Neuberger Berman isn’t a big fan of the term “alternative investments.” Instead, the firm refers to these investments – broadly defined as anything other than stocks or bonds – as “the new traditionals,” since times change and traditions change along with them. Using the term “alternative” implies that real estate, commodities, and infrastructure investments are somehow abnormal, when in reality they’ve been used by institutions and the ultra-rich to hedge and profit since at least the late 1940s. Now, with the advent of “liquid alts,” these “new traditionals” are available to a much wider class of investors – and that’s a new tradition worth protecting.
Alternatives Aren’t New
Sophisticated investors have long recognized the advantages of investing in real estate, commodities, infrastructure, currencies, private equity, and other businesses that generate returns with limited correlation to the stock and bond markets. The Ivy League Endowment Model began championing alternatives decades ago, and today’s endowments and foundations have roughly 20% of their assets allocated to alternatives, according to Neuberger Berman. Endowments’ allocations to alternative investments are split almost equally between private equity, hedge funds, and real estate, as noted in the graphic below.
Liquid Alts Arrive
The global financial crisis of 2008, during which time stocks and certain segments of the fixed income market both sank in tandem, alerted retail investors of the correlation problem, and helped lead to the development of liquid alternatives. The enhanced liquidity of liquid alts also made them attractive to accredited investors who experienced the disadvantages of hedge-fund and private-equity illiquidity during the ’08 meltdown. Neuberger Berman says alternative investments offer a “solution set for today’s markets” that addresses the problems of volatility and correlation, while also potentially enhancing performance.
Advantages of Alts
Historically speaking, adding alternatives to an investor’s portfolio has been shown to decrease volatility over time, which can limit portfolio drawdowns and boost risk-adjusted returns. Over the longer term, alternative investments have maintained lower correlations to standard equity and fixed-income indices, and even as the investment world has changed, there’s no reason to believe this won’t continue. And as for the potential of enhancing absolute returns, Neuberger Berman says that liquid alts in particular “have been shown to be an effective means to enhance portfolio performance.”
Liquid alts have been rapidly growing in popularity, but they haven’t been adopted by everyone. Why? Well, according to Neuberger Berman, there are four common concerns investors have with liquid alts: risk, leverage, liquidity, and access. In response, Neuberger Berman points out that many alternative strategies employed by liquid alts are actually designed to reduce risk, not take more on; that liquid alternative mutual funds and ETFs are prohibited from taking on the most aggressive leveraged strategies of the hedge funds they emulate; and that liquid alts have all of the liquidity and ease-of-access as standard mutual funds.
Importance of Manager Selection
Perhaps a better reason to be cautious about liquid alternatives is the great disparity between the performance of similar alternative funds. As you can see from the image below, there is a much greater spread between the best and worst managers of global hedge funds than between the best and worst of traditional mutual funds. The 10th percentile, 5-year return for event-driven hedge fund managers, for example, was over 20% through January 2014, while the 90th percentile barely broke even – a spread of roughly 20%. By contrast, the best long-only “large-cap blend” mutual fund managers slightly underperformed the best event-driven hedge funds, but the spread between the best and worst large-cap managers was a mere 5%.
Clearly, manager selection is far more crucial when selecting an alternative fund – or as Neuberger Berman would like them to be known, a “new traditional” fund. Long-only mutual funds, by contrast, capture mostly beta, or the market’s return. Alternative managers are in pursuit of alpha, or returns that are based on manager skill rather than the broad market. For this reason, active managers of alternative funds typically charge higher fees, which may be worth it – but as the image above testifies, this isn’t always the case. Neuberger Berman says manager experience and track record are key, and it’s particularly important to see how a manager’s strategy performs over a multi-year market cycle.
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