The Holy Grail of Portfolio Construction
De-correlated returns. They’re the holy grail of portfolio construction. They can reduce portfolio risk, sometimes at little cost to expected returns. But just as Indiana Jones encountered some hair-raising threats in his pursuit of the grail, investors on the hunt for de-correlated returns can expect trials and tribulations along the way. Yes, we’re talking about 'alternative investments’.
Modern portfolio theory (or MPT for the geeks) tells us that anything with low correlation to the risk-assets that dominate portfolios (stocks) is likely to improve the quality (risk-adjusted return) of a portfolio - even if the returns to such assets are just so-so. And it’s mostly true. Anything with low correlation (or even better, zero correlation) deserves a hard look from investors looking to build robust portfolios for clients.
Knowing this, the alternatives industry offers a variety of solutions. Supply always meets demand! Traditional alternatives like real estate and commodities have always been with us and continue to play a useful role. Private equity and hedge funds are available to accredited investors. Beyond that, today, private investors or those willing to explore niche micro-cap closed ended funds, can dabble in exotic assets like music royalties, litigation finance and reinsurance contracts. Do exotic investments like these belong in your client’s portfolios?
Theoretically, yes. But in practice the answer is often no. At NextStep, we seek to help you understand the “why” and figure out if any of these “non-core” assets warrant a place in your portfolios. The conversation centers on the fact that alternatives are not all alike. Some offer real diversification value. Others (like private equity) simply don’t.
Assuming advisors and clients have access to these investment strategies, NextStep can provide the expertise to evaluate them. And that evaluation is even more important than in traditional asset classes. After all, dispersion in results within these categories is typically much higher than in traditional equity and bond portfolios.
While alternatives and exotic assets have clear theoretical benefits from a portfolio construction perspective, they pose significant operational challenges that need careful consideration. Namely:
If not all clients have access to the strategy or asset class, introducing alternatives will immediately multiply the number of portfolio models you need to manage.
Rebalancing around illiquid assets can be tricky.
Clients tend to lack the patience to hold truly diversifying strategies long term because, on average, they’ll lag the stock market.
When illiquid assets don’t perform well, they tend to become persistent eyesores on clients’ performance reports. You can’t just exit and move on.
Generally, including alternatives will tend to significantly increase the weighted average cost ratio in your client’s portfolio.
At NextStep, we believe alternatives have a constructive role to play in a typical portfolio, assuming the analysis, recommendation and execution is done in a fiduciary, open-architecture setting that judiciously accounts for the drawbacks and costs of such strategies. Still, we believe that alternatives must be approached in a discriminatory fashion. For a typical non-accredited investor client, the ‘right’ type of alternatives allocation will be one which is diversified, liquid and relatively low cost, typically packaged as a 40-act mutual fund.
On the other hand, solutions are usually available for clients that demand less liquid or more niche assets, but offering these types of portfolios requires a commitment on behalf of the advisor because these assets require deep due diligence, a focus on understanding the entirety of the structuring, a focus on cost and thorough conversations with clients about the pros and cons of the position. Generally, this makes sense only if the advisor foresees a significant portion of his/her current or future client base utilizing these kinds of strategies.
In other words, these conversations are not just about portfolio construction. They’re also about your client’s characteristics and how you want to run and develop your practice.
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The information and opinions expressed herein are for general information and educational purposes, and may change at any time. They do not constitute investment advice and are not a solicitation for the purchase or sale of any security or implementation of any specific investment strategy.