The Good, The Bad And The Ugly: Alternative Investments

Derek Henderson Two very interesting and historic events occurred in 1966. The film The Good, The Bad and the Ugly was released, and Fortune magazine published an article about the first modern-day hedge fund.^[1]

In 1966, the Spaghetti Western genre was not widely accepted by critics, so the epic Clint Eastwood film was not given the critical acclaim it deserved until years later. Of course, today it is recognized as one of the most influential western films ever produced, if not one of the greatest films. Occasionally it takes time for revolutionary innovations to gain approval, but eventually recognition is given where it is deserved.

This is how we feel about the alternative asset class.

Although alternatives still seem to be widely misunderstood, the importance of including alternatives in asset allocation strategies has been proven to be not only important, but also prudent. Historically, only institutional investors and advisors for ultra-high net worth clients have benefitted from the ability, and willingness to include hedge funds, private equity, infrastructure and other types of alternatives into their portfolio strategy. Today, we have begun to see real strides in the mutual fund and ETF industry, providing investors with the ability to utilize alternatives, although, still to this day, very few investors are aware of the options that they have to incorporate alternative investments within their traditional portfolio.

Undoubtedly, one of the most commonly known alternatives is the hedge fund, a perfect example that alternatives are misunderstood. Many investors share a common belief that hedge funds are new and inexplicable strategies that are expensive and illiquid; many people associate hedge funds with risk.

Although it may seem that hedge funds have come into the limelight in recent years, they actually date back to 1949 when Alfred Winslow Jones developed the first hedge fund in New York City.^[2] For 15 years the A.W. Jones method was only divulged to a select few savvy investors, until the 1966 article in Fortune magazine highlighted his investment strategy’s superior performance.^[1] By 1968, there were 140 hedge funds in operation and today, almost 50 years later, hedge funds are still the most recognized type of investment in the alternative category, though they are only one example of what falls under the alternative investment distinction.

According to Morningstar^[8] there are three distinct categories of alternative investments:

Non-traditional asset classes, such as currencies and commodities;
Non-traditional strategies, such as shorting and hedging;
Illiquid assets, such as private equity or private debt and real estate.

According to a report—Liquid Alternatives: Considerations For Portfolio Implementation by Justin Blesy and Ashish Tiwari, PIMCO ^[4]—since 2008, alternative investments have attracted almost half a trillion dollars into what are called “liquid alternative strategies”. Liquid alternatives or “liquid alts”, which are typically in a mutual fund structure or ETFs, provide retail investors with access to alternative strategies that only large institutional investors used to be able to access. Blesy and Tiwari state that “liquid alternatives have been a democratizing force for investors, and we believe today’s market environment arguably has only made them more attractive.” Goldman Sachs published a report in 2013^[3] that stated that the USA liquid alts are just now in the early stages of a substantial 10-year growth period; they estimate that we could see more than $2 trillion of assets flock to these types of strategies in the next decade.

Given the current economic climate and market conditions, it seems the benefit of incorporating alternative investments is starting to be realized^[3]. However, it should be noted that as investors are implementing liquid alternatives in portfolios, alternatives do present a complex set of challenges that must be considered.

Hopefully my movie reference isn’t too obscure, but for those of you readers who have seen the movie I’ve referenced in the title, you’ll remember the sweeping widescreen cinematography and the extreme close ups. It is through both of these types of lenses that we need to look before making the decision on alternatives. When analyzing alternatives for your investing strategy, you need to ensure you are looking at it from a high-level asset allocation perspective to see if alternatives are right for you and your strategy. Similarly, you need to make sure that you get a close-up look by conducting the appropriate amount of due diligence on the strategies and tools you use for your alternative asset exposure. You need to completely analyze your options and the potential benefit before you pull the trigger and start to incorporate alternatives into your investment strategy because, as with anything, there is always the Good, the Bad, and the Ugly.

The Good

The traditional equity and fixed income portfolio has served investors well over the last number of years. We have been in an environment of quantitative easing, stagnant inflation and historic low interest rates. This may change. In a world where fixed income has become a risk, coupled with narrowing correlations and the expectation that global growth will be sluggish, investors need to seriously evaluate options that may provide them downside protection while continuing to provide both yield and growth. Many investors have started to explore the alternative investments and how they could incorporate them into their allocations—liquid alternatives being an option for both institutional and retail investors.

As mentioned, liquid alternatives are available through investment vehicles such as closed-end funds, ETFs and mutual funds across an array of strategies which may include global macro, multi-strategy, event-driven and equity long-short. Much like traditional alternatives, the objective of liquid alternatives is to produce differentiated returns and lower correlations to traditional asset classes that serve to help reduce portfolio volatility and help enhance risk-adjusted returns, while offering daily liquidity, improved transparency, all with a lower fee than traditional funds.

