Make alternative assumptions at your peril
Alternative assets are a very diverse category, and, unlike equity and bond funds, there are substantial differences in the performance and behaviour of funds within each investment style.
It is important to assess what the fund holds and the way in which it invests, because the investment style of a fund can bring in unintended exposures into your portfolio.
We’ve removed the dedicated trend following manager from our diversified multi-asset portfolios (conservative through to high growth) and introduced an absolute return equity fund with good historical returns but very low exposure to equity markets, sectors or traditional equity styles like value or quality. This reduces the portfolio’s equity exposure and should provide steadier returns while protecting the portfolio from valuation or growth shocks.
GOALS FOR ALTERNATIVES
When selecting the asset allocation and investment solutions that are suitable for each investor, an adviser has a number of goals:
- Ensure the investment strategy fits the required strategic asset allocation. The vast majority of advisers work within a framework where the overall asset allocation range is determined by a committee or consultant based on long term asset class risk and return assumptions;
- Adapt the allocation to the current market conditions. While some advisers use “set and forget” strategies and never change allocations, most make adjustments to strategic asset class weightings or investment mix within each asset class that reflect their views on the current risks and opportunities across markets; and
- Select investments to achieve the desired allocation. This stage involves balancing many factors: suitability of investments for their role in the portfolio, historical performance, qualitative and quantitative assessment of each investment, external research ratings, fees and other costs, liquidity and capacity.
Given that equities and bonds are both at high valuations we have been increasing our allocations to alternatives, and within alternatives we are looking for investments that can deliver reasonable returns but are not strongly correlated to equities and bonds.
Unlike equities and bonds, there are a broad range of differences in the performance, investment style and behaviour of alternative assets. Therefore, it is crucial to assess what the fund holds to avoid any unintended consequences.
For example, a long-short hedge fund that invests in value stocks and shorts quality stocks can be correlated with equities even if its net equity exposure is zero, because its investment style is correlated with equities. In fact, most of the Eurekahedge Hedge Fund indices are correlated with equities, even if the net exposure to equities of the underlying funds are low or nil.
Selecting funds with hidden correlations not only raises the risk of the portfolio, it could violate the assumptions that underlie the strategic asset allocation (SAA): if the SAA assumes that alternative assets have a low correlation with equities but the actual investments selected have a high correlation with equities, the overall portfolio risk could be outside the investor’s risk tolerance, leaving the adviser open to compensation claims from their clients after a severe equity market drawdown.
We divide the alternatives universe into a number of categories, but of these only absolute return equity and trend following – often referred to as commodity trading advisers (CTAs) or managed futures funds – have a majority of funds with low equity exposure.
This article will outline the main points of our review of these two subsets of the diversified alternatives universe. We focus on the managers that are already available on the main investment platforms that our clients (advisers) use. For this article we’ve replaced the names of the investments with generic names.
FUND SELECTION
In our diversified multi-asset portfolios (conservative through to high growth), the bulk of the investments are through managed funds or exchange traded funds (ETFs). We divide the portfolio into asset classes and sub-asset classes, each of which has a SAA weight that we vary dynamically as markets change.
For most sub-asset classes, we use managed funds (or ETFs) to gain exposure. When selecting a fund, we face a problem: there are thousands of funds operating in the marketplace, often with very similar sounding processes and philosophies. Almost every fund say they invest in “higher quality” assets than the market at lower-than-average prices, so how do we determine which fund managers are most likely to give us the exposures we want in the portfolio?
Research ratings are helpful in determining a short list of managers that are well regarded and have appropriate systems and processes. But we don’t find research ratings very useful for working out which manager is the best one to implement our views or how much to allocate to each fund. The most effective tool that we have to answer those questions is style regressions.
When combined with holdings analysis and traditional review of funds, these allow us not only to identify the managers who have been consistent with their stated style and process but also how much of that style they bring into the portfolio. And, unlike the marketing collateral, we can see substantial differences between funds when we look through this lens.
ABSOLUTE RETURN EQUITIES
Looking at the returns over the last five years (Chart 1) we can immediately see differences in the return profiles and the correlation of the investments with equity benchmarks and long/short equity benchmarks (both Australian and international).
Remember that we’re specifically trying to reduce our equity market exposure. Fund A is around 80% long equities, on average, so despite the fund’s excellent historical performance including it in the portfolio will not help us reduce the overall equity risk that we hold. The other funds have low net equity exposure.
Turning our attention to the equity style factor exposures of the funds, we use style analysis to assess whether fund managers are “true to label” and, just as importantly, how strongly their investment style influences their returns. This allows us to contrast different managers and construct portfolios with the exposures we want.
Fund C and Fund D have very low style exposures, with their returns being almost entirely attributed to alpha in the below framework (Table 1). The other funds have substantial style exposures (a loading of +/-0.30 or more would be considered a large exposure to the Fama-French factors that we’ve used here).
These factor loadings are a reflection of the funds’ underlying investment processes. Reviewing Fund C’s investment process, the manager explained that they actively manage sector allocations: the portfolio managers divide the universe of investment into groups of companies with similar drivers and goes long those stocks with positive characteristics and short those that are less attractive, while seeking to keep the fund’s overall exposure to any one theme or sector low.
Fund D is similar, but the other funds deliberately take long positions in themes or sectors that are attractive to the fund managers and go short themes or sectors that they find unattractive.
The consequence of this is despite all funds having low net exposure to equities through their histories, their risk profiles are very different.
Fund C and Fund D have never had a drawdown greater than about 3%, while the others have often experienced drawdowns of 10% or more when their high conviction positions have turned against them.
For our alternatives allocation goals, the risk-controlled equity market neutral funds are a better choice than the high conviction funds (Chart 2).
TREND FOLLOWING MANAGERS
Although momentum is a well-recognised premium across many markets, returns for the trend following style have been poor for the best part of a decade.
Looking into the exposures of the trend following managers, they have been broadly long bonds for most of the last 10 years as interest rates have fallen.
Given that we’re anticipating higher rates in the future, and we are concerned about reversals in other markets due to high prices across equities and commodities, we have decided to remove dedicated trend following managers from our portfolios for the time being.
CONCLUSION
Like many investors, given high equity market valuations and expectations of higher interest rates, we’ve reduced our allocation to equities and bonds and increased our allocation to alternatives.
But to deliver outcomes required by investors we need to understand how their investment processes and positioning influences the risk profile of the funds and the overall portfolio.
Assuming that all funds in a category will support the strategic asset allocation could be a mistake.
Dr Rowan Stewart is co-chief investment officer at Aequitas Investment Partners.
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