The correlation conundrum and liquid alternatives

The vast majority of these funds are new, and they require scrutiny in context of other assets.

As the popularity of so-called liquid-alternative funds increases, many of us wonder how they will perform in the inevitable bear market.

In fact, it seems as if the entire liquid-alt industry was created as a result of the “lost decade” that ended in 2009, a period in which the S&P 500 posted a 9.1% decline — the worst-ever 10-year performance for the benchmark.

The vast majority of the products available today did not exist during that time, so performance through periods of stress and volatility can be viewed only through a lens blurred by back-testing and optimization. Clarity will ultimately come in waves and over longer market cycles.

Sure, the volatility witnessed in months like October and December 2014 might provide a few signs, but advisers need to take a step back, look at the bigger picture and ask themselves a different question.

One of the basic tenets of Investing 101 is not to put all your eggs in one basket. A contrarian view would espouse owning a single asset class, and plenty of empirical evidence debunks that as a sound investment strategy.

SOLO EGG

But in reality, just one “egg” represents your retirement account or college education fund, or some other goal-oriented strategy.

There is also just one basket: the market, defined in its broadest terms.

The goal should be to allocate this single egg to a series of uncorrelated risks that can all be located in this single basket.

The question about the expected performance of liquid alts in a future down market seems to play into a theory that investors should be thinking about a core basket with traditional stocks, bonds and cash, and a second basket containing the liquid-alt solutions.

The thinking never followed that path before the advent of liquid alts, and it should not be doing so now.

Are liquid alternatives a product or a solution?

The answer depends on how the user expects to implement them. Most investors — from sophisticated institutional managers to novice retail buyers — have proved that market timing is not a winning strategy.

Past performance does not guarantee future results, and no return stream is truly predictable and linear. This simple axiom applies to equities, bonds, liquid alternatives, real estate, collectibles and virtually any other asset class you can name.

RISK-ADJUSTED RETURN

Why not start with a solutions-based portfolio that examines a wider range of uncorrelated return streams that can create the very best risk-adjusted return?

The true benefit of these liquid-alt products is the wider set of tools now at our disposal.

Rather than wondering how products might perform given a certain market cycle, you should be thinking about how they will perform relative to one another.

Perhaps funds will correlate more than expected in the short term, but the analysis should be to make sound determinations on how they will or won’t correlate over longer market cycles.

BUFFETT WAS RIGHT (AGAIN)

One of Warren Buffett’s simplest but most profound quotes defines risk as resulting from not knowing what you’re doing.

It is not the instrument, product or solution (and that certainly includes liquid-alt funds) that causes or prevents the dreaded drawdown risk. Rather, it is user error, which comes from not understanding the intended use and benefits of all available tools.

Take the time to reacquaint yourself with your portfolio. Ask yourself about its construction. If liquid alternatives are part of the current solution, ask why. If they are not, you also should have an explanation for that.

Get educated, for your sake and that of your clients. Education is the perfect antidote for ignorance.

William J. Kelly is chief executive of the Chartered Alternative Investment Analyst Association.