A report published by PwC^[5] predicts that global alternative assets will increase to $15.3 trillion US by 2020, an influx of assets that the report calls a period of transformation for the global alternative asset management industry. The potential advantages of alternative investments are evident and the ability to access alternatives through liquid alternative is progress, good innovative progress.

The Bad

As the data indicates a trend^[7] toward inclusion of alternatives given their benefits, we must also be aware of the bad side of alternatives. We must be cognizant of the potential risks of the asset class itself as well as some of the downfalls of the tools that help us with our exposure to alternatives. Here is a list of a few of the negatives that we should always be aware of.

Liquidity: Traditional alternatives such as real estate, private equity and infrastructure come with inherent liquidity challenges, liquid alts tout the benefit of being liquid but there are specific niche ETFs that may pose significant liquidity problems, and in many cases a lack of transparency in the strategy can mask these liquidity issues.

Value: It is often difficult to mark-to-market alternatives investment, a challenge that is actually viewed as one of the benefits, given that it helps to minimize some of the volatility. The research report Asset Allocation: Risk Models for Alternative Investments by Niels Pedersen & Sébastien Page May/June 2014^[6] states that often the lack of mark-to-market data lures investors into the misconception that alternative asset classes and strategies represent somewhat of a “free lunch.” Their research demonstrates that, despite the fact that alternatives may seem less volatile, most are still exposed to many of the same risk factors that drive stock and bond returns.

Benchmarking: One of the ways we evaluate the performance of any investment is by looking at how it performs against a given benchmark. Given the complex nature of alternative investments, it is often difficult to assign a benchmark for a number of reasons, including that limited data may be available, but also that striving to find a comparable benchmark for some of the unique alternative strategies can sometimes be impossible.

We have just listed three challenges associated with these types of investments but there could be many more challenges associated with certain aspects of alternatives.

The Ugly

In addition to some of these challenges, the real ugly problem that we see with the increase in appetite for alternative investments is a severe lack of understanding. Many of the investors and advisors who are flocking to alternatives have not done the appropriate amount of due diligence. Nadia Papagiannis, Director of Alternative Investment Strategy with Goldman Sachs Asset Management, has stated that, “Every survey out there shows advisors want liquid alternatives for diversification. Yet most of the money is going into a single type of strategy: long-short equity, which seeks to provide some cushion to falling markets by shorting a select group of stocks alongside a traditional portfolio.” ^[7]. Understanding risk characteristics of alternatives is paramount. The alternative landscape is made up of an array of subset classes and strategies which convolute the process of analyzing each investment.

Blesy and Tiwari^[3] believe investors contemplating adding liquid alternatives to their portfolios should have a solid grasp of the following:

Total volatility and risk such as correlations to traditional portfolio risks and interest rate risk;
Historical drawdown and drawdown potential compared to expectations;
Use of leverage and options to identify potential hidden risks; and,
Performance across different market environments.

Although Canada’s liquid alternatives market isn’t nearly as robust as that of the U.S., we are beginning to see increasing demand for the asset class. While there are hundreds of alternative investment options in the U.S., the list here in Canada is small. Morningstar currently shows 30 distinct funds in its alternatives category for mutual funds in Canada, and only five ETFs.

1966

1966 was an important year for Western films and alternative investments.

Fast forward almost 50 years and it seems that just as it took years for us to understand the importance of one film, we are still just beginning to recognize the important role alternative strategies may play in asset allocation. As you work with your advisor on strategies to consider incorporating alternatives into your portfolio, be sure to understand the Good, the Bad and the Ugly. Once this homework has been done you can start to invest “For a Few More Dollars”, and then, with a dedicated strategy, you may find yourself with that “Fistfull of Dollars” you’ve been working towards.

G. Derek Henderson CIM, Invsestment Advisor

The Bush-Henderson Investment Team, CIBC Wood Gundy

Email: Derek.Henderson@CIBC.com.

[1] Loomis, Carol, "The Jones Nobody Keeps Up With." Fortune April 1966: 237–247

[2] Alan Rappeport, A Short History of Hedge Funds. CFO Magazine 27 March 2007

[3] Goldman Sachs Global Investment Research, Retail Liquid Alternatives: The Next Frontier, December 6, 2013.

[4] Liquid Alternatives:Considerations For Portfolio Implementation by Justin Blesy and Ashish Tiwari, PIMCO, September 2015

[5] rice Waterhouse cooper Alternative Asset Management in 2020: Fast Forward to Centre June 2015

[6] May/June 2014, Volume 70 Issue 3 Asset Allocation: Risk Models for Alternative Investments Niels Pedersen, Sébastien Page, CFA, and Fei He, CFA

[7] 2014 Alternative Investment Outlook Championing growth Finding agility in uneven conditions, Deloitte & Touche LLP

[8] http://www.morningstar.com/advisor/alternative-investments.html

CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada.If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor.

G. Derek Henderson is an Investment Advisor with CIBC Wood Gundy in Waterloo. The views of G. Derek Henderson do not necessarily reflect those of CIBC World Markets Inc