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Feb 22 2012

Spotlight – Why You Need Alternatives in Your Portfolio

Managing risk-adjusted returns is the key to long-term investment success

By Kerry O'Boyle, Aston Asset Management

Alternative funds are all the rage these days, and for good reason—there is a sound investment rationale behind their inclusion in a portfolio. The difficulty for most investors is in understanding just what an alternative investment is and how best to fit Alternatives in with a traditional portfolio of stocks and bonds. Opinions vary, as the relative newness of the asset class in mutual fund form and the myriad of strategies available makes it difficult to come up with a standard approach. Regardless, the basic justification for using Alternatives remains. They serve as a unique diversifier to traditional asset classes that can help improve the overall risk-adjusted returns of a portfolio.  

Alternatives Defined

Just what is an Alternative investment? At Aston, we define Alternatives as strategies focused on managing volatility and providing lower correlations to traditional asset classes using hedging techniques. The key to our interpretation is that risk management is an overarching theme in running the portfolio. Using Alternatives means something more than being just a different asset class than stocks and bonds, and relying on the traditional concept of diversification of volatility. Alternatives do that, of course, but they should also contribute to better risk-adjusted returns by managing and, ideally, lowering volatility inherently.

To accomplish this, we believe that Alternative strategies must actively manage risk and/or use some sort of hedging technique. Hedging, whether frequent, infrequent, or in between, comes in many forms regardless of the underlying securities used. Techniques employed include long-short, derivatives, options, futures, and in certain circumstances even leverage. Alternatives that actively manage risk without the direct use of hedging are typically described as Tactical Asset Allocation strategies. Here the focus is more on managing overall volatility through sector and asset rotation than on security selection or hedging. These two approaches—hedging and active risk management—define Alternatives as something more than merely a diversifier of long-only volatility.

Given that definition, some examples of what we do not consider alternative investments—Real Estate Investment Trusts (REITs), long-only foreign securities, convertible bonds, and Treasury Inflation-Protected Securities (TIPS)—may prove instructive. Despite their focus on real estate, a REIT is mainly a tax structure that closely resembles, and has relatively high correlations, with long-only equities. International or global portfolios that merely hedge back foreign currencies to the US dollar don't pass muster as utilizing an active hedging strategy. Although often used in arbitrage strategies that would be considered alternative, convertibles alone are merely a hybrid of long-only stock and bond characteristics. Finally, doubts still remain as to the actual inflation hedging benefits of TIPS, which in all other facets act like typical bonds.

Investors would also do well to note that Alternatives don't necessarily mean hedge funds. The term “hedge fund” can be a bit of a misnomer, as a number of hedge funds exist today that do not hedge. Such hedge funds may be aggressive and opportunistic, but without risk management as an integral part of their mandate. Although many hedge funds do employ alternative tools, understand that not all hedge funds are true Alternatives.

Volatility Effect

The case for Alternatives derives from their ability to dampen downside volatility while maintaining return potential over the long haul. The advantage of lower volatility rests with the common, though often overlooked, problem of asymmetry of returns—the return needed to recoup losses after a decline. For instance, an investor that suffers a portfolio loss of 25% requires a gain of 33% to get back to even, not a gain of 25%. A 33% loss needs a 50% gain, and after a loss of 50% a portfolio must double (100% gain) just to get back to where it started. By minimizing such drawdowns—how much a portfolio falls from peak to trough during a market decline—investors stand a better chance of improving the long-term returns of their portfolios.

The reason for this lies in the power of compounded returns. Since most investors don't walk away from the table at the end of each year, or after big windfalls or losses, the logic of compound annualized returns supports the case for minimizing downside volatility. By reducing drawdowns, investors retain a greater amount of principal on which to earn subsequent gains, even if they earn less on the upside. Thus, for example, an investor that generates returns of 15%, -10%, and 10% in three successive years outperforms a rival with returns of 30%, -25%, and 10% by more than two percentage points annualized, even though both investors achieved a simple average return of 5%.

Given the importance of minimizing downside volatility, a frequently asked question related to Alternatives is why wouldn't an investor simply use cash or short-term US Treasury bonds to reduce volatility instead? The answer to that question goes to the heart of why Alternative strategies have a place in any portfolio. By going to cash, an investor has removed volatility, but they have also eliminated return potential as well. With any significant moves into cash the onus then falls largely on an investor’s ability to consistently time getting in and out of the market correctly—an incredibly difficult proposition.

In regards to Treasuries or other short-term bonds, neither is completely without risk and both suffer return limitations. The recent financial crisis and debt buildup by the U.S. government has raised questions even about the stability of Treasuries, while near zero interest-rates have severely limited the return potential of short-term bonds. In addition, an added benefit for a number of Alternative strategies is the ability to dampen downside volatility while being less correlated with areas of the market considered relatively safe havens, such as bonds. This highlights how Alternatives offer diversification on many levels in potentially reducing volatility in a traditional portfolio structure.

Risk-Adjusted Returns

Ultimately, the goal isn't just to minimize potential volatility, but to enhance overall risk-adjusted returns. The risk one takes in achieving returns is important. Strong returns earned today taking great risk may prove fleeting and disappear tomorrow, while taking on too little risk may hamper the achievement of long-term portfolio goals. Too often, investors analyze returns and risk in isolation or consider past returns and past volatility as a proxy for the future. Adding a well-conceived Alternative strategy or group of strategies to a traditional portfolio can aid in dealing with this uncertainty, minimizing the need for timing decisions on the part of the investor and likely leading to more consistent long-term risk-adjusted results.

To accomplish this, however, investors must set proper expectations in their use of Alternatives. True Alternatives can offer reduced correlation and risk-managed exposure to traditional asset classes, meaning that such strategies are not likely to outperform during significant market rallies and investors shouldn’t expect them to. A common complaint with Alternative investments is that they come into favor during or after a market crash—when investor concern with risk and correlation is heightened—and then underperform during subsequent market rallies or don’t perform to elevated expectations. Although there is that potential, it seems to be more of a knock on investor behavior than Alternatives themselves.

The purpose of Alternatives is to help smooth out returns over the long run by accounting for risk, not to boost near-term performance. By focusing solely on performance instead of risk-adjusted returns some investors fall victim to a short-term mentality that leads to performance chasing and inconsistent results. What appears “wrong” in the short run can turn out to be correct on a risk-adjusted basis over the long haul. In combining Alternative strategies with a traditional portfolio of stocks and bonds investors can instill discipline in their investment process, curbing the urge to excessively time the market, and develop a consistent approach to enhancing long-term risk-adjusted returns through better management of downside volatility.

Kerry O'Boyle is an Investment Strategist with Aston Asset Management. Prior to joining Aston he wrote on a variety of investment topics as a mutual fund analyst for Morningstar, Inc. He is a graduate of the U.S. Naval Academy, and holds an M.A. in Liberal Arts from St. John's College, Annapolis, MD.

For more information about Aston Asset Management, LP and its subadvisers, please call 800-597-9704, or visit www.astonasset.com.

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