A key attribute of alternative investments is that alternative managers are typically given considerable freedom in how they invest. This freedom means that manager selection, an important consideration for all investors, becomes particularly crucial when investing in alternatives.
Alternatives managers blaze their own path to success
In traditional investing, manager performance is typically benchmarked against a common index, such as the S&P 500. Simplistically speaking, managers seek to beat their index while still investing in the same universe of stocks. US large-cap managers don’t try to outperform the S&P 500 by investing in international small-cap stocks, for example. Rather, they overweight US large-cap stocks they believe will outperform and underweight those they believe will underperform. As a result, their performance generally tracks the index, while their active decisions will cause them to outperform or underperform to a degree.
For alternatives, most strategies lack a common benchmark and most alternative managers have an absolute return orientation — in other words, they seek to deliver positive returns no matter what the stock or bond markets are doing. That’s where freedom comes into play: Alternatives managers often can invest on a long and short basis across a diverse array of markets. They are not expected to stay in a certain “box.” They are expected to find and deliver returns. As a result, the performance of the broader market, as reflected by a benchmark, is not usually the primary driver of an alternative manager’s return. Typically, the biggest driver of alternative managers’ success is their ability to effectively execute their strategy, and that ability varies widely across managers.
Mind the gap: Measuring the difference between top and bottom managers
Taken together, alternative strategies’ lack of traditional benchmarks and emphasis on manager skill result in a wide range of returns across alternative managers. On the other hand, traditional managers’ returns tend to be more tightly grouped around their benchmarks.
To illustrate this distinction, let’s examine the historical gap in performance between top decile and bottom decile managers in both alternative and traditional investment strategies. For the period from 2010 to 2014, the top decile of alternative managers in the Long/Short Equity category returned 11.9% while the bottom decile of managers returned 3.0%; that’s a gap of 890 basis points.1 In contrast, over that same period, the top decile of traditional equity managers in the World Stock category returned 12.1% while the bottom decile managers returned 6.2%, a gap of 586 basis points.1 The performance gap in Long/Short Equity is 1.5 times as large as that in World Stock.
Given the above, manager risk (e.g., the risk of selecting an underperforming manager) is a significant risk when investing in alternatives. It is critical that alternatives investors understand this risk and seek to mitigate it. Part two of this blog will address ways to do this.
1 Source: Morningstar. ©2015 Morningstar Inc. All rights reserved. Morningstar does not represent information contained herein to be accurate, complete or timely.
One basis point equals one one-hundredth of a percentage point.
Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.
Short sales may cause an investor to repurchase a security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, exposure to potential loss is unlimited.
Past performance cannot guarantee future results.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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