Finding A New Balance With Alternatives

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Includes: DIA, IWM, QQQ, SPY
by: BMO Global Asset Management

Summary

The expected strong bond returns within a traditional 60/40 portfolio are unlikely in our current low yield environment.

Investors should consider incorporating alternatives into their portfolios for optimum diversification.

BMO Global Asset Management recommends compiling a complementary blend of active alternative managers and multi-alternative strategies.

By Lowell Yura, CFA, ASA, Head of Multi-Asset Solutions;
Kristina Kalebich, CFA, Senior Alternatives Specialist & Co-Portfolio Manager;
Kristi Hanson, CFA, Managing Director & Head of Investment Research;
John Lennox, Investment Writer

Alternative investment options available to most investors present challenges and opportunities. Until recently, retail investors had limited access to alternative strategies and therefore may not be very familiar with these types of investments and how they can add value. They are increasingly popular, with assets in liquid alternative funds growing from around $50 billion in 2006 to more than $300 billion in 2015. What often gets lost when investors are sorting out all these distinctions is the reason they turned to alternatives in the first place. A better understanding of the role of alternatives in today's economic environment - and in tomorrow's - can help guide investors' decisions as they weigh their options in the alternatives space.

As we move further away from the Great Recession, the traditional 60/40 portfolio faces headwinds. This much-used paradigm allocates 60 percent of a portfolio to equities and 40 percent to bonds, balancing over the long term the growth (and higher risk) associated with equities with the stability (and lower risk) associated with bonds. Yet a significant assumption within the 60/40 paradigm - historically strong bond returns with low volatility - is no longer realistic with low bond yields in the current environment. We expect that even moderately risky balanced portfolios should expect more than a four percent decrease in returns over the next 10 years compared to what a 60/40 portfolio delivered in the last 35 years.

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Investors need to find a way to adapt, as doing nothing may result in missing one's diversification objectives. Assuming lower returns, greater risk or reduced liquidity are unsatisfactory options; a plan to find new sources of return should involve choosing from a spectrum of alternative options, noting these should provide either a higher return for the same amount of risk or the same return for a lower amount of risk.

To meet these diversification challenges, investors will need to distinguish liquid alternative strategies that rely on new market exposure, such as volatility and frontier markets, and those that rely on manager skill, such as market neutral, 130/30, long/short equity and macro strategies. Here it is important to note that many "new market exposures" may already appear in investors' portfolios via REITs and commodities. The difficulty of finding truly new exposures, then, encourages a longer look at active management.

Our research indicates best practice may be to compile a complementary blend of active alternative managers specializing in different strategies, thus creating a multi-alternative fund. Manager selection in the alternatives space is arguably more difficult than in traditional long-only strategies. As evidence of this, we have found the dispersion of returns among several categories within the alternative space is greater than that of long-only funds. More importantly, we believe such dispersion among alternative managers suggests diverse sources of alpha: Alternative managers generate alpha using very different skill sets.

When conducting due diligence, it's important to take sources of differentiation into account in regard to strategy, performance, risk management, organization and structure, among other items. To avoid diluting the contribution of an individual manager, we recommend a pool of six to 10 underlying managers while evenly distributing allocation to each one.

A multi-alternative fund can offer access to a concentrated portfolio of alternative managers, combining front-end due diligence, portfolio construction and management, and risk oversight, all performed by experienced, professional managers. The built-in diversification of multi-alternative approaches helps answer the fundamental question that began the search process in the first place: Is the portfolio diversified by manager and strategy? In short, an alternative allocation that combines expertise on manager research, asset allocation, portfolio construction and risk management should offer a flexible, portfolio-ready option.

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Index definitions: S&P 500® is an unmanaged index of large-cap common stocks. Barclays U.S. Aggregate Bond Index is an index that covers the U.S. investment-grade fixed-rate bond market, including government and credit securities, agency mortgage pass through securities, asset-backed securities and commercial mortgage-based securities. To qualify for inclusion, a bond or security must have at least one year to final maturity and be rated Baa3 or better, dollar denominated, non-convertible, fixed rate and publicly issued.

Investments cannot be made in an index.

Additional definitions: Beta is a measure of a portfolio's volatility. Statistically, beta is the covariance of the portfolio in relation to the market. A beta of 1.00 implies perfect historical correlation of movement with the market. A higher beta manager will rise and fall more rapidly than the market, whereas a lower beta manager will rise and fall slower. Alpha is the incremental return of a manager when the market is stationary. In other words, it is the extra return due to non-market factors. This risk-adjusted factor takes into account both the performance of the market as a whole and the volatility of the manager.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.