Designing an alternative strategy

As more financial advisers offer liquid alternative-investment solutions such as open-end mutual funds and exchange-traded funds, the two…

As more financial advisers offer liquid alternative-investment solutions such as open-end mutual funds and exchange-traded funds, the two questions most often asked are: “How much of my portfolio should I allocate to alternatives?” and, “Which alternative strategies should I use in my portfolio?”

Over the years, both individual and institutional investors have grappled with how much of a portfolio to allocate to alternatives. With traditional asset classes, it makes sense to use software that optimizes the construction and analysis of investment portfolios when developing a strategic asset allocation.

But this approach doesn't work with alternatives, because their risk, return and correlation properties tend to trigger too much allocation, even 100% of a portfolio in some cases. For most investors, such a large allocation is inadvisable.

In recent years, large institutional investors with long-term investment horizons, such as university endowments, have allocated a large portion — 60% or more — of the overall portfolio to a diversified basket of traditional alternative investments.

The large allocation employed by the so-called endowment model, however, is impractical for individual investors due to the smaller accounts involved, shorter time horizons and their need for liquidity. But implementing liquid alternatives overcomes these constraints and allows for a more meaningful allocation to alternatives.

Because it is difficult to arrive at an “optimal” allocation to alternatives, most individual investors are best served by implementing a common-sense approach that allocates enough to enhance the risk/return profile of the overall portfolio. For many investors, a range of 10% to 30% allocated to alternatives provides a good balance.

In constructing the portfolio, investors typically will want to add alternatives by proportionally reducing the allocations to equities and fixed income.

Once the allocation decision has been made, the specific alternative strategies and funds must be selected.

Here you have two primary approaches: the alternatives portfolio as a stand-alone option or building the alternatives portion with the aim of achieving the goals of the overall portfolio. The latter approach is preferable for individual investors but is somewhat more involved.

Defining the objective in incorporating alternatives in the portfolios is a key aspect of the allocation process.

Is the goal to achieve an absolute return, regardless of how traditional stock and bond investments perform? Is the goal to achieve hedged equity-like performance, seeking the upside of equities but with less volatility?

In practice, many individual investors want to incorporate alternatives into their portfolio as a means to reduce the risk of their overall portfolio while attempting to capture as much of the upside of the long-only portion as possible. In essence, the goal is to enhance the risk-adjusted return of the overall portfolio.

One method of achieving this goal is to seek to minimize the “shortfall risk” — the level of loss expected given a preset level of probability (e.g., 10%) — while maintaining a low tracking error between the long-only portfolio (i.e., the portfolio without alternatives) and the overall portfolio (i.e., including alternatives) in order to participate in upside moves.

SELECTING STRATEGIES

How can alternative strategies be implemented in practice? Three alternative strategies — market neutral, hedged equity and managed futures — are effective in achieving balance between shortfall risk and upside capture (the magnitude of the portfolio's participation when markets move higher) when used in combination.

In other words, advisers need to find a balance between minimizing potential losses and sacrificing potential gains, just as they would with a traditional portfolio.

For example, take a moderate-risk portfolio with a long-only 60%-40% allocation between stocks and fixed income, enhanced with a 20% allocation to alternatives. Our research shows that for a moderate portfolio, the allocation across liquid alternative strategies that achieves the best balance between shortfall risk and upside capture is 45% market neutral, 40% hedged equity and 15% managed futures.

Proportionally reducing the equities and fixed-income allocations to accommodate the 20% allocation to liquid alternatives results in an overall portfolio allocation of 48% equities, 32% fixed income, 9% market neutral, 8% hedged equity and 3% managed futures.

Brandon Thomas ([email protected]) is the co-founder, managing director and chief investment officer of Envestnet PMC, Envestnet's portfolio management consultants.