Which alternatives now? Webcast transcript

The following is an edited transcript of the Aug. 23 webcast “Which Alternatives Now.” It was moderated by deputy editor Evan Cooper and senior editor Jeff Benjamin. Panlelists featured were: Ricardo L. Cortez, Broadmark Asset Management LLC,Senior Portfolio Specialist and President; David C. Reilly, Decision Critical Resources Inc., President; Thomas C. Meyer, Meyer Capital Group,Chief Executive Officer. InvestmentNews: Tom, can you describe the goal of an alternative investment strategy or an alternative investment? Mr. Meyer: The way we view it is that we want to have our clients participate 100% in the game. We call the game the market. By utilizing alternative strategies and alternatives, we feel that we can bring the risk of that particular portfolio down by 30% to 50%. So look, we always ask our clients: “Do you want to lose less or make more? Will you give a little bit on the upside to make sure that you have more buffer on the downside?” And after the past three years, our clients are happier to have some type of a buffer utilizing alternatives than if they were in a 100% long [modern-portfolio-theory] type of portfolio. InvestmentNews: Rick, What is the goal of an alternative strategy? Mr. Cortez: What an alternative strategy does is, it has embedded within it a risk management component. We all have been taught over the many years we have been in this business to mitigate risk by asset allocation by using asset classes and noncorrelated classes and diversification, etc. Alternatives go one step further. At the manager level, just as Tom just said, there is a risk management component. That risk management component could be the use of short sales as a long/short portfolio. It could be the use of options or buying puts or — I'm not a fixed-income expert, but in the fixed-income field, I am sure, there are ways of mitigating risk. In our strategy, we use cash, we also use short sales, and we try to use noncorrelated assets as well to mitigate downside risk. The goal with an alternative, as Tom said, is to manage the risk at the manager level. Alternatives are to a certain extent a rejection of the buy-and-hold philosophy. They're a rejection of relative returns — the idea that you are doing well if you are only down 20% and the market is down 50%. And I think it is, on the positive side, an attempt to try to either have a positive return every year or have your return within certain predefined risk parameters, unlike long-only managers. Alternatives put the emphasis on risk as the most important component, whereas with traditional investments, the emphasis is on return.

MORE EFFICIENT

InvestmentNews: David, the same question. What is the goal of an alternative strategy? Mr. Reilly: In the work that I do and that I have done in the past, the focus of alternatives in the construction of portfolio has primarily been upon creating a more efficient portfolio. What that really comes down to is using the characteristics of alternatives to make the portfolio more robust when you get into highly correlated — and, particularly, downtrending — markets. Alternatives have been proven very useful for reducing portfolio volatility without a meaningful impact on the return-generating potential of the portfolio. So that makes the intelligent use of alternatives within a multiasset portfolio really one of the closest things to a free lunch you can find in finance. The reason that alternatives are useful in addressing portfolio volatility is because of their correlation characteristics and most people tend to, when they talk about alternatives, think of solely their correlation characteristics. But in order to be useful, alternatives really need to do three things: They need to represent a source of return independent of traditional asset classes, they have to have volatility characteristics that are tolerable for the end-investor and, ideally, they would offer attractive correlation characteristics that can carry through even when correlations tend to spike. And alternatives, even through the most recent market downturn, have demonstrated their ability to do that. The benefit from an investor's end standpoint is that it simply enables you to be less penalized by the asymmetry of returns. We all know that if you suffer a 50% decline in a portfolio, you have to subsequently have that portfolio increased by 100% in order to get back to your starting point. So in terms of long-term investment success, getting a handle on portfolio volatility and avoiding that negative asymmetry of returns, alternatives are really indispensable. InvestmentNews: Let's step back a little bit. What is an alternative? Mr. Reilly: If you ask 10 people what an alternative is, you will probably get 10 different answers.

