Here, Donald Robinson, chief executive and co-chief investment officer of Palladiem Partners, and a veteran alternative investor who launched Lockwood Advisors in the mid-90s, lays out some of the basics that clients should know about alternative investing.
FWR: There has been a lot of interest in alternative asset classes in the past few months. To what extent do you think clients and advisors understand these assets?
DR: Most investors are slowly learning what alternative investments are, how they tend to behave relative to traditional investments, and how they fit into broadly diversified investment portfolios. We’ve also seen some investors confuse the use of leverage or other forms of financial speculation with “alternative investments,” when most of those vehicles are being employed to help mitigate the risks that are associated with stock and bond investments.
FWR: What are some of the basic facts that should be understood?
DR: First, investors need to understand the underlying features of each alternative investment vehicle, including its long-term return composition, volatility characteristics, and how its assets move or behave relative to other assets.
In order for that to happen, there has to be full transparency with respect to the vehicle’s holdings, costs, etc. Investors should also take care to understand the liquidity of the vehicle and any restrictions that may apply.
FWR: Do you think it’s a mistake to use the term “alternatives” so broadly – and what, in your understanding, is covered by it?
DR: The term alternative is fine as long as the basic investment features are defined up front. Investors do need to recognize that there are several investments that could fit this description, but which do not all look alike.
It is important to understand what type of alternative investment fits a particular investor’s long-term financial objective, and how much to allocate. In other words, an active approach should always be followed in selecting and weighting the appropriate alternative investment vehicles within the overall asset class.
FWR: How much is demand for alternatives being driven by the low yield environment, and do you have any theories about how this scenario might play out/unwind in the coming years? What impact might this have on investment portfolios?
DR: We believe the demand for alternative investments is not driven by the low yield/interest rate environment at all. Rather, it is being driven by several factors, including dissatisfaction with the lack of diversification effects from fixed income investments with equity characteristics, and concern among investors that during periods of financial crisis (eg, 2008) all investments tended to move lower (highly correlated) when the exact opposite was expected.
While the marketplace has quickly adopted the use of so-called “liquid alternatives,” there is of course the risk that these vehicles may eventually demonstrate higher correlations to publicly-traded traditional investments (and thus provide less diversification benefit).
FWR: What is your view on correlations between asset classes now and following 2008?
DR: Correlations of course are time-varying, meaning that they are not stable over longer periods of time due to volatility spikes. Generally speaking, correlations have recently normalized as volatility has been relatively low and markets relatively stable. Looking forward, we believe there is a high probability that correlations between the traditional asset classes may rise again, as many of the structural macroeconomic problems in the developed world have not been sufficiently addressed since 2008.
FWR: Over the years products such as alternative ETFs have developed with the idea of introducing more transparency and liquidity into alternative investing. As the return from alternative investment is supposed to derive partly from giving up liquidity and taking on more risk, does this not fundamentally undermine the argument for investing in them?
DR: There are certainly a number of different methods and rationales for investing in alternative investments. The first and most significant impact on portfolios is the risk mitigation effect of being able to buy alternative beta, cheaply. Secondly, like any asset class, there is the opportunity for security alpha. These opportunities still exist in the traditional investment arena as well. There is a liquidity premium, but most investors are unable to withstand the risk associated with longer-term lock up periods of their assets.
The rapid growth of daily priced mutual funds in the alternative investments area has also allowed investors access to potential alpha that was once only available to a few “qualified” investors. In addition, retail investors are not burdened with the cumbersome reporting requirements or the excessive fees that have been normally associated with limited partnership structures.