Alternative strategies can be programmed to deliver a dizzying variety of return patterns. To cut through the clutter, investors can start by understanding the settings a manager uses.
The number of alternative strategies continues to grow, but category definitions simply haven’t kept up—they remain a lot broader than equity categories. Because alternative managers can follow so many approaches, their return patterns can vary substantially (Display 1). A few commonsense steps can help you pin down which strategy makes sense for you.
First, ask yourself what you really want from an alternative investment—and be specific. What balance of return potential, diversification and downside protection makes sense for you? How much of each thing do you really want?
Once you’ve set those criteria, you can identify which alternative subcategory to focus on. Then you can start zeroing in on a manager with a philosophy and approach that are able to deliver the balance you need.
Three Levers That Influence Alternative Returns
The key is to understand three manager decisions that act like levers in defining a strategy’s potential return patterns.
1. Type of Market Risk: Managers stake out their playing field by choosing a specific geographic focus, market cap, and even sector specialization. These choices can tell a lot about the likely direction of a manager’s returns. Let’s say you buy a long/short equity strategy to hedge your market risk, and the long positions in the strategy are US large-cap stocks. If US large-caps decline, your alternative strategy will probably decline, too.
2. Amount of Market Risk: The second lever defines how much your strategy declines when the market’s down. Some managers take more risk than the market—in technical terms, their beta is greater than one. Other managers take less risk than the market (a beta of less than one). If strategies vary their betas over time, the performance gaps can be even bigger. The bottom line: over a full market cycle, two strategies can operate in the same market but deliver very different return experiences.
3. Structure of Market Risk: Managers can combine a wide variety of exposures to get to the same amount of market risk. They can mix long stock positions, short positions in specific stocks or market indices, and even cash. Each choice changes the way a strategy behaves—including how it tracks the market and the balance of stock-specific risk and market risk.
Same Market Risk…but Not the Same Risk
Three hypothetical managers (Display 2) illustrate how these three levers can influence returns. Each strategy invests in US large-caps and has net market exposure of 50%—the sum of its long and short positions is 50%. In other words, the first two levers are set the same for each strategy.
But the managers use very different portfolio structures, and differences in that third lever alone can create very different risk profiles.
Manager A’s performance will move up and down with the market. But its net market exposure is only 50%, so it will move only half as much. Manager B has the same 50% net market exposure. But it has 75% in long stock positions, so it has 25% more stock-specific risk than Manager A: 75% versus 50%. This also means that Manager B has a lower correlation to the market than Manager A.
Then there’s Manager C, also with 50% market risk: 250% long exposure minus 200% short exposure. Because all of C’s positions are in individual stocks, there’s a lot more stock-specific risk than the other managers. C also likely has the lowest correlation to the large-cap equity market.
So, three alternative managers in the same category can have the same amount of market risk but very different levels of security-specific risk—A has the least, C has the most and B falls in the middle. The more security-specific risk a manager takes relative to market risk, the more differentiated the overall performance is likely to be.
Alternative managers set and adjust these three levers to define the way their strategies operate. As these levers interact, their impact can multiply, creating the broad return dispersion we see in alternative categories today.
This diversity can be a challenge to navigate, but it can also provide an advantage—better portfolio diversification. No strategy can be all things to all investors, but understanding the settings managers use can help you find a strategy that’s the right fit for your portfolio.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.