The following is an edited transcript of a webcast, “Why Alternatives, Why Now,” held Aug. 27. It was moderated by InvestmentNews senior columnist Jeff Benjamin.
InvestmentNews: We're going to go around the horn for some introductions, and then we're going to get right into the questions of how, when, why and where to find alternatives for client portfolios.
Mr. Ball: Thanks, Jeff. My name is Jim Ball, with Ball Financial Services Co. in Westboro, Mass. We have an independent wealth management firm affiliated with Commonwealth Financial Network. As a group, we manage about $560 million in assets under management.
InvestmentNews: Zoe, how about you?
Ms. Brunson: I'm director of investment strategies at Genworth Wealth Management. We're a third-party asset management platform with about $20 billion under management, and we're focused on providing investment solutions to independent financial advisers. The average account size on our platform is around the $250,000 to $500,000 range, so I'm definitely dealing a lot with more of the liquid-alternative space.
Mr. Chapin: I am the chief investment officer of Mill Creek Capital Advisors. We manage approximately $3.1 billion on behalf of about 250 clients. We work with high-net-worth individuals, endowments and foundations, and corporate defined-benefit pension plans.
InvestmentNews: Can you tell us why now is uniquely suited for alternatives inside portfolios — if, in fact, it is?
Mr. Chapin: I'm not sure now is uniquely the time, but I think we are in a unique and evolving time where we've never had a greater selection of alternative investments than we have today. So I think the good news/bad news is, there's a wider selection of products and programs to choose from today.
Why now in particular? In a three-year period ended July 31, U.S. equities returned about 17.7% annualized, so we've been through a great period of equity returns. And I think a number of advisers, including ourselves, are saying, “Where do we go from here?” Is there a way to take some of that risk off the table without giving up too much in the way of returns? And we are certainly in a unique position relative to history in the U.S. bond market. We are coming off of 50-year lows in interest rates, and we are probably going up from here. So the 5% to 6% annualized returns that investors are used to getting on their bond fund investments won't be there for the next 10 years. It's time to think about ways to take some of the money that you would have put into bonds and look for other absolute-return strategies.
Ms. Brunson: Even though we've had a strong equity run over the last four years, there's been a quarter within each calendar year where we've seen some of that volatility play out. So there should always be some exposure to alternatives or alternative-type strategies within a portfolio in an effort to limit some of that downturn exposure. We're never going to know when is the right time to be in or out of the market. But being balanced across exposures, we have a less volatile experience over the long term.
It's like insurance. You never buy insurance after the event when you need it; you buy it before the event in the hope you're never going to use it.
InvestmentNews: Jim, how about your take on why alternatives now?
Mr. Ball: I think this Federal Reserve quantitative-easing experiment has never been done before, and so no one really knows how markets are going to respond when they remove it. It's created some phenomenal returns, and until we see exactly how this thing unwinds, I think there's a real value there.
Today's environment can cause emotional reactions and bad decisions that are tough to undo later. So I think by adding some of these alternatives, it can take the edge off some of the extreme moves a bit.
In addition, we're seeing too many people have a lot of capital on the sidelines. Absolute-return strategies, along with short fixed income, are a great way to get people off the sidelines and hopefully stay ahead of inflation.
InvestmentNews: Can alternatives help in a rising-rate environment, with the volatility that's likely to come from that?
Mr. Ball: There are a lot of areas that can be beneficial and offset that risk, and it can be within fixed income — moving from the traditional core fixed income to long-short fixed income and unconstrained funds. Whether you consider the alternative or not, there are certainly managers out there that have more flexibility to short the fixed-income markets or to at least earn some reasonable rate of return or income with zero duration risk. So I think those assets have the opportunity to offset rising rates.
You can look at bank loans and you could look at real estate, depending on the type of real estate. You need to be careful about your lease duration and be in properties that can raise rents more quickly. But I think all of those areas within alternatives have the ability to behave better than core fixed income.
InvestmentNews: In this environment, in a rising-rate cycle, some of your hedging strategy would be to reduce traditional fixed income and use things that are kind of pseudo-fixed-income, such as real estate or bank loan strategies, or something like that?
Mr. Ball: I would combine alternative strategies such as real estate and bank loans. Managed futures made money in declining rates for 30 years. They've been performing less well as of late, because they're not earning a lot on their capital and some of those trends are gone, but they may just start going the other way.
And I think allowing more flexibility in your bond managers [is worthwhile] to give them the ability to short certain markets, or at least go to zero duration so that the interest rate risk is gone and they can try to make you money through credit risk management instead.
Ms. Brunson: It's thinking about why you hold fixed income within your portfolio — is it there just for diversification? Is it there for the provision of income? Is it there for the provision of volatility management? Or is it there for the deflation hedge? How is it really being used? So for example, fixed income's in there for income play. Well, it's not been a great income play over the last period of time. And we know in a rising-rate environment, you're going to get greater income. But you're going to get depreciation and you're not going to see the capital appreciation associated with it. So think about using a different type of income solution that can go into the expanded income asset classes to get that exposure.
