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I’ve spoken with hundreds of allocators over the past 20 years, and one problem that has become increasingly prevalent during the last two years is a mismatch between expectations and outcomes for their alternatives allocations. They might, for example, expect a return-seeking strategy with equity market exposure to also provide a degree of portfolio diversification for which it is not actually designed.
In this short note, I offer a framework for thinking about alternatives objectives and suggest a set of simple but sensible questions to help guide due diligence and establish realistic expectations.
What do investors really want?
Most allocators I speak to are looking for alternatives to achieve one or more of these three objectives:
- High returns — The aim here is consistently strong returns. If the allocation delivers on this objective, the higher risk and potentially higher costs will be tolerated.
- Convex beta — Here the alternatives strategy is meant as a replacement for equity, rates or credit. If the equity market rises 20%, for example, such a “convex beta” strategy might rise only 15%. But, if markets fall 20%, the strategy might be down only 10%. Over time, this reduced downside capture can have a tremendous compounding effect on returns.
- Uncorrelated returns — The objective in this case is to allocate to strategies with returns that help diversify the overall portfolio. Bear in mind that “uncorrelated” means the results of these strategies don’t bear any relation to what’s happening in broader markets. It does not necessarily mean that, when the market is down, these strategies are up — though the results may help mitigate the effect of a market downturn. The trade-off may be more modest return potential than you get with other alternatives allocations.
Each of these objectives is sensible and should be achievable. But they are very different, and bringing them together in a portfolio may mean having more than one alternatives bucket, with different performance yardsticks, fees and structures for each. Just remember that you are highly unlikely to find a strategy that will consistently deliver on all three objectives at the same time.
Finding the right fit for each alternatives bucket
So how can you ensure that alternatives allocations align with your objectives? Dig into the managers and their strategies, asking the right questions, such as:
- Are the manager’s sources of returns understandable/repeatable?
- How has the manager achieved convexity? Is it through macro calls or through market or factor timing? Is there a clear, repeatable process?
- How correlated are the strategy’s returns to traditional betas and factors? Is the correlation stable? What is the conditional correlation?
- How has the strategy performed in crisis periods? Are the managers able to explain their biggest drawdowns and how they responded?
- How much diversified return is the manager achieving per unit of leverage?
Conclusion
The strong beta rally in bonds and equities over the past 10 years has left most strategies that were not levered long plays trailing. This has led to significant questioning of the role alternatives play in a portfolio just when they are in fact likely to be needed most. I believe it’s time to reframe the performance debate to focus on the function alternatives play in a portfolio and not just simplistic return numbers.
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