An alternative to beta? Alternatives beta

Anemic performance over the past few years notwithstanding, it would be a mistake to give up on alternative investments, according to Scott Welch, senior managing director at Fortigent LLC.

Speaking Monday in Chicago at the CFA Institute’s annual conference, Mr. Welch drove home the importance of allocating a portion of client assets to alternative strategies. But he also stressed the importance of due diligence when contemplating products and strategies.

“There are some pretty game-changing things going on with respect to alternatives,” he said. “I believe, despite anemic recent performance, that alternatives still belong in most portfolios.”

Mr. Welch’s presentation highlighted the fact that from 1990 to 2011, the HFRI Fund of Funds Composite Index produced an annualized return of 7.4%, compared with 8.2% for the S&P 500.

He noted, however, that advisers should be watching overall correlation as well as performance.
Over the same 22-year period, the hedge fund index had an annualized standard deviation of 5.9% and a correlation to the S&P of 0.53.

With that in mind, Mr. Welch is recommending a core-and-satellite approach to alternative allocations. Similar to the way some advisers will build a portfolio around a large market beta position that is supported by more aggressive strategies, Mr. Welch favors a core allocation to what amounts to “alternative beta” that is supported by strategies that strive to achieve alternative alpha.

Essentially, whatever the target alternative allocation is, it will be supported by broad alternative market exposure. Mr. Welch believes such alternative beta can be captured through certain indexes, replication strategies and even some mutual funds.

“You want to build the alternative beta exposure in a cheap way and then surround it with alpha-seeking exposure,” he said. “You could build the core and satellite all with limited partnerships or all with mutual funds, or a combination of both, but they should contain liquid investment options.”

He noted that five years ago, advisers didn’t have the ability “to apply this core-and-satellite strategy to the alternatives space” — a reference to the influx of new products and strategies that offer exposure to alternative investments.

Along those lines, Mr. Welch offered a big warning with regard to the majority of registered mutual funds promising alternative investment strategies.

“Of the roughly 800 alternative strategy mutual funds, probably 750 are crap,” he said. “But they are getting increasingly better and more creative at managing the leverage constraints of mutual funds, and that means that performance should start to move toward the performance of the limited partnerships.”

In researching any alternative strategy, Mr. Welch advised, “don’t trust the back-tested performance.”

“This is kind of a Wild West, certainly with regard to mutual funds, because products are coming to market so fast, it’s really hard to keep up,” he said. “And just because a fund company does a good job with your long-only fund doesn’t mean they are going to be able to manage alternative strategies; its a different skill set that requires a different set of expertise.”
“When looking at an alternative mutual fund, you really have to dive into, and get your arms around, the investment process,” he added.