Finding value in unpopular alpha

I have been talking with advisors recently about alternatives. One of the points I always make is that the definition of alternative investments has varied significantly over time, so it’s important to be very specific about what you mean when you say alternative.
In the middle of the last century, for example, you could have made the case that stocks themselves were alternative. At the time, stocks had always yielded more than bonds and always would because they were riskier. Since then, of course, we have seen the opposite conclusion, that stocks are less risky than bonds over time, become the prevailing wisdom. Stocks, at the time, meant U.S. large-cap. Small-cap stocks were dangerous, risky, not for small investors. Until, of course, they weren’t, and now small-cap is a core part of most portfolios. Foreign stocks were dangerous, scary—they don’t speak the same language, so how can we trust their assets? Until they weren’t scary anymore, and again, foreign stocks are now part of core portfolios. The same logic has played out with emerging markets, with high-yield bonds—formerly known as junk—and now with alternatives.
The reality of what has happened is that unpopular asset classes are much more likely to be mispriced. If everyone is scared to go there, then there will be no competition and prices will not get bid up. Asset class alpha is therefore, to some extent, the result of unpopularity, which I call (obviously enough) unpopularity alpha.
The current poster child for an asset class with a change in the perception of risk is managed futures. Until quite recently, it was considered by many to be a scary, unreliable asset class, one that was difficult to understand and worked with markets and strategies that were obscure and unreliable. Sound familiar with respect to many of the asset classes listed above?
The strategy is becoming more widely used and is now available in mutual fund formats. The question then becomes, as unpopularity declines, will the unpopularity alpha also go away? Or, put another way, as more money moves into strategies, will they stop making as much money—or even stop making money at all?
Again, managed futures can provide some answers. David Harding of Winton Management, one of the founders and major players in the industry, has a presentation in which he lays out different substrategies that the firm has employed over time and how they declined in profitability from initial deployment until they were eventually retired. Strategy decay does happen, and research and investment is required to stay ahead of it. It does not seem, though, that the unpopularity alpha is necessarily at risk solely due to increased interest, as the managers can continue to shift to less popular strategies, even as prior strategies become less effective. Nonetheless, this is an issue worth keeping an eye on.
Another issue is this: you can make a case that much of the return opportunity for investors in the futures markets is due to the presence of non-investor participants who are there to hedge and not to make a profit. A farmer, for example, selling wheat futures is not trying to trade those futures for a profit but to lock in a price for his crop. The more non-profit-maximizers there are in a market, the more opportunity for traders to make a profit. As more and more traders move into these markets, you can argue that there will be fewer opportunities for each of them.
To my mind, this is the critical issue with any alternative strategy: how crowded is it? As it gets more crowded, is there a fundamental reason to believe that past performance will continue? Or can we expect to see performance decay, as investors bid up prices? This is one of the key issues I focus on when I look at alternative strategies. In many respects, the more unpopular the better.

Brad McMillan is vice president and chief investment officer for Commonwealth Financial Network LLP.

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