I’m headed down to New York this morning to speak at a conference about alternative investing strategies, and it occurred to me that many investors have heard a great deal about alternatives—and perhaps know some of the fundamentals—but haven’t really looked at the types of strategies involved, why they might work, and how they are supposed to add value. Today, I want to focus on strategies that use liquid underlying investments (that is, investments that can be easily bought and sold), as these are the strategies that most investors will run into.
This type of strategy isn’t an alternative, but rather the baseline against which alternatives are judged. The idea here is to buy things—stocks or bonds—that will go up in price. Success depends to some extent on the manager’s ability to identify undervalued things to buy, but also to a great extent on how the market as a whole does. Returns don’t come only from price appreciation—coupon payments or dividends also contribute—but the price has to appreciate as well.
While individual securities can do well on their own, very few can buck the market completely. Because of this, long-only strategies depend on the market as a whole; to hit the targeted return over time, the market has to go up. This works very well in bull markets but not so well in range-bound or declining markets. Since the market does tend to go up over time, you need substantial exposure to these strategies—here at Commonwealth, we refer to them as core financial strategies—but since they don’t perform well in all market environments, they’re not enough. You also need strategies that will perform well in range-bound or declining markets.
These are essentially a mix of long strategies, as described above, with short strategies. Managers in this area use a range of mathematical and statistical techniques in an attempt to identify where a wide range of asset classes are going, either up or down. Investments are made across those asset classes based on their individual characteristics, and the result should provide a steady return. Because of the way the investments work, most of the capital is actually held in fixed income investments, and returns come from a mix of correct calls on the direction of the various markets, combined with the return from the fixed income investments.
As the name suggests, these strategies typically do well in trending markets, either up or down, and when interest rates are high. Many did well in 2008–2009, as they were able to take advantage of the downward trend. Conversely, many markets haven’t had significant trends over the past couple of years, which, combined with low interest rates, has hurt recent returns. Because of the potential of these strategies to make money in downturns, they can provide meaningful diversification from long strategies.
These strategies seek to identify mismatches in price and make money as those mismatches correct themselves. One of the most common is merger arbitrage, where managers invest in the buyer and seller, either long or short, to capture the price changes between deal announcement and closing. This isn’t risk-free, certainly, but done well, it can provide a return stream that doesn’t depend on the market as a whole going up. Identifying such a return stream is key to the idea of alternatives, and this asset class is a good example of that.
These are an expansion of the long-only strategy, to include an allocation to shorts—that is, betting that a security price will decline rather than rise. The idea is usually to reduce the volatility of the returns, rather than to generate higher returns. If the market goes up, for example, the long positions benefit; if the market goes down, the short positions should do well. With these strategies, you can potentially get stock market returns with lower downside risk.
When looking at these strategies, it’s important to determine whether the manager actually has skill in shorting. While it’s assumed that the ability to go long implies the ability to go short, that’s not the case. Here, a track record, with real money, in down markets can provide an indicator of just how much reduction in volatility you can realistically expect.
The essence of these strategies is that there is some form of signal generated that lets an investor know when to buy or sell, and lets the manager get ahead of upturns and out of downturns. Research shows that this can work over time, but it’s by no means foolproof in the short run. While many of these strategies do appear to work, this largely depends on the market environment, with tactical strategies typically underperforming in up markets and outperforming in down markets.
Like the long-short strategies, the idea is to potentially provide stock market returns with less risk of loss. Also like the long-short strategies, it is important to determine whether the manager can actually execute on the plan. For strategies like these, it’s critical to determine that the returns presented are based on real money, rather than hypothetical back tests.
All of these strategies use liquid underlying investments, either stocks or bonds. Because they are liquid, they lend themselves well to structures that require daily liquidity, such as mutual funds. Other, less-liquid strategies add additional requirements, and I will discuss some of them tomorrow.
Diversification and asset allocation programs do not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.