THREAT OF RISING RATES
InvestmentNews: Historically, it seems like alternatives were thought of as a way either to hedge some risk or enhance performance, and a lot of that was associated with what was happening on the equity side. For a lot of advisers and a lot of investors, it's the first time in their lifetime that they've seen the threat of rising rates after such an extended cycle of declining rates. How can alternatives be used in that environment?
Mr. Chapin: Many of us have come from a long-term environment and think about portfolios in two dimensions. We have allocations to risky assets like equities, and we have allocations to traditionally safe asset classes such as investment-grade bonds or high-quality municipal bonds. We're now evolving into a world where we need to think about three- or four-part portfolios — each part of which is trying to do different things for us. Now we're looking for some amount of dampening-down of the high risks that we take in equity portfolios by implementing traditional hedge strategies like long-short equity or other higher-volatility, higher-returning strategies.
We can continue to count on fixed income to generate some amount of income in portfolios, but we can't necessarily count on it to provide low volatility. We need to sort of fill this mid-risk bucket with some things from the riskier assets that we own, and potentially from the erstwhile safe assets we own.
With continued recovery from the long economic recession, we'll get back to more normalized real returns in fixed income. And so that means the 10-year Treasury — which already has gone up more than 100 basis points — could go north of 4% from here, though we're still with very low yields on two-year Treasuries and five-year Treasuries.
InvestmentNews: Zoe, what's your take on the best way to gain access to alternatives and start the due-diligence process?
Ms. Brunson: If you think about the retail liquid-alternative space, it's critical to think about the talent of the portfolio management team. Do they really have alternative talent and tenure running this strategy? Or is it just kind of an extension of something that they've already been doing? So, for example, equity long-short — and someone's just launched a long-short bond. Do they really have experience on that short side?
In the liquid-alternative space, there is a huge range between the best-performing funds and the worst-performing funds. For example, if you just look at equity long-short and you look at the three-year-period-ended-June group, there's a difference of almost 30 percentage points between the best-performing funds and the worst-performing funds in that peer group. So it's really critical that you ensure that the team that's running the strategy really knows what they're doing, because by picking the wrong manager, you could be putting yourself in a worse place than you were originally.
InvestmentNews: A member of the audience wants to know what a liquid alternative is. My understanding is that when we talk about liquid alternatives, we're really talking about registered products such as mutual funds. Is that correct?
Ms. Brunson: Correct. Typically, if you talk about liquid alternatives, it's something that's giving you daily liquidity, as opposed to some of the traditional hedge-fund-type products that may have monthly or quarterly or annual liquidity buying or openings, or the ability to buy or sell might be locked up for years.
They're a solution that gives you the ability to buy or sell on a daily basis. It gives you exposure to one of the alternative strategies. The most common ones — and we've seen a plethora of funds get launched over the last several years — are absolute return, market-neutral, equity long-short and managed futures. To a degree, you can go global macro, and we're now seeing a lot more that are being termed “multistrategy.” So you're not going into a single hedge fund or alternative strategy, but they're combining different strategies so that you, as an adviser or an investor, don't have to pick one specific alternative.
InvestmentNews: And Zoe, when you talk about liquid, is it usually a registered product such as a mutual fund or exchange-traded product, or a differentiated fund or note?
Ms. Brunson: Those are the ones that we are predominantly using and take exposure to. There are some ETNs that can give you short or long on specific fixed-income periods.
InvestmentNews: This is a question I've always had for the alternatives industry and the fund industry. If you can offer me a long-short strategy in a mutual fund format, I'm going to get better liquidity and I've got to assume lower fees. Are they as good as the pure hedge fund? And if they are, why aren't institutions investing in these mutual funds instead of paying one and 20 or two and 20?
Mr. Chapin: I think you hit the nail on the head. I think the defense of the traditional hedge fund programs would be that because they are not operating in an SEC-registered type of vehicle that is required to value all of its assets daily and provide for daily liquidity that the traditional hedge fund can invest in underlying investments that are less liquid. They can employ leverage where there are prohibitions within "40 Act vehicles for the amount of leverage you can take.
So the advantage of the traditional hedge fund strategy, as we know it, would be a little more flexibility and a little less requirement for having to be able to mark everything to market to meet redemptions on any given day.
But you hit exactly on the advantage of liquid alternatives — the ability to build a pretty balanced program of alternatives by picking eight to 12 different managers and putting $5,000 in each and building a really well-diversified program.
IS "40 ACT PRODUCT BETTER?
InvestmentNews: Jim, what's your take on that? If the registered products are even 90% or maybe 75% as good, it sounds like it's a better deal when you throw in the fees.
