Why Manager Selection Is Critical For Alternative Investors

Posted by Walter Davis, Alternatives Investment Strategist on Apr 10, 2018, in Alternatives

The recent (and long-awaited) return of market volatility has put alternatives back on the radar screen. But not only must investors familiarize themselves with the different types of alternatives that are available to them, they must also assess the skill level of the managers running these funds. Manager selection is a question that all investors face, of course, but it’s especially critical for investors in alternatives because these managers have greater freedom in their investment strategies. This freedom leads to a wide dispersion between the top-performing and below-average alt managers, and that dispersion is typically greater than what is found in traditional equity investments.

Comparing top and bottom managers

The below table examines the dispersion of returns for alternatives and traditional equities. For this example, alternatives are represented by the Morningstar Long-Short Equity Category. Traditional equity investments are represented by the Morningstar World Large Stock Category. (We chose the latter category to represent a more “traditional” investment as it represents the type of long-only, large-cap strategies that most equity investors have exposure to.) The table examines the historical gap in performance between the top quartile and third quartile for each category. After comparing these returns over three different periods, we can see the much wider range of returns in our alternatives example. Past performance is not a guarantee of future results. Alternative investments include private equity, managed futures, commodities and derivatives, while traditional investments generally refer to equities, bonds and cash. Alternative investments can be less liquid and more volatile than traditional investments, such as stocks and bonds, and often lack longer-term track records. Investors should consider using financial advisors when making portfolio decisions.

Source: Zephyr. Data as of Dec. 31, 2017. Top performers are represented by the first quartile in the Morningstar category, with bottom performers represented by the third quartile. (The third quartile was used to remove the effect of outliers within the very worst performers.) To determine quartiles, funds are ranked based on descending order of returns (best to worst). The first 25% of the funds are in the first quartile, the second 25% of funds are in the second quartile, the third 25% of returns are in the third quartile, and the last 25% are in the fourth quartile. Note that the return dispersion of other alternatives and equities categories may differ.

What might be causing the performance gap?

While the performance of any fund or security is never guaranteed and will fluctuate over time due to a wide variety of factors, we believe that there are two main reasons why there could be a wider performance gap in alternatives as compared to traditional investments:

1. Most alternative strategies aren’t tied to a traditional benchmark. In traditional long-only stock investing, the manager’s performance is typically benchmarked against the common index that best matches the long-only strategy. Furthermore, the index itself is comprised of a basket of individual stocks whose characteristics are consistent with that of a particular category. When investing, many managers will primarily invest among the stocks that make up the index, overweighting those stocks they believe will outperform and underweighting the ones they believe will underperform. As a result, performance tends to generally track the index, with the managers’ active weighting decisions contributing to outperformance or underperformance.

Like traditional long-only indexes, alternative investments have various performance indexes that seek to measure performance for various strategies (e.g. Long/Short, Global Macro, Market Neutral, etc.). Alternative indexes, however, differ from traditional indexes in that the index is typically an average of manager performance (as opposed to being comprised of a basket of underlying stocks). As a result, alternative managers have more freedom to define and pursue their own investment objectives (within the parameters of the fund prospectus). Such objectives tend to vary widely across managers, even among those using the same strategy. The pursuit of widely differing investment objectives understandably leads to a wide dispersion of returns across alternative managers.

2. Alternative managers have much greater flexibility than traditional managers with regard to how they invest. Traditional portfolio managers typically invest on a long-only basis within well-defined strategy classifications (small-cap growth, large-cap value, emerging market, etc.). Thus, these managers generally employ similar approaches and invest across the same universe of investments. The opposite is true for alternative managers.

While the strategy classifications for alternatives are also well-defined, alternative managers have much greater flexibility with regard to how they execute their investment approach. Furthermore, depending on the strategy, alternative managers may have the freedom to invest on both a long and short basis across different categories of stocks (large cap, small cap, domestic, international, etc.). They may also invest across multiple asset classes (stocks, bonds, currencies, commodities, etc.) and use a variety of complex trading techniques. In addition, alternative investments are more technical in nature and use more complex trading techniques that are impacted by market conditions. To deal with these factors, the investment approaches employed by alternative managers tend to vary greatly. This can lead to a wide dispersion of returns.

Two ways to help address manager risk

For these reasons, manager risk (the risk of selecting an underperforming manager) may be greater for alternatives than for traditional investments. It is critical that investors be aware of this risk and the role it may play when considering an investment in alternatives. In my opinion, there are two actions that may help mitigate this risk.

1. Conducting due diligence on the manager before investing. This may help investors select a quality manager. When conducting due diligence, it’s important to consider many key factors, including (but not limited to) 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 could help him or her succeed.

2. Diversifying across multiple managers. This step further reduces manager risk by diversifying across multiple managers. This can happen through a multi-alternative fund (as highlighted in my previous blog) or by diversifying your alternatives allocation across multiple managers and/or strategies.

The two steps discussed are tools that may help investors mitigate manager risk. That said, conducting manager due diligence and diversifying across managers is a tall order for most investors and does not guarantee the investment will meet performance objectives. For this reason, I believe investors would benefit considerably from working with a financial advisor who is knowledgeable and experienced in alternative investments.

Important information

Blog header image: Gajus/Shutterstock.com

The investment techniques and risk analysis used by the portfolio managers may not produce the desired results.

A long position is the buying of a security with the expectation that the asset will rise in value.

A short position is a directional strategy in which shares of borrowed stock are sold on the open market. The expectation is that the price of the stock will decrease over time, at which point the new shares are purchased in the open market and the borrowed shares are returned.

Investing in stock involves risks, including the loss of principal and changes in dividend policies of companies and the capital resources available for dividend payments. Although bonds generally present less short-term risk and volatility than stocks, investing in bonds involves interest rate risk; as interest rates rise, bond prices usually fall, and vice versa. Bonds also entail credit risk and the risk of default, as well as greater inflation risk than stocks.

Diversification does not guarantee a profit or eliminate the risk of loss.

Morningstar rankings are based on total return, excluding sales charges and including fees and expenses, versus all funds in the Morningstar category. Open-end mutual funds and exchange-traded funds are considered a single population for comparison purposes. Past performance is no guarantee of future results.

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.

©2017 Morningstar, Inc. All rights reserved. The information contained herein is proprietary to Morningstar and/or its content providers. It may not be copied or distributed and is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of 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.

NO BANK GUARANTEE

MAY LOSE VALUE

NOT FDIC INSURED

All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. PowerShares® is a registered trademark of Invesco Ltd., used by the investment adviser, Invesco PowerShares Capital Management LLC (PowerShares) under license. PowerShares and Invesco Distributors, Inc., ETF distributor, are indirect, wholly owned subsidiaries of Invesco Ltd.

Why manager selection is critical for alternative investors by Invesco US.