TWO CATEGORIES

What I have attempted to do is to keep it as simple as possible. And you can broadly divide alternatives into two categories. The first one would be alternative investment strategies. An alternative investment strategy is any investment strategy that is basically trying to do something other than beat an index. If you are trying to move beyond a relative-return mentality, which is to beat an index, that almost invariably starts to lead you into the area of absolute-return-style investing, where you are using the ability to short various markets or individual securities and you often have a free mandate. Beyond alternative investment strategies, there are alternative asset classes, which are simply return-generating assets that aren't equity or fixed-income assets. And those can be things such as commodities, currency, real assets, things of that nature. Mr. Cortez: In the past, maybe 10 years ago, five years ago, I think many people took alternatives — whether it was strategies or the actual asset classes — and just set them aside as completely different than traditional asset classes like stocks, bonds and cash. However, we invest in [exchange-traded funds] and we tactically manage those ETFs. ETFs are traditional, they represent baskets of stocks, so why are we alternative? Well, it is because of the strategy that we employ. I think what consultants are doing more and more is segregating, taking long-short, for instance, and saying, “Well, maybe long-short is really equity.” There are no different asset classes or underlying securities; it is just a different way of approaching equities. And similarly with bonds or bond arbitrage, maybe they belong in the bond bucket, not the alternatives bucket. When the underlying securities are the same as traditional, we are seeing them lumped into/merged into the traditional buckets. Mr. Meyer: Let's look at a long-short or even a market-neutral. If we have a manager, we usually use ["40 Act investment companies] on the mutual fund side. So we would look at a few of our market-neutral managers as an asset class. They deal on the small-cap side as a market-neutral [manager]. In almost every asset class, we have a long-short manager — whether it be large-cap, growth or value, or mid-cap — and so forth and so on. InvestmentNews: Is there a way to dip your toe into the water and experience a little bit of noncorrelated asset allocation? Mr. Meyer: Today it is easier than ever. A lot of these funds and/or ETFs did not even exist three years ago. Things have changed drastically. A lot of the funds or managers that we use were on the old platform, where you had to be an accredited investor or have $1 million minimum. And today you can get in with as little as $1,000 and press a button, and it can be done. So it is very, very easy. It is very liquid and it is very transparent.