Mr. Ball: Generally speaking, there are some quality liquid "40 Act-type alternative funds out there. But I think when it comes to real estate, event-driven arbitrage and, to some extent, bank loans, even though they're certainly available in liquid funds, people tend to buy and sell them at the wrong time. So I prefer business development corporations, which are less liquid strategies where a manager can be opportunistic and build a portfolio over time.
InvestmentNews: Are there some strategies that just don't equate or adapt well to the registered model or registered wrapper?
Mr. Ball: Some of the true hedge funds, if you look at an event-driven fund where you might need some time or some ability to leverage, you simply can't do those in a fund or they don't fit well with folks that might want their money back tomorrow. The same with real estate. Clearly, there are benefits to liquid real estate funds, but there also are benefits to nontraded real estate investment trusts and their ability to build a portfolio through the lows of a market cycle. There is a time in the cycle where purchasing real estate in an illiquid fashion is going to give you better value, although they've re-priced recently, I think. A lot of liquid REITs and REIT funds have certainly priced back close to fair value.
But I think when you're building some of these illiquid strategies, you should stick to illiquid. And people's attempts to re-create them in funds is questionable at best.
Ms. Brunson: And just to add on to that, there was actually a study just recently completed by Cliffwater [LLC] that looked at the difference between the liquid versus the nonliquid peer groups. They surveyed and evaluated roughly 400 firms, larger firms, and they found on average, there was a 1% difference between the private versus the liquid alternative, but then that's the average. But if you look at specific different peer groups or strategies, there is a larger difference between the returns that were achieved in the private traditional-hedge-funds space versus liquid-alternative space and that was coming up to almost 2.5% over a 10-year period. So there are definitely certain strategies that blend well and can work well in a liquid-alternative space, and there are some that definitely would do better in the traditional space.
WHERE DO YOU START?
InvestmentNews: Tom, I know that you must use registered products for your clients in addition to other types. Where do you begin? If you're a financial adviser and you haven't done a lot in this area yet, are there places you could start doing your due diligence? Do you go to Morningstar Inc. or Lipper Inc. and start running screens?
Mr. Chapin: I would say you need to start with that, as with any sort of decision on an asset class or a manager. Start with identifying what type of program you are trying to deliver to clients. Are you looking for absolute-return-type strategies to take some money out of traditional bonds and then put it into absolute return? Are we looking for equity long-shorts?
So if you start with what you're looking for in terms of either strategies or the types of returns and risks that they're going to deliver, then there are a variety of different databases that people use, whether it's Morningstar or industry publications. All of the companies that are coming out with these strategies are trying to get them in front of investors and get noticed. So it really is doing the old-fashioned shoe leather of reading as much and being exposed to as much, going to conferences, doing webinars like this and taking meetings as we do with any number of the firms that are coming through town.
And then sometimes the strategies don't necessarily strike a chord. But other times, you come across something, either in conversations or in going through databases, a strategy and a manager you may not have been otherwise aware of. And then that's back to customary due diligence — all those good things that go into vetting any kind of active manager of a strategy or asset class.
InvestmentNews: Tom, is there any strategy in the alternative space that you wish you could get to through a registered or a liquid version that hasn't been created yet?
Mr. Chapin: Not every strategy that works in the hedge fund space will or can work in the liquid space. But I think, as I said earlier, I'm thrilled and pleased that you get big, very well-known firms that are running credit strategies. There are big firms that have had tremendous long-term success putting some good portion of what they do into a "40 Act vehicle and providing you with something close to what they can deliver on the traditional hedge fund side.
InvestmentNews: Jim or Zoe, do you see anything that you think might be coming down the pike in the alternative space for liquid alternatives, or something that should be there?
Ms. Brunson: I think you're going to see more growth. I think you're probably going to see more growth of multistrategies rather than if it's in a sales strategy. If I had to make a prediction, it would be a case of people wanting a more diversified strategy alternative, where an adviser doesn't have to go out there and pick this manager and then this manager, and then decide how to allocate across those choices. You're going to have an investment firm that's got experience, and they will come up with a multistrategy fund. They've got the experience of picking managers, and they put them together in an allocation across their firm.
Mr. Ball: The other area you're seeing new pricing is in the real estate sector. With regard to nontraded REITs, you're seeing a lot of folks trying to work on allowing access but reducing funding costs on those things. And I'm really curious to see how that goes.
And then I think some of the other areas like event-driven — I don't think they should be made liquid. Some folks are attempting it, but I'm not sure it will work well and I don't know of any that have, as of yet. I think the options are going to be broader and deeper.
I think what's also exciting is, a number of these strategies now do have three-, and many are approaching five-, year track records. In the global macro space, others even have 10-year records. So it's maturing fairly quickly. And I don't know that we could have possibly had a better test period than the last five to 10 years.