Allocating to Alternative Investment Strategies | Part 1

Author: Nathan Rowader
Date: November 6, 2014
Category: Financial Planning
Tags: , , , , , , ,

Following the market declines in 2008 and 2009, many investors have shown interest in alternative investment strategies such as hedge funds and mutual funds that employ hedge fund-like strategies. These types of strategies have been around a long time, but until recently their use among individual investors has been somewhat limited. So, investors and their advisors have had to tackle a series of new challenges, such as trying to identify good managers or determining what is a reasonable allocation to alternatives. Some investors have been disappointed by the performance of alternative investment strategies. Part of their disappointment can be attributed to the fact that stocks have been in a very persistent bull market with very low volatility, which is a challenge for any strategy that utilizes a hedging activity. However, I believe the problem may be that most investors have struggled with understanding how to allocate to alternative investment strategies and that poor allocation decisions have led to less-than-optimal portfolio results.

I think that many investors have elected to view alternative investment strategies as a separate asset class from stocks and bonds and have cut out a portion of their portfolio to allocate to one or more strategies. In reality, hedge funds and their mutual fund brethren are in fact stock and bond investments that are executed differently than traditional funds. Therefore, investors should still consider alternative investment strategies to be stock and bonds and allocate to them to enhance their overall allocation strategy. Let’s look at a way that we could use hedge funds to complement a traditional allocation strategy.

Forming an opinion on market conditions
The most important part of determining an allocation is to have an opinion about the market conditions (i.e., bull or bear market). There are dozens of ways this can be accomplished, but I am partial to using something akin to the Sharpe ratio to determine market conditions in which I use 100 day percentage change and its standard deviation to normalize average return per unit of risk. I calculate this for each month-end; any reading above zero is a bull market and any reading below zero is a bear market for the coming month. Here are the results using the month following of MSCI ACWI using this market condition analysis:

Market Performance Using a Monthly Market Condition Analysis

Total Return Standard Deviation Max Monthly Gain Max Monthly Loss
Bull 7.53% 12.96% 9.52% -14.15%
Bear -2.08% 20.03% 11.48% -19.91%
MSCI ACWI 4.52% 15.50% 11.48% -19.91%

Source: Bloomberg, 12/31/89 – 09/30/14. This hypothetical example is for illustrative purposes only and does not represent the returns of any particular investment. Past performance does not guarantee future results.

As you can see, this method has definitely been able to separate good markets from bad markets and is a way that an investor can determine how to adjust allocations based on market conditions. Let’s now take this market condition analysis and apply it to hedge funds. Below is an analysis that takes the market condition of the MSCI ACWI as discussed above and examines the performance of the HFRI hedge fund indices in the month following each market condition. The results are summarized below:

2014-11-nrowader-allocating-to-alts-performance

As shown in the table, during bull markets for stocks, equity hedged and event driven strategies perform the best. During bear markets, macro and relative value strategies tend to perform best. This makes sense since relative value strategies tend to use bonds, and managed futures strategies are in the macro category. So, an investor can use this knowledge to guide their allocations based on market conditions.

In Part 2, I will show how an investor can actually execute on this idea.

RISKS

Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

Alternative strategies typically are subject to increased risk and loss of principal. Consequently, investments such as mutual funds which focus on alternative strategies are not suitable for all investors.

Asset allocation does not assure profit or protect against risk.

Nathan J. Rowader is a registered representative of ALPS Distributors, Inc.

One cannot invest directly in an index.


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