ALTERNATIVE MUTUAL FUNDS

Mr. Cortez: It is easier than ever now to at least explore. There are something like 200-plus mutual funds out there that are classified by Morningstar [Inc.] as alternative. That is, most of them have a risk management component. And the increase in size or assets is probably faster than with most other areas. And many people, including me for many years, thought that mutual funds cannot have a risk management component, because you can't short or something. That's not true. For instance, on a mutual fund, we can go short, we can own cash, and many others can, too, and offer other types of ways of mitigating risk. Many, many strategies are represented now in mutual fund form and some in separate accounts. Now we are going to have to see how these different mutual funds and more liquid vehicles perform relative to the strategies that are represented by the big hedge funds. Nonetheless, I think this is a step in the right direction. Mr. Reilly: Tom and Rick have touched on really what is the sea change in the way the industry can construct portfolios. The problem with alternatives for many, many years were the structural impediments that have been touched on — high fees, lockups, the lack of transparency, funny tax reporting, performance fees, accredited-investor rules, individual-manager risk. Now that alternatives have moved into the registered environment,— "40 Act funds, ETFs — those structural impediments have really been swept aside and you have something you can look at every day. You have a daily [net asset value]. You have daily liquidity, all of that sort of thing, which is great. But beyond that, since many alternative strategies and asset classes are reasonably low-volatility and have attractive correlation characteristics — which is kind of contrary to popular wisdom — that gives you the ability to really control portfolio volatility much more effectively and it also gives you the ability to target a hard-risk target in the portfolio if you wanted to do so. And again, this is all kind of contrary to popular wisdom, because when you say “investments” to the average investor, they are going to think about the stock market. And if you look at historical volatility, long-only equities are about the most volatile asset class you can get your hands on. So by including alternatives, you are doing so in a daily liquid sort of format and you are really dropping the volatility of the portfolio down in most instances. There are a couple of exceptions to that. Long-only commodity tends to be pretty volatile. [Real estate investment trusts], which fall in an [alternative] bucket in many occasions, tend to be pretty volatile. But beyond that, absolute-return investing, long-short equity, managed futures, currency strategies are really, really effective at getting a handle on portfolio volatility. Mr. Cortez: David said something very important: Stocks and bonds can be very, very volatile. We all know stocks can go down 50%, 60%. They have in the last few years. They have in the last decade. And bonds — I mean, who knows where bonds are going? But if interest rates just pick up a little bit back to levels of a few years ago, we could see a 20%, 30% or 40% decline in bonds. So both of these traditional long-only asset classes can be very volatile. But we have been taught that these should represent the core of your portfolio. For the baby boomers, a core that can go down 50% isn't a core. And I think that with the advent of alternative mutual funds — they are liquid, they don't have K-1s, they have 1099s, they are registered with the [Securities and Exchange Commission], they have transparency. For many investors, you should try these more as a core holding, because there is some risk management, rather than traditional stocks and bonds, which can be very, very volatile. Mr. Meyer: The core of investors between 55 and 65 are scared to death but they are living longer lives. They have to play the game. Adding alternatives, lowering the risk [and] having risk-adjusted returns are fantastic. But it is a learning process, because what we were all taught as we grew up in this business, I myself for 29 years, is basically that long is always going to win out in the end. Well, guess what? Maybe that is not the case. So how do we mitigate risk, and what are the costs? These are huge hurdles in educating your client. So how do you explain sitting there, recommending to your client a market-neutral fund with absolutely no star ratings or no historical performance — “And oh, by the way, you'll have to pay 2% internal costs.” This is a road that we have been down for the last three years, and we have to do our homework. We have to drill down and find out who the managers are, what type of institutional returns they have, so that we can bring this to the table for our client, because we are dealing with a far more sophisticated clientele than we were 20 years ago. InvestmentNews: What do you gentlemen recommend that our adviser listeners do to get their clients, investors, to think in terms of alternatives? A lot of people might still see alternatives as Bernie Madoff, that is all bad stuff. Tom, can you give us some advice on that? Mr. Meyer: Things have changed so drastically in the last three years that [you can miss out on a good opportunity] if you don't have an open mind and aren't willing to sit down and listen to somebody, or take that phone call that usually you wouldn't take, because a lot of these [alternatives managers] are upstarts. They don't have the marketing budget so they actually outsource to marketing individuals that may come calling. Give them five minutes, because you never know. We have found a number of smaller — what were smaller alternative managers — that we never would have found if it weren't for us taking a phone call. So I think it starts there. And then you have to educate your staff. You know it is a complete educational process here. It goes from you to your staff to your client. But don't be closed-minded and do not get turned off by the fees. I cannot tell you how many times I have sat down with a peer and discussed alternatives, and I mention one of our best market-neutral funds. As soon as they hear their fees are 2.5%, they just go, “forget about it.” Well, guess what? It's not a long-only manager at 2.5%. They are bringing a lot to the table, so keep an open mind. Mr. Reilly: As more and more of this moves into the registered environment, "40 Act and ETF, the fee structures come screaming down. So the necessity of paying the 2% and 20% fee structure is really a thing of the past. But having said that, there is no such thing as a free lunch. As many of these strategies move into their registered environment, what you tend to end up with is less of the alpha-generating potential many times and more of the beta of alternatives. And while that might sound negative, it is actually extraordinarily useful in the portfolio construction process. The characteristics of alternatives tend to be the opposite of what the investors assume. So if you can walk your end-client through that, then I think the advantage of doing this becomes self-evident. Mr. Cortez: Take the meetings. If somebody calls you and they have an interesting new strategy, put the fee aside for a second. Listen to the strategy and see how that might fit in your portfolio. Mr. Meyer: With these newer strategies that have great managers, the onus is on us to go out and do our due diligence — because, after all, that is what we get paid to do — and find out who these managers are. Remember that when you are dealing with a market-neutral or a long-short manager, you want to make sure that that manager knows when to cut the cord, because shorting stocks is a very dangerous thing to do, as we all know.

