In part one of this blog, Alternative Investing: Why Manager Skill is Crucial to Results, I discussed why manager risk (e.g., the risk of selecting an underperforming manager) is a significant risk when investing in alternatives. Here, I discuss how investors can mitigate manager risk.
Mitigating manager risk involves two things:
- Conducting due diligence on the manager before investing. This helps increase an investor’s chances of selecting a successful manager.
- Diversifying across multiple managers. This step helps reduce manager risk by diversifying across multiple managers.
Conducting due diligence
When conducting due diligence, it’s important to focus on things such as the experience and pedigree of the manager, the investment process utilized, markets traded, assets under management, capacity of the manager’s strategy, and the infrastructure in place supporting the manager. As part of this process, it’s imperative to clearly identify the manager’s “edge,” namely, the unique aspect of the manager’s approach that will enable him or her to succeed.
A critical aspect of the due diligence process is developing an understanding of what to expect from the manager from a performance standpoint. To this end, an investor should only invest with a manager once they have an understanding of:
- Expected return and risk.
- Relationship of returns to traditional markets (e.g., correlation and beta).
- The market environments that may be most/least favorable for the manager.
- Expected performance in bull and bear market environments.
- Expected performance in high/low volatility market environments.
Once the due diligence process is complete, an investor should have a thorough understanding of the manager and be in a position to decide whether or not to allocate to that manager. The due diligence process will also prove helpful when evaluating the manager’s future performance, as the manager can be evaluated against the performance expectations established as a result of the due diligence process.
Diversifying across multiple managers
While a robust due diligence process helps improve the odds of selecting a successful manager, it does not eliminate manager risk. To further mitigate manager risk, investors should diversify their alternatives allocation across multiple managers, ideally across managers that have complementary approaches and relatively low correlation to one another.
Investors can either build their alternatives portfolio piece by piece, or they can consider a multi-alternative fund-of-funds that invests in multiple funds run by multiple managers. In this case, the investor depends on the fund-of-fund manager’s expertise in asset allocation and manager selection.
Talk to your advisor
The two steps discussed above are essential for mitigating manager risk. That said, conducting manager due diligence and diversifying across managers is a tall order for most investors. For this reason, I believe investors would benefit considerably from working with a financial advisor who is knowledgeable and experienced in alternative investments. Such an advisor can help their clients navigate the challenges of investing in alternatives in general, and help mitigate manager risk, in particular.
Learn more about alternative investing at invesco.com/alternatives.
Correlation is the degree to which to investments move in relation to each other.
Beta is a measure of risk representing how a security is expected to respond to general market movements.
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.
Past performance cannot guarantee future results.
Diversification does not guarantee a profit or eliminate the risk of loss.
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.
All data provided by Invesco unless otherwise noted.
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