Vanguard urges caution on liquid alts

Fund company says performance has not been living up to the billing

Aug 29, 2014 @ 10:37 am

By Trevor Hunnicutt

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The Vanguard Group Inc. is urging advisers to take a wait-and-see approach before adopting alternative mutual funds into client portfolios.

In an interview with InvestmentNews Thursday, Vanguard senior investment analyst Christopher B. Philips said the products sometimes called “liquid alts” have not yet proven themselves to provide either reduced risk or enhanced returns.

“There is a presumption in the investment community that with yields low and with the potential for risk high that there has to be a better way than just your stock-and-bond approach, and if we buy into that blindly, then it can be very easy to see a marketing message from an alt fund and just assume it's a great way to invest,” Mr. Philips said.

(Related: Rise of alternatives should give advisers night sweats)

Vanguard's wary approach to alternatives comes as the products increasingly are being adopted by advisers to guard against the predicted end of a long run up in stock prices and a rise in interest rates, which would hurt bond values. As of July, $354.7 billion were held in alternative mutual funds and ETFs, according to an InvestmentNews analysis of data from Morningstar Inc. They are the fastest growing type of fund, with assets gaining 43% annually since 2008, according to Citigroup Inc.

With limited exceptions, Vanguard — the world's largest mutual fund manager — has avoided alternatives. Although it has some products that use hedging strategies to reduce risk, including a long-short product (VMNFX), the Malvern, Pa.-based fund house has largely dodged popular alt strategies, many of which allow managers to deviate widely from a benchmark and use exotic trading methods.

Now Vanguard says neither investors nor product manufacturers know enough about the value those strategies will have over the long run. Many of the products available today did not exist before 2008, when many of the world's largest economies fell into recession.

“We don't have enough information as product providers or as investors outside of the cost and strategy description,” Mr. Philips said. “When you combine the cash flows and the product launches out there with, to be frank, the performance that we've seen in them, the reality is they haven't been living up to their billing.”

(More: Popular liquid alts funds face regulatory scrutiny)

Vanguard recently produced a study finding that a 10% reallocation to alternatives in a portfolio with 60% stocks and 40% bonds did not increase the portfolio's Sharpe ratio. That statistic measures performance for a given unit of risk.

But David Lafferty, chief market strategist at Natixis Global Asset Management, said Vanguard's analysis used an allocation to alternatives that was too low to meaningfully provide the benefits those products are supposed to offer. He said 10% is just the starting point for an allocation to alts.

Natixis, a division of a Paris-based banking conglomerate, is the seventh-largest U.S. provider of alternative funds.

Mr. Lafferty said advisers' expectations of alternatives may be too high.

“They're extremely useful portfolio tools when incorporated into an asset allocation, but they're not a panacea — they're not going to solve every problem,” he said. “Many folks in the business seem to believe that alternatives should increase returns, that this is a return-enhancing vehicle, and the disconnect is that they're a risk-management and diversification vehicle.”

(More: Liquid alts to get their own benchmarks)

He said diversification could come in handy as equity returns come down, volatility increases and interest rates rise, all of which he predicts.

Advisers are adopting the funds, but many said they're taking a “critical eye” as they evaluate them, with many keeping portfolio exposures in the single-digit percentages.

David Schauer, chief investment officer at Hanson McClain Inc., said portfolio hedges can keep wary investors in the market.

“2008 had a lot of people panic and go to cash and then watch the market ascend for the next five years,” Mr. Schauer said. “To me, if it can take some risk off the table and provide some volatility buffer, could it be valuable even at a 5% threshold? Yes.”

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