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Introduction
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.”
Absolute-return strategies
It also is interesting to examine the three-year rolling performance of absolute-return strategies (using the HFRI Fund-of-Funds Index as a proxy), compared to bonds (see Figure 1). Absolute-return strategies outperformed bonds in most three-year rolling periods over the past 20 years, with two notable exceptions: the bear market of 2000–2003 and the financial collapse of 2008–2010. What was common about those two periods? Both were precipitated by market crashes (technology and housing, respectively) that compelled the Federal Reserve to drastically cut interest rates, which benefited the total return of bonds.
FIGURE 1: FOFS VS. BONDS: THREE-YEAR ROLLING PERFORMANCE
The flip side of this dynamic is equally interesting. Given historical performance, investors might expect absolute-return strategies to outperform bonds in rising-rate environments, and this has happened over the past 20 years (see Figure 2). Since rates currently are at historical lows and eventually will move up, this may bode well for absolute-return strategies going forward.
FIGURE 2: FOFS VS. BONDS IN RISING-RATE ENVIRONMENT
Hedged-equity strategies tell a similar 20-year story to absolute-return strategies (see Figure 3). The objective of most hedged-equity strategies is to participate in the general directionality of the equity markets while cutting off the highs and lows to deliver a more consistent performance over time. In particular, investors expect skilled long-short managers to protect capital in down markets.
FIGURE 3: EMPLOYING HEDGED EQUITY TO PROTECT IN DOWN MARKETS
Examining hedged-equity performance in up markets and down markets illustrates this point. These strategies underperformed in up markets over the last 20 years, but this was more than made up for by dramatic outperformance in down markets (see Figure 4).
FIGURE 4: HEDGED EQUITY IN DOWN AND UP MARKETS
A comparison of hedged equity with broader equity markets supports the hypothesis that hedged equity closely track the general performance of the equity markets but with less volatility (see Figure 5).
FIGURE 5: CORRELATIONS AND VOLATILITY FOR HEDGED EQUITY VS. BROAD EQUITY MARKETS
CTA (managed futures) strategies
CTA strategies, synonymous with managed futures strategies, invest primarily in liquidly traded futures and option contracts on commodities, interest rates, equities and currencies. CTA managers may employ fundamental analysis to take long or short positions in these contracts, or more frequently, they employ highly quantitative technical analysis in an attempt to capture the upward or downward trends of the underlying price movements. “Global macro”strategies are closely related to CTAs (both use futures contracts to implement their views). It refers to managers that make investment decisions based on large-scale macroeconomic, geopolitical, trade-balance and business-cycle developments the world over.
CTA strategies have gained popularity over the past decade, and with good reason. They are liquid and transparent, and historically they have shown almost no correlation to either the equity or fixed income markets (see Table 3). Over the past 20 years, they also have generated equity-like returns with lower-than-equity-market volatility. This has made these strategies important diversifiers within global portfolios.
TABLE 3: CTA/GLOBAL MACRO STRATEGIES (10- AND 20-YEAR HORIZONS)
Time horizon is an important consideration with CTA strategies: Over short periods, they can exhibit high volatility because trends in underlying prices can reverse quickly. Applying a longer time horizon, however, shows a remarkably different story. As shown in Figure 6, CTA strategies generated positive returns in every three-year rolling period in the past 20 years. In some periods, equities strongly outperformed CTAs, but in the bear markets of 2000–2003 and 2008–2009, CTAs added important ballast to diversified portfolios.
FIGURE 6: PATIENCE HAS REWARDED CTA INVESTORS
Putting it all together
Having argued individual cases for the inclusion of absolute-return, hedged-equity, and CTA strategies, it is useful to summarize how they work together within diversified portfolios. Figure 7 shows the growth of different portfolios over a 10-year time horizon:
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Portfolio A shows the performance of the MSCI All World index (3.7% annualized return with a standard deviation of 10.3%).
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Portfolio B shows the performance of a more traditional portfolio consisting of 60% in the Russell 1000 index and 40% in the Barclays Aggregate fixed-income index (3.9% annualized return with a standard deviation of 5.5%).
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Portfolio C shows a similar 60/40 portfolio with the equity allocation bucketed into large, small, micro-cap, value, growth and so forth. This is intended to represent a typical HNW portfolio that includes no alternatives. Over the 10-year time horizon, it generated an annualized return of 6.9% with a standard deviation of 8.5%.
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Portfolio D is a fully diversified portfolio with allocations to traditional equity, hedged equity and fixed income as well as absolute return, hedged equity, CTAs and other nontraditional strategies such as master limited partnerships and commodities. This portfolio generated an annualized return of 7.4% with a standard deviation of 4.1%.
