Building portfolios using alternatives: The researcher’s view

By Jayson Forrest - Managing Editor  - IMAP Perspectives

Alternatives' is a catchall for a huge range of investment opportunities designed to improve returns or reduce risk in portfolios. Daniel Stojanovski (Centrepoint Alliance) talks to three research house experts - Deanne Baker (Lonsec), Steven Tang CFA (Zenith Investment Partners) and Tim Murphy CFA (Morningstar) - about their views on using alternatives in portfolios.

There is a strong case for including alternatives within a multi asset portfolio, ranging from the benefits of diversification and access to alternative risk premia, right through to reducing portfolio risk and accessing manager skill to drive stronger returns.

But using alternatives in portfolios also presents investors with a range or risks to consider, such as illiquidity and historical fund underperformance.

Therefore, at a time of record-breaking equity markets, the lowest yields from fixed interest in recorded history and looming inflationary pressures, should advisers be reconsidering alternatives strategies in their hunt for yield? And if so, which types of alternatives strategies work best in portfolios?

These were some of the key questions the Head of Research at Centrepoint Alliance, Daniel Stojanovski, asked three prominent researchers at a recent IMAP specialist webinar exploring alternative investments in portfolios.

Deanne Baker - Portfolio Manager, Multi Asset at Lonsec - agrees that most of the major asset classes are currently very expensive, meaning advisers need to look elsewhere for yield. In the current environment, some of the opportunities Lonsec is looking at are in the global macro space.

“We actually think that COVID has thrown up some good opportunities in global macro,” says Deanne. “Different countries are opening up at different speeds and implementing different fiscal and monetary policies. This is leading to quite a wide dispersion in economic performance across countries and the asset classes within these countries.

“Macro managers rely on that dispersion in and across asset classes to deliver returns, and they also tend to be quite good at trading around these policy settings, as well.”

The other area Lonsec continues to be positive about are market neutral strategies. Similar to global macro, market neutral strategies tend to benefit when the gap between stock winners and stock losers widens, as has happened during the COVID pandemic.

According to Deanne, COVID has presented some great opportunities for market neutral managers. For example, she points to airports as being some of the big losers, as less people travel, while tech companies were some of the big winners, as more people were forced to work remotely from home.

“So, anywhere that widening dispersion is happening is where we’re most excited about at the moment,” says Deanne.   

Steven Tang CFA - Head of Consulting at Zenith Investment Partners - agrees with Deanne about the investment opportunities thrown up by COVID. However, despite these opportunities, he adds that the key challenge for any investor is to remain forward-focused with their asset allocation.

“The reality is, none of us know what’s going to happen in the future. So, we try and diversify across different strategies. And while we don’t classify unconstrained fixed income in our alternatives category, we do have a lot of allocations to that space,” he says.

Although Morningstar has zero allocation to alternatives in its portfolios, it doesn’t take the view that because every asset class is overvalued, investors should be out of the market.

Instead, Tim Murphy CFA - Director of Manager Research, APEC at Morningstar - says that while Morningstar’s capital market assumptions for major asset classes are not as high as they were three years ago, it still believes that exposure to core traditional assets, like equities, will still play an important role in client portfolios, particularly for medium to long-term client strategies.

However, when it comes to alternatives strategies, Lonsec believes in strategy diversification, with multi-strategies playing a role in its portfolios. Deanne adds that the type of strategies used depend on how they correlate with each other.

“Whether the strategy is event-driven, market neutral or utilises a range of different underlying strategies, it’s all about using strategies that bring something different to the portfolio.”

Zenith also diversifies across multiple strategies. For example, it incorporates the Janus Henderson Global Multi-Strategy Fund as an allocation within its portfolios, which it views as an advantage.

“Typically, the difficulty with this type of global multi-strategy is the manager allocates to external teams. However, the Janus Henderson Global Multi-Strategy Fund is internally managed, which in our view, is a positive and provides our strategies with further diversification,” says Steven.

While Tim agrees that if you’re going to use alternatives in your portfolios, then using a multi-strategy approach brings some diversification that a single strategy might not. However, he cautions that the performance results from some of the larger and more diversified alternatives funds in recent years have generally been disappointing. 

“So, you really need to conduct careful due diligence on the type of alternatives strategy you’re considering,” says Tim.

In a low return environment, the hunt for yield continues. Given the illiquidity risk with many types of alternatives, Deanne concedes that from a portfolio perspective, she is seeing more risks being taken by clients in the alternatives space, as they search for yield.

