The Role of Alternative Asset Classes in Diversified Portfolios

8/9/2019 The Role of Alternative Asset Classes in Diversified Portfolios

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The Role of Alternative Asset Classes

in Diversified PortfoliosJune 2010

Bill McKay, CFA, CAIA


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For Information Purposes Only 2

Traditional vs. Alternative Strategies

Traditional Strategies

Long-only equity and fixed income strategies

Majority of returns derived from market participation(beta) with some coming from manager skill (alpha)

Transparency and liquidity generally good

Cost is an important criterion (beta is cheap)


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Traditional vs. Alternative Strategies

Alternative Strategies

Long/short equity and market neutral/low volatility hedge

funds

Private equity, real estate, commodities

Majority of returns derived from manager skill (alpha)with some coming from market participation (beta)

Transparency and liquidity generally not as good asTraditional strategies

Detailed due diligence process required to identify andselect appropriate managers

Costs are higher


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Complementing Traditional Equity with Equity Long/Short

Rationale

Most active form of equity management

Returns are correlated with equity markets

Net exposure is generally positive, but has large variation

Asymmetric return profile

Most value is added in down markets (when its most needed)

Fees are higher, but justified by after fee performance


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Advantages

Risk measured in absolute terms, not tracking error to an index

Short exposure can be used to manage risk or as a source of alpha

Managers can hold cash and take a more market neutral position,or even go net short

Dynamic exposures

Volatility substantially lower than traditional equities

Disadvantages

Liquidity, transparency, cost

Idiosyncratic risk


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Performance Profile

Performance In:Down

Months

Up

Months

MSCI World -3.9% 3.1%

HFR Equity

Hedge-1.6% 2.1%

Capture Ratio 41.1% 67.2%


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Complementing Fixed Income with Low Volatility Hedge Funds

Rationale

Similar volatility profile as fixed income

Returns are uncorrelated with bonds

Performance not as sensitive to interest rates as bonds

Provides the ability to tilt portfolio away from fixedincome without increasing equity exposure


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Advantages

Not dependent on equity market direction for returns

Non-directional, relative value strategies

After crisis in 2008/2009, spreads on underlyingstrategies have widened

Tax effective (for taxable investors)

Low correlation to fixed income

Disadvantages

Liquidity, transparency, cost

Idiosyncratic risk


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Performance Profile

Correlation to bond markets: 0.01

BondsFund of

Funds

50/50

Mix

Annualized Returns 6.7% 3.8% 5.3%

Risk 4.0% 5.7% 3.5%

Sharpe Ratio (RF=2%) 1.19 0.31 0.96


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Traditional Portfolios

Typical Balanced Portfolio Allocation

Even split between traditional equities and

bonds/cash Half of portfolio exposed to equity market

direction

Half of portfolio exposed to interest ratedirection

Typical Balanced Portfolio Performance

Bond allocation has provided good buffer toequity market volatility

Secular trend in interest rates has been down,supporting bonds


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Adding in Alternatives

Diversified Balanced Portfolio Allocation

Equity long/short used as a complement to

traditional equity Low volatility hedge funds used as a

complement to fixed income

Traditional equity utilizing fundamentalindexing

Different, more diverse sources of alpha

Diversified Balanced Portfolio Performance


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Performance in Bear Markets


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Analyzing the Performance

You can put together a better

portfolio without taking a lot of

risk

It will perform better in most

market environments

BUT during a liquidity crisis,

you will lose money no matter

what your portfolio looks like

Crises happen periodically:

Dont Panic

MSCI

World

50/50

Balanced

Diversified

Balanced

Annualized

Returns-0.4% 3.7% 5.1%

Risk 16.7% 6.5% 7.3%

Sharpe Ratio

(RF=2%)-0.15 0.26 0.43


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regulations may change and or the application of laws and regulations may vary; the information may be neither current nor accurate. Additionally, the information contained in this document is intended to provide

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of the issues discussed. All individuals should obtain specific professional advice with regard to the respective tax or other professional area. No action should be taken or omitted to be taken in reliance upon any of

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The Role of Alternative Asset Classes in Diversified Portfolios