FIGURE 7: THE BENEFIT OF INCLUDING ALTERNATIVES IN DIVERSIFIED PORTFOLIOS
The inclusion of alternatives in Portfolio D did not prevent losses in the 2008–2009 market collapse. Over the 10-year period, however, Portfolio D generated significantly better performance with volatility comparable to a more traditional portfolio. Standard deviation, of course, is a necessary but insufficient measure of risk (it does not measure risks such as liquidity, credit and counterparty risk, for example), and the next 10 years may be significantly different from the past 10. That said, at least based on historical performance, the argument is strong for including alternative investments within diversified portfolios.
Taxes
A common criticism of alternative investments (or, more accurately, of hedge funds) is that the short-term trading nature of many strategies makes them very tax-inefficient for taxable HNW investors. Over the years, various tax strategies have developed to improve the tax characteristics of hedge funds (e.g., call options and warrants linked to hedge fund performance, private placement life insurance strategies and so forth). Regardless of their merits, adoption has been low – the vast majority of investors seem simply to accept the tax-inefficient nature of hedge fund strategies. This may be due to the complexity or audit risk of some of the tax management strategies, or it simply may be the consequence of an investor base that focuses on pre-tax returns.
This pre-tax focus is echoed by the funds and managers themselves. Few, if any, hedge fund managers attempt to differentiate themselves on the basis of tax efficiency – the focus is almost always on net-of-fee but pre-tax performance. Until and unless tax rates rise sufficiently to drive investor demand for improved tax efficiency, this focus is unlikely to change.7
Summary and conclusions
Investors need to determine what is appropriate for their portfolios based on their objectives, sophistication, liquidity constraints and time horizons. Despite the negative media and perceptions of the past two to three years, alternative investments have added value to well-diversified HNW portfolios.
One interesting development in alternative investments has been the rapid growth and acceptance of mutual funds, regulated investment companies (RICs) and undertakings for collective investments in transferable securities (UCITs)8 — that is, highly regulated legal structures that invest in various alternative strategies. The market implosion of 2008 resulted in investor aversion to LPs that is now abating slowly.9 Investors who wanted exposure to alternative investment strategies increasingly turned to mutual funds or registered products. Given the investment and leverage constraints of these more-regulated vehicles, investors should not expect the same risk-and-return characteristics even if these strategies are managed similarly to an LP run by the same portfolio manager. Despite this, and despite the relatively short track records of most funds, many investors seem happy to exchange the potentially superior performance of an LP for the liquidity and greater regulatory oversight associated with mutual funds. Assets invested via LP structures still dwarf those in mutual funds, and direct investment into single-strategy LPs remains fairly strong. In the future, however, mutual funds will most likely cannibalize investment flows that might otherwise have gone into multi-strategy funds-of-funds.
The conversation between advisor and investor about alternative investments has changed. Given the growth of mutual-fund products, an aversion to LPs is no longer a reason to avoid alternative strategies. Assuming that an investor’s sophistication and investment objectives warrant including alternative investments within a diversified portfolio, the conversation needs to focus on the characteristics an investor expects and desires from that alternative exposure: What is the appropriate trade-off between performance, risk, liquidity, fees and regulatory oversight?
One result of such conversations may be an eventual acknowledgement that “alternative investment” is an unfortunate misnomer. The real discussion is about the constraints investors want on the construction and management of diversified — and ultimately traditional — portfolios.
Scott Welch, CIMA®, is the Co-Founder and Senior Managing Director of Investment Research & Strategy at Fortigent, LLC, in Rockville, MD.
Acknowledgments
Robert Mileff, CAIA®, CIMA®, Director of Alternative Investments at Fortigent, and Shaun Jones, Alternative Investments Analyst at Fortigent, contributed significantly to this article.
7. For a more in-depth analysis of hedge funds and taxes, please see “Will Hedge Fund Investors Start Asking for Tax Alpha? Can Hedge Fund Managers Deliver It?”, published in the Spring 2011 issue of The Journal of Wealth Management, pp. 44-50.
8. The UCIT is a European Union legal structure, similar to but not quite the same as a RIC and a mutual fund in the United States.
9. In response to the events of 2008, many LP managers improved the transparency and liquidity of funds and institutionalized due diligence, administration and oversight efforts. These steps were positive, but the recently announced SEC investigations into insider trading, which encompass both traditional and alternative investment managers, are likely to perpetuate an aversion to LPs. To date, very few funds publicly identified as targets of the investigations have been charged with any wrongdoing, and most have announced that they simply have been asked for information as part of a broader investigation. Regardless, the story is likely to feed the current media and political narrative that investors should be wary of “hedge funds.”
Read more articles by Scott Welch, CIMA
