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The Role and Use of Alternative Investments

The savviest investors are making significant allocations to alternative investments, according to Tony Davidow, CIMA, author of Goals-based Investing.

By Tony Davidow, CIMA

Emphasizing inefficiently priced asset classes with interesting active management opportunities increases the odds of investment success. Intelligent acceptance of illiquidity and a value orientation constitutes a sensible, conservative approach to portfolio management. -- David F. Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment

David Swensen, the brilliant CIO of the Yale Foundation, espoused the merits of alternative investments for decades before his untimely death. Swensen famously allocated heavily to an array of alternative investments, often in excess of 70% of the portfolio, leading to the Foundation’s long-term historical outperformance. Other foundations, and institutions, attempted to mimic his success; and many wealth management firms embraced the Endowment Model in the late 1990s and early 2000s.

I am not recommending that HNW investors allocate more than half of their investments to alternative investments, but rather showing that the savviest investors are making significant allocations to these unique investments. HNW investors have had limited access to many of these strategies historically, and there may be structural trade-offs in accessing certain of these strategies at lower minimums. HNW investors may require greater liquidity than institutions that invest over a longer period.

Why Alternative Investments? Why Now?

Alternative investments include hedge funds and private markets: private equity, private credit, and real assets. Hedge funds can be divided into equity-hedge, event-driven, relative value, macro, and multi-strategy. The following driving factors should lead to growth in the use of alternative investment strategies by HNW investors:

Market environment. The next 10 years likely will be vastly different from the past 10 years, with lower traditional equity returns and bond yields, and increasing correlations across investments. The markets will be dealing with the impact of the global pandemic, negative-yielding assets across the globe, rising inflation, and increasing global tensions. This environment may be conducive for alternative investments to help dampen volatility, provide alternative sources of income, hedge the impact of inflation, and potentially deliver better returns than traditional investments.

Product and structure development. Product innovation has allowed managers to offer alternative strategies to investors who previously were unable to invest due to accreditation, access, and minimums. New product structures, and improvements to existing structures, provide more and better choices for HNW investors.

Regulatory changes. Regulatory changes have made it easier for privately offered funds to market themselves. The federal Jumpstart Our Business Startups (JOBS) Act allowed for crowdfunding and eased restrictions on marketing hedge funds and private equity to individual investors. Along with the new product structures, these investments are now more accessible to a broader group of investors.

This blog will primarily focus on hedge fund strategies as the next blog will focus on private markets.

Hedge Funds

Alfred Jones launched the first hedge fund in 1949, using leverage to amplify his long positions and short selling to mitigate market risk. Jones is often referred to as the “father of the hedge fund” industry, as he was long and short stocks in equal proportion, and his results depended on picking the right stocks to buy and sell. The fund avoided the requirements of the Investment Company Act of 1940 by having no more than 99 investors and using a limited partnership structure. Jones took 20 percent of profits as compensation.

Today, hedge funds retain the core elements of the Jones model: a partnership structure where a percentage of profits is paid as compensation to the fund manager, a finite number of limited partners, and long and short positions used to generate returns. Hedge funds can provide several benefits in a portfolio, including potentially stronger returns, particularly in environments with high volatility and low correlation. They can protect capital, through active risk management and hedging, and can diversify traditional exposures through access to different markets. Investors often think of hedge funds as being homogenous, when in fact, there is a great deal of diversity from one strategy to the next. Hedge fund strategies represent a broad set of diverse solutions.

Equity-hedge includes long-short strategies, market-neutral, and short-biased among others. Long-short strategies are long the companies they expect to rise and short those they expect to fall. They attempt to make money by employing either fundamental or quantitative analysis. These strategies often exhibit a higher correlation to traditional equity markets than other hedge fund strategies.

Event-driven Includes activist, merger-arbitrage, and distressed among others. Many investors think of hedge funds as they are portrayed in Michael Douglas’ movie “Wall Street”. His character Gordon Gekko famously said “greed is good” as he sought to take over a target company. Today, activist investors often take large positions and board seats to unlock value in companies. Activism can result in restructuring or selling off unproductive assets.

Relative value includes pairs trading, fixed income arbitrage, and convertible arbitrage among others. Relative value strategies take advantage of market mispricings, taking long positions in market sectors that appear undervalued, and short positions in sectors that may be overvalued. Relative value is often referred to as “reversion to the mean,” as managers trade two highly correlated assets.

Macro Includes global macro, managed futures, and currency hedging among other strategies. Global macro strategies typically exhibit low correlation to the overall market, as they invest across various market segments to exploit geopolitical risks and/or economic events. These strategies typically exhibit low-to-negative correlation to the overall market.

Multi-strategy invests across the various hedge fund strategies, often structured as a fund-of-fund where the manager allocates capital across a range of strategies and underlying hedge funds. The managers provide diversified hedge fund exposure and can choose the strategy they think will perform best in a given market environment

Conclusion

With a backdrop of increased volatility and more shocks to global markets, hedge funds should be able to earn their stripes by taking advantage of market dislocations in the coming years. The next decade will be an environment in which the skilled hedge fund manager can add considerable value relative to traditional investments. Traditional returns will likely be muted and well below historical norms, while hedge funds will have greater flexibility in exploiting opportunities across the various market segments.

Hedge funds dampen portfolio volatility by accessing different segments of the marketplace and by exercising their freedom to be long and short the market. Historically, this broader investing palette has led to lower correlation to traditional investments and better downside protection.

Hedge funds are valuable and versatile tools in building portfolios, according to an article I wrote in the November-December 2018 issues of the Investments & Wealth Monitor titled “Alternative Investments: A Goals-Based Framework.” However, not all hedge fund strategies are designed to fulfill the same role in client portfolios. Wealth advisors need to take the lead in understanding these unique tools, and assemble them in the appropriate fashion, to help their clients navigate through today’s challenging market environment.

About the author: Tony Davidow, CIMA

Tony Davidow, CIMA, is president of T. Davidow Consulting, an independent advisory firm focused on the needs and challenges facing the financial services industry. Davidow leverages his diverse experiences to deliver research and analysis to sophisticated advisors, asset managers, and wealthy families. He has held senior leadership roles at Morgan Stanley, Charles Schwab, Guggenheim Investments, and Kidder Peabody among others. He is focused on developing and delivering content relating to advanced asset allocation strategies, alternative investments, factor investing, sustainable investing, and other topics. In 2020, Davidow was recognized by the Investments and Wealth Institute, with the Wealth Management Impact Award, which honors individuals who have contributed exceptional advancements in the field of private wealth management.

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