INCREASED BURDEN

InvestmentNews: How much time and attention do you have to pay to this as an adviser if your clients' portfolios have more alternatives in them? How does it differ in terms of the time demands on you to keep up with what is going on in the markets, for example, and make adjustments to the portfolio? Is it more time-consuming, less time-consuming? How does it work on a day-to-day basis? Mr. Reilly: From where I sit, it adds to the burden, because you now have to start to think about and analyze and follow things such as commodity markets, energy markets, currency markets. You have to look at: Does your manager really have the skill set to short? Because shorting can be very dangerous and it can be very volatile. And you have to look into the futures markets, because if you are embedding things like managed-futures strategies into the portfolio, that is there, as well. So it really increases the workload quite a bit. In the past, you can say things like currency markets and commodity markets impacted equity markets on a tangential basis. Now you have to look at them directly and you have to get up to speed. So it increases the responsibility of the adviser, but it also increases the ability to turn around to the client and say, “Look, I'm doing a lot more value-add for you other than just watching CNBC and watching the Dow every day.” InvestmentNews: A question from the audience: “How do you measure the performance of an alternative strategy?” Tom? Mr. Meyer: That is a great question, because when you commingle it with the asset class, large-cap growth, say, or small-cap, you actually go against the Russell 2000. Or do you look at Morningstar, which has its own class? They have the returns every day, so that is not a problem. They also have their classifications. So you would be able to measure that particular fund against its peers, against the long-short or market-neutral index that they have. Mr. Cortez: I agree that the burden on the financial adviser is going to be greater because of greater knowledge that is going to be required. On the other hand, to a certain extent, that is why we get paid. So the burden is going to be greater in terms of just tracking on how that manager is doing. You are going to have to sit down with each manager or each strategy and talk about what is the relevant benchmark for that strategy and both come to an agreement. It's not as cut-and-dry as it is in the traditional world. Mr. Reilly: Right. Although the benchmarks may be a little bit more obscure, relevant to the S&P 500, for each manager, there is a benchmark. So you can identify how your alternative manager or your alternative strategy or your vehicle is doing. But the next step is to see how much value you have added, versus a traditional benchmark, a blended benchmark — say, the 60/40 portfolio — by having added nontraditional investments into the mix. So that is the next level of performance measurement that I think the adviser has to look at. So you have to see, “Is my individual vehicle doing what it is supposed to be doing and have I improved the efficiency of the portfolio, versus just running a standard long-only equity and fixed-income basket?” InvestmentNews: David, do you think that there is a tendency for advisers to view alternatives through the prism of their own equity and fixed-income viewpoint, and leave out other alternative investments such as commodities and real estate? Mr. Reilly: Well, I think it does happen, and I think it is all part of the industry's evolution process. But clearly, the focus on alternatives over the last few years indicates that it is under way. But people will go with what they know first and foremost. So your first baby step into alternatives might be something like a 130-30 fund or a 120-20, or you might move a little bit more out on the spectrum on long-short before you get all the way out to market-neutral. But then beyond that, there are a whole series of alternatives — absolute-return strategies, managed futures, long-short commodity, currency harvest strategies, long-only currency investment strategies — which are very low-volatility. And the benefit of them, particularly if the adviser is running a more aggressive portfolio, is that they can act as risk anchors. Because of their volatility and correlation characteristics, they can really help get a control on that portfolio volatility. So it is, again, kind of counterintuitive, but the more you go out the esoteric spectrum into things like managed futures, long-short commodity and currency, actually in many cases, you are going down in volatility, which is conceptually opposite of how many investment advisers still kind of perceive this.

UPSIDE, DOWNSIDE

InvestmentNews: Tom, on that point of limiting the upside, that is one thing that when volatility is high and the market is moving 500 points in both directions, people are thinking, “Let's hedge this thing, let's take it off a little bit.” But if the market is roaring, a roaring bull market stretch where maybe it is going up 50, 60 points a day, but it is going up that way for months, a lot of these alternative strategies are going to dampen some of that long-only performance, aren't they? Mr. Meyer: There is no question about that. If you think about it, we just went through this. The market had two 7% crashes back to back, just about. And look, we got phone calls when the market went [from] up 1% to up 7% overnight and we were maybe only up 5% or 6%. And you know what, those clients are getting a phone call now saying, “Do you understand now? Do you get it?” And look, we don't look for times like this, believe me. But this just adds credence to what we do.