlighted the mismatch of the underlying strategies and their investors’ liquidity terms, particularly in FoFs. Investors, left dealing with partial redemptions, gates and side pockets, might not get the balance of their money back for years.
To top it off, the Bernie Madoff scandal broke in December 2008. Madoff’s scheme wasn’t a hedge fund or an alternative investment, but hedge funds and alternative investments were vilified in its wake. In particular, investors developed an extreme aversion to the LP structure, which they now associated with illiquidity, lack of transparency and lack of regulatory oversight.4
Life, most definitely, was not good.
The last two years
During the past two years alternative investments have more or less returned to normal performance. Investors are once again reallocating portions of their portfolios to the multitude of strategies now available. But where is the industry heading next?
This article is the first in a two-part series on the evolution and future of alternative investments. This first part revisits the argument for including alternatives within diversified portfolios, keeping in mind the events of 2008–2009 while also applying a longer lens to historical performance.
Trends and developments over the past five years now allow greater access to alternative strategies and dictate a different conversation with investors about the purpose and trade-offs of such strategies, as well as appropriate ways to incorporate them into well-diversified portfolios.5 An analysis of these trends and developments will be the focus of the next article.
Just the facts, ma’am
Alternative investments performed well over the past 20 years, the events of 2008−2009 notwithstanding (see Table 1). Since 1990, most hedge fund strategies have generated risk-adjusted performance equal to or better than the S&P 500 or Barclay’s Aggregate Bond indexes with significantly lower volatility than stocks.6 The time period is highly useful for analytical purposes, because 1990–2010 spanned alternating extreme bull and bear markets for equities and was one of the most bullish environments for bonds in history.
Table 2 shows the historical diversification benefits of alternative investments, highlighting the low correlations between most strategies and either stocks or bonds. Correlation coefficients are not static, of course, and during the “perfect storm” of 2008, most alternatives (with the notable exception of CTAs) did not deliver the diversification or alpha-generation benefits investors expected. In many cases, diversified portfolios that included alternatives did not lose as much value as the broad equity markets. But a loss of only 15–20% when the broad equity markets were down 30–40% was cold comfort to most investors.
TABLE 1: ALTERNATIVE INVESTMENT PERFORMANCE
TABLE 2: THE LONG-TERM DIVERSIFICATION BENEFITS OF ALTERNATIVES
1. Throughout this article the phrase “absolute return” is used to describe investment strategies designed to have relatively low directionality (i.e., low correlation to equity markets) and that are supposed to generate steady, consistent returns with below-equity-market volatility. The alternative investment community, however, did itself and its investors no favors by coining the phrase “absolute return,” because the events of 2008 showed clearly that there was nothing absolute about the performance of these strategies. The term “diversified alternatives” is preferable because it describes what the strategies are rather than what they are supposed to do. But because “absolute return” is so firmly entrenched in the industry lexicon, it will be used throughout this article. Whenever the reader sees that phrase, however, I respectfully ask that he or she mentally place scare quotes (“ ”) around it.
2. Industry growth statistics can be found in multiple sources, such as the HFRI Global Hedge Fund Industry Reports, The Russell Investment’s 2010 Global Survey on Alternative Investing, the KPMG White Paper, “Transformation: The Future of Alternative Investments (June 2010) and “Results of the Credit Suisse 2010 Global Survey of Hedge Fund Managers’ Marketing Strategies” (March 2010).
3. Alternative investments and hedge funds are not synonymous, though the media and investors frequently use the terms interchangeably. Hedge funds and limited partnerships are more closely related and are not investment strategies at all — they are simply the delivery vehicles and corresponding compensation structures for many alternative investment strategies. The difference is more than just pedantic, as demonstrated by the rapid growth of alternative investment mutual funds, UCITs, exchange-traded funds and exchange-traded notes.
4. Once again, it is important to be specific. CTAs generated positive performance in 2008, and most hedged equity strategies did not face a lack of transparency or a lack of liquidity. While investors tended to lump all alternative investments together, it was primarily absolute return strategies that failed to meet investor expectations with respect to performance and liquidity.
5. This article focuses on relatively liquid alternatives — absolute return, hedged equity and CTAs. Private equity and private real estate, as well as other more illiquid investments (e.g., timber), may have an appropriate role in diversified portfolios for many investors, but they are not addressed in this article.
6. Some readers may take issue with the use of the HFRI indexes in this comparison, citing the many inarguable weaknesses in the construction and representativeness of those indexes. That point is valid, but I defend this usage with an adaptation of Winston Churchill’s famous quote about democracy: “They are the worst indexes available, except for all the rest.”