Liquid Alternatives: Clarifying Some of the Recent Press

We’ve seen some bad press lately about liquid alternatives saying that in general these new funds have not proven themselves. It’s no coincidence that this comes at a time when the equity markets are at all-time highs after a 5 year bull run. This bad press is unwarranted.

Many of these articles fail to point out exactly why alternatives are a necessary part of one’s portfolio. They are there as a diversifier to the rest of your portfolio; the zig to the zag. This diversification comes in quite handy when equity returns decline, volatility increases, and interest rates rise. All of which could happen sooner rather than later.

It wouldn’t make any sense if alternatives were up say 20% in a year stocks were up 20%. If so, those two asset classes are totally correlated. Alternatives best trait is being non-correlated to other asset classes, be it stocks and/or bonds. Frankly, expectations of alternatives are probably too high for most people. Our expectations for alternatives (as a group) would be around 6-8% per annum. But more importantly, our expectations for alternatives is that they won’t be down dollar for dollar when equities have a 10% or worse correction.

And that’s the real beauty. By using alternatives and avoiding a blow-up like many hard-core equity investors did in 2008, you don’t have a huge hole to dig yourself out of.

Investors should know that alternatives come in two categories:

  1. Alternative strategies – that utilize traditional asset classes (stocks and bonds) in non-traditional ways. Examples: Long/Short Equity, Long/Short Fixed, Market Neutral
  2. Alternative assets – non-traditional asset classes (anything that’s not a stock or bond). Examples: Real Estate, Infrastructure, Commodities

*Some alternative funds combine both strategies and assets. Examples: Managed Futures, Multi-Strategy, Fund of Funds.

Alternatives are typically used for four major reasons:

  1. Reduce Volatility
  2. Generate Income
  3. Increase returns
  4. Address A Specific Risk

Most alternatives may only align with one of the four objectives above. Very rarely will an alternative be able to do all of that. For example, infrastructure is really just a “generate income” play. Whereas Market Neutral isn’t necessarily increasing returns or generating income but there to reduce volatility and limit max drawdown. The table below shows how different these alts can be.

Liquid alts

That being said, you need to know what you own to invest in this area. As a portfolio manager, DWM seeks to understand the risk/return profile, market exposure, correlation to traditional asset classes and the manager skill and experience before we make an addition to our Liquid Alternatives Model. We also identify how one fund correlates (or hopefully doesn’t correlate) with the other funds within the model. We think our model blends the above objectives in a optimized way to benefit our clients’ portfolios. We’ve been working with “liquid alts” for a decade now and they have proven to be quite beneficial for us and our clients.

In conclusion, the bad press we see every once in a while on liquid alts is not warranted and typically comes from the misunderstanding of what can be a complicated area. We hope this article has provided some education. For further information on alternatives, don’t hesitate to contact us.

What’s Next for the Economy and Markets?

crystal-ballTough question. A more relevant question would be: “How do I obtain long-term investment success?” We’ll discuss both today.

First, the economy and the markets are not correlated over the short-term. Last week’s overall market selloff again demonstrates this. Yes, over the long-run, there is a correlation between GDP growth and corporate earnings. But data demonstrates that over the short-term, there is no correlation.

Second, it is imperative to filter the noise of the media and put the current situation in broader context, than to guess about the future. Our economy is still recovering from the 2008 credit crisis. Similar crises were followed by weak GDP and job growth. The Fed confirmed last week that we are following this historical pattern. Since September 2012, when the latest QE program started, the unemployment rate has fallen from 7.8% to 7.6%. The Fed expects GDP to increase 2.3-2.6% this year. Inflation is up only 1.05% year over year.

Of course, these results, and the stock markets, have been influenced by easy money policies. Since 2008, the fed funds rate has been near zero. Hence, the Fed has employed additional policies to boost the economy. The most significant has been QE. The Economist on Friday described Chairman Bernanke’s tough assignment: “In a zero-interest rate environment, the central bank can influence monetary conditions more through words than through actions.” Mr. Bernanke’s comments last week, which pointed to the path that actions were “data dependent” were interpreted (perhaps incorrectly) by many investors to mean greater “hawkishness” (tapering was about to start). Virtually all markets tumbled.

The economic data doesn’t support a change in the bond-buying policy. Unemployment is still at 7.6%, labor participation rates are near 29 year lows, inflation expectation are falling, and perhaps, most importantly, there has been no substantial improvement in job growth:

chart

Yet, despite the weak pace of overall growth, the recovery in the last four years seems to be getting smoother. The housing market is up, the energy sector is booming, auto sales are improving, household finances are looking healthier and consumer confidence is at a five-year high. The Fed has increased its 2014 growth forecasts to 3% to 3.5%, from a March forecast of 2.9% to 3.4%. So, we’re making progress, but will it continue? And, if so, when will tapering start?

We agree with Yogi Berra, who said: “It’s tough to make predictions, especially about the future.” We humans are not so good with making accurate predictions. However, these days, you can generally find an opinion to confirm almost any point of view. In fact, studies have shown that the most confident, specific forecasts are a) most likely believed by readers and viewers, and b) least likely to be correct.

We prefer to focus on the long-term. People seem to lose sight of their financial future in the midst of all the noise. Most of us have a long-term investment horizon- perhaps 20, 30 years or more. During that time, we can expect bull and bear markets, volatility and short-term market swings. Emotional reactions to short-term events and media noise can cause you to miss market rallies and doom you to long-term investment failure.

You need a disciplined investment strategy and perhaps a full-time professional investment adviser to help you with it. Your asset allocation needs to represent the three asset classes; stocks, bonds and alternatives, with further diversification within each asset class. Your portfolio needs to be reviewed continually and rebalanced regularly. You need to make your capital work for you all the time, and not leave money sitting in cash. Over time, asset allocation, diversification, rebalancing and mean reversion will all work in your favor.

So, we won’t focus on predictions. Instead, what we will do is to help you establish and maintain a long-term probability-based investment approach that should reap dividends and investment success for you for years to come. Give us a call. We’d be happy to chat.