She says private market investing has particularly taken off in the retail space over the last 12-18 months, with a lot of products coming to market via listed vehicles and traditional managed funds. Yet, despite investors increasingly using private market offerings, Deanne does have concerns about illiquidity risk.

“No matter what type of structure is used to bring a private equity vehicle to market, it’s still an illiquid asset,” she says. “This means investors need to be mindful about some of the trade-offs they need to make if they decide to sell that position. With the listed vehicles coming to market, you do need to be particularly aware that those kind of strategies can trade at significant discounts to net asset value. This means it might not always be easy to get out when you need to. So, investors need to keep illiquidity risk in mind.”

Tim agrees that the growth of private assets has definitely been a trend in the market. And while there is a role for private assets at the large institutional level, he remains concerned about how private assets are getting packaged down and componentized in more widely available unit trusts.

However, he adds: “The type of investor who is more likely to use a private equity fund in a portfolio is likely to be a higher risk investor. This means that if something does go wrong with their investment, they should be able to tolerate that.”

Zenith has also looked at less liquid assets, but has shied away from recommending them in managed accounts, citing illiquidity as the prime risk for doing so.

Like many different types of investment strategies, all three researchers agree that strategies in the alternatives space also fail from time to time, which investors need to be aware of. According to Steven, this failure usually is the result of two key elements: when the assets fail to fulfil the role you expect them to within the portfolio; and whether the portfolio is hitting its objectives.

“Determining when a strategy has failed is an interesting exercise,” says Steven. “Performance-wise, alternatives have had a difficult period and there are a lot of funds that haven’t performed well. So, you need to understand the type of environment alternatives have been operating in and what might be causing that under-performance. It could be an environment that is not suitable to that style of investing.

“So, when considering strategies for alternatives, you need to look at it from a portfolio perspective and determine whether alternatives have played their role and have hit their targets, and whether that makes sense in the current environment.”

Deanne adds that ‘style drift’ is another consideration investors need to be aware of. Style drift is the divergence of a fund from its investment style or objective. It can result naturally from capital appreciation in one asset relative to others in a portfolio, and it can also occur from a change in the fund’s management or a manager who begins to diverge from the portfolio's mandate.

Given that there have been a lot of false dawns with many alternatives funds that have underperformed substantially, how do you get conviction in using alternatives managers and strategies?

“That’s a great question,” says Steven, who acknowledges that getting this conviction with managers can be challenging for investors.

“At Zenith, we’re all part of a research house that has big teams that conduct comprehensive due diligence against these types of strategies. This includes how the strategy works, what it’s aiming to achieve, what the returns look like, and all the other ‘bells and whistles’ that go with the strategy.

“However, despite all this due diligence, unfortunately, you’re not always going to get it right. That’s the reality,” he says. “There are times when everything looks great with the strategy and it all lines up, but the strategy simply doesn’t perform. And that’s why you have to continuously monitor the strategy to see if it’s performing to expectations, just like any investment.”

Lonsec also relies heavily on its research team when appraising alternatives managers. Some of the additional things that the research team considers includes operational risk, track record, and manager skill.

Deanne explains: “We look at operational risk because a lot of hedge funds have historically blown-up because of things that have gone wrong in the back-office, rather than the investments themselves. The manager’s track record is also important, including understanding how that track record has evolved. For example, has that track record been delivered in a time that has been beneficial or had a good tail wind for that strategy, and is it something that can be delivered going forward?

“It’s also important to ensure that the manager has the required expertise and enough ‘skin in the game’. That alignment of interest is critically important, particularly for hedge funds, where you’re relying on the manager’s skill to drive returns.”

Tim agrees that due diligence is absolutely essential for manager conviction.

“A lot of strategies come to market on track records that were based on small assets or in different legal structures that aren’t scaleable or even legal in Australia,” he says. “By working through our due diligence process, the Morningstar research group in Australia has currently only issued a handful of alternatives funds with positive ratings. So, due diligence is absolutely essential.”

Deanne Baker is a Portfolio Manager, Multi Asset at Lonsec;

Steven Tang CFA is Head of Consulting at Zenith Investment Partners; and

Tim Murphy CFA is Director of Manager Research, APEC at Morningstar.

They spoke in an IMAP Specialist Webinar Series on using alternative investments in portfolios.

The session was moderated by Head of Research at Centrepoint Alliance, Daniel Stojanovski.