An incisive note from Goldman Sachs Asset Management details the three pitfalls in daily liquid alts investing.

Theodore Enders, Global Head of Goldman Sachs Asset Management (GSAM) Strategic Advisory Solutions, says that investors are sometimes disillusioned with their investments in alternatives. However, on closer analysis, it turns out that poor implementation choices within portfolios are more often the problem rather than flawed strategies. (GSAM)

GSAM used the equity market drawdown triggered by the coronavirus endemic in early 2020 as a case study.

Three common implementation pitfalls

·        Defining the term “alternative”

GSAM defines daily liquid alternatives (DLAs) more rigidly compared with Morningstar. In the opinion of GSAM, DLAs are similar to hedge funds because they reduce portfolio risk, better manage equity drawdowns, and provide differentiated returns from both equities and fixed-income. Several funds considered as alternatives by Morningstar do not fall within the ambit of this definition.

“During the Coronacrisis drawdown, the Morningstar funds that we exclude from our stricter definition exhibited sharp performance disparity—with nearly a quarter having deeper drawdowns than the S&P 500 (-34%),” writes Enders. “Investors owning these funds and expecting better performance were likely dismayed by the outcome.”

·        Lacking strategy diversification

Investors tend to crowd into the equity long/short strategy. However, there are other DLA strategies available such as tactical trading, relative value, and event-driven.

The problem with excessive use of the equity long/short strategy is that these funds also have the highest beta to equities.

“Therefore, they may disappoint exactly when investors hope to realize the benefits of alternatives,” says Enders. “During the Coronacrisis drawdown, the median Equity Long/Short fund fell -22%, double that of all other alternative funds.”

GSAM recommends the use of a multi-strategy approach.

·        Excessive manager concentration

The third pitfall identified by GSAM is the use by investors of only one or two managers. GSM points out that though the median DLA outperformed US large blend funds during the corona crisis, the range of outcomes was nearly 3 times as wide. This shows the greater potential of return dispersion across managers.

“If an alternatives sleeve was comprised of only one or two managers, investors were likely frustrated if those managers were at the bottom end of that range.”

GSAM’s recommendation: Use multi-manager strategies or hedge fund replication strategies.

Related Story:  Retail Investors Can Use Alternative ETFs To Their Advantage