Strategies, not just assets, key to alternative investing

What is the cost in portfolio performance if an investor's retirement, education or other goals come before the market ultimately resumes its upward course?

During the past 10 years, markets essentially have gone nowhere. If this trendless direction continues — which is altogether possible — financial advisers will be forced to reconsider the widely accepted asset diversification/asset allocation paradigm.

Traditional asset diversification is based on the assumption that the value of all financial assets eventually rises over a long period.

But what if an investor’s time horizon is shorter than “eventually”? What is the cost in portfolio performance if an investor’s retirement, education or other goals come before the market ultimately resumes its upward course?

The problem manifests itself in institutional as well as individual portfolios. One reason for the crisis in U.S. and global pensions, in which vast pools of assets still aren’t large enough to meet future promises of income, is that investments are made based on the traditional asset diversification paradigm.

In this country, the majority of 401(k) plans are long-only market directional portfolios, making the average American a hostage to markets’ having to rise in order to retire successfully. Regardless of whether the traditional portfolio is diversified among large-cap growth, small-cap value or any one of a dozen asset categories or style boxes, classic diversification among traditional assets ultimately leads to the creation of market directional portfolios that follow the long-only buy-and-hold mantra blindly.

Investing in alternative assets by itself doesn’t get investors out of the long-only bind. For that, investors must turn to non-directional alternative-investment strategies.

Unfortunately, alternative investments and alternative strategies often are misunderstood and considered as one.

Although commodities and real estate are alternative-asset classes that provide access (sometimes) to uncorrelated markets, participating in those assets through mutual funds — the most practical vehicle for most investors — still results in long-only, buy-and-hold market-directional portfolios.

In order to capitalize on the true potential of alternative assets — and conventional assets, for that matter— I think that investors and their advisers should pursue true non-directional alternative-investment strategies that are now available in mutual funds — including absolute-return funds — that use traditional and alternative strategies along with traditional and alternative assets.

There is considerable confusion surrounding alternative assets and alternative strategies, largely as a result of the boom in hedge funds and alternative assets that forced an unnatural and unnecessary drive to include them in the classic asset diversification paradigm. Many called hedge funds and alternatives a “new asset class.”

In truth, neither non-directional alternative mutual funds nor hedge funds are a new asset class; they are non-directional alternative-investment strategies, which sometimes may employ traditional assets.

True diversification away from market direction and cyclicality can be achieved only by non-directional alternative-investment strategies that can succeed whether or not the markets go up. These strategies include long/short, market-neutral, fixed-income arbitrage, convertible arbitrage, statistic arbitrage and risk arbitrage.

In the institutional world, the Yale University endowment model, which was predicated on investing in hedge funds and private equity — plus alternative assets including commodities, real estate, lumber, fisheries, wineries, oil and gas partnerships, and movies — was a first step away from traditional-asset diversification to alternative-asset diversification.

However, even the progressive Yale endowment model has suffered because its alternative-asset-allocation diversification wasn’t a true substitute for alternative-investment-strategy diversification. Its private-equity allocation, for example, proved to be just another equity-type market-directional investment that is profoundly cyclical.

So, too, were its real estate and lumber investments.

Today, even after the lessons of the recent past, the Yale endowment model is predicated on asset allocation, which leads predominantly to long-only market-directional portfolios without strategy diversification.

This investing model, therefore, creates the false illusion that, because it contains alternative assets, it is properly diversified. It isn’t.

What advisers need for their clients is what I would call a reformed and expanded Yale endowment model that provides not only asset diversification among traditional and alternative assets but also diversification among market-directional and nondirectional strategies utilizing a wide array of traditional and alternative assets. A reformed and expanded model also would work in the institutional world, where endowments, foundations and other public funds recently have experienced funding problems and have a collection of assets that don’t match their stream of liabilities.

In the new strategy and asset allocation model illustrated here, portfolios D and C achieve balanced strategy diversification, with portfolio C offering strategy and asset diversification through its use of traditional and alternative assets and strategies.

By contrast, portfolio A — the current approach in the adviser area — misses multiple diversification opportunities. Portfolio B, the typical Yale endowment model, goes to the other extreme of excessive alternative-asset allocation while still relying on a predominantly long-only strategy with its huge market and liquidity risks.

For advisers who want to deliver true diversification to their clients and unshackle them from the often unapparent constraints of long-only investing, strategy diversification is a path worth taking.

Gabriel Burstein is the former global head of investment research and fund research at Lipper and Thomson Reuters, and will be a featured speaker at the InvestmentNews Alternative Investments Summit in October. The research and views expressed here are his own.