Life After Beta: Are You Asking the Right Questions About Alternatives?
Investors have had mixed experiences with alternative investments lately, as the market landscape has made it hard for managers’ skills to shine. It’s time to ask some pointed questions to get the right fit.
Alternatives are designed to provide less market exposure and more emphasis on outperformance through security selection or other active investment decisions. Reducing market exposure offers some protection in difficult times—and alternatives were largely successful at this. But recent market downturns have tended to correct quickly, so the real stumbling block for alternatives has been that they didn’t reap as much upside as investors expected when markets rallied over the past six years.
We think investors need to adopt a new framework that will help them assess their specific needs in terms of alternatives—and help them choose a manager that’s more likely to deliver.
DEFINING EXPECTATIONS: IT DOESN’T HELP TO BE GENERAL
To start with, investors need to be more specific about what they want in alternatives. Objectives such as capturing some of the market’s upside and getting some protection in down markets are good, but they’re too broad. How much of each? 70% of the market’s gain during a rally? Half the market’s loss in a downturn?
Defining these preferences more precisely can shine the spotlight on the exact up/down capture experience an investor is looking for. Investors can use these needs and expectations to build a framework designed to home in on the right alternative strategy or strategies (Display).
To find the best fit in an alternative strategy, investors need to ask the following three questions:
QUESTION ONE: WHERE DOES ITS MARKET EXPOSURE COME FROM?
The market an alternative strategy invests in makes a big difference in defining its returns. A long/short equity strategy can invest in any combination of geography, market capitalization, style, and even sector and industry. Credit long/short strategies can invest in a combination of geography, fixed-income sector and credit quality. Whether we’re talking about US large-cap stocks or high-yield bonds, don’t overlook the type of market risk—also known as its source of beta—that an alternative strategy takes.