How Much in Liquid Alternatives? You Need a Framework

In meetings with advisors and other investors, and at every conference, there seems to be an ongoing debate about how much of a portfolio should be allocated to alternative investments. Answers vary widely as you would expect, and as they should because there is no right answer. Every investor is different. At the recent InvestmentNews Alternative Investments Conference in Chicago, there were several speakers who addressed this question and generally came up with similar answers. Nadia Papagiannis of Mornignstar noted that “any move into alts should start with an allocation of at least 5%, but in order to have any kind of real impact, that allocation should grow to at least 20%” while Steve Medina of John Hancock had a similar view of at least 20%, but felt that a starting point should be at least 10% to make a difference.

These are both good answers, but in order to make an allocation to alternatives, and to know where to make the allocation from, investors and advisors need to have a clear framework for making this decision. Here are four questions that help develop a framework for making an allocation to alternative investments:

1. What am I trying to achieve with an allocation to alternatives?

There are various reasons why one might want to make an allocation to alternatives. Risk reduction is often a primary driver, and risk reduction can occur through simple diversification, or the re-allocation of assets from higher risk strategies to lower risk strategies. Alternatives can help on both of these fronts. Other reasons might be return enhancement or downside protection. Both of these are valid as well, and both will result in allocations to different types of alternative strategies. Return enhancement strategies will likely be riskier, more concentrated strategies with perhaps more market exposure. Strategies that provide downside protection will be hedged strategies or non-correlated strategies that will typically lag the broader market during strong equity market runs.

2. What is my overall risk tolerance? How is this reflected in my portfolio?

This is an important question because it establishes a starting point. Allocations to alternatives will be quite different for an investor with a low risk tolerance and a large current allocation to fixed income than an investor with a larger risk appetite and a large allocation to equities. Lower risk alternatives that have a low correlation with bonds would be more useful for the conservative investor while higher risk strategies with a lower correlation to equities would benefit the more aggressive investor.

3. Where in my portfolio am I not getting rewarded for risk?

There are a variety of risks in the market, but there are two to think about here. One is realized risk that shows up as the standard deviation of historical returns, and the other is perceived risk – risk that may or may not show up in the future. The first is easy to measure; the second is not so easy (see Question 4 below for some insights). In regard to realized risk, typical assumptions are that stocks are more volatile than bonds, and within each of those asset classes there are various components that are riskier than others. For example, emerging market stocks are more volatile than U.S. stocks, while high yield bonds are more volatile than investment grade bonds. With perceived risk, one needs to take into account the broader macro environment and lay out their own set of potential risks that may impact their portfolio.

So how does this impact an allocation to alternatives? One way is to use alternatives to mitigate realized risk by substituting lower volatility alternative strategies for higher volatility traditional strategies. For instance, migrating out of long-only equities and into long/short equity with lower volatility would reduce overall portfolio risk. Assuming the long-term expected return is the same for both strategies, there would be no give-up on the return side, while the portfolio would benefit from lower overall volatility and improved compounding of returns.

On the perceived risk side, portfolio adjustments can be made as a hedge against potential market forces that will have a negative impact on a portfolio. For example, as a hedge against rising interest rates, investors could allocate away from traditional bond strategies and into strategies that have less duration risk and low correlations with fixed income. Strategies that fit this profile might include long/short fixed income, merger arbitrage and equity market neutral.

4. What over-arching market factors should I be correcting for in my portfolio?

This is the big picture – what macro forces are impacting investment performance, or may have an impact in the near term. Today, there are really two dominant forces in the market, both linked to each other. First is the quantitative easing being implemented by the U.S. Federal Reserve and similar programs by the central banks of other developed markets. This “market support” has fueled strong rallies in the equity markets and leaves investors with the question of “What happens when the music stops?” While nobody knows for sure, and the experts don’t agree (as usual), it may be prudent to expect a pullback in the equity markets. Thus, taking some precautionary measures in a portfolio dominated by stocks may be wise. The second dominant force in today’s market is the potential for continued increases in interest rates. This will be felt mostly in fixed income portfolios when it occurs (we already experienced an initial increase in May and June of this year). Re-allocating a portion of your fixed income portfolio to low volatility alternative strategies, as mentioned in the last paragraph of the response to Question 3 above, would be prudent.

Having a framework for making portfolio decisions is critical. It allows for consistency in your decision making process. Use the four questions above to help outline your decision making process for allocating to alternative investment strategies.

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