Diversification must carry the ability to deliver on non-correlation as well

Today, being different is not enough to be considered diversified in the market place. As the past several years have illustrated, sometimes painfully, global markets tend to react serially to the news which impacts them in a meaningful way. This risk on/risk off mentality creates large-scale movements that can contribute to a cascading effect across market classes, leading to excessive correlation among varying assets. The alternatives category of investments has risen in prominence in direct relation to this correlation effect, as investors seek better protection against wholesale volatility in their overall portfolio, which adds to their risk exposure. Entrepreneurial alternative managers can benefit from this increased interest by investors in seeking true diversification. These managers identify and exploit select and discrete investment opportunities to produce results with demonstrated return characteristics that do not track the broader market movements, and thus, deliver this non-correlated effect on portfolio allocation.

Risk matters: the risk/reward relationship will ultimately carry the day for investor decision-making

The twin investor mandate to diversification with non-correlation is the equally pressing need to find investments that can also balance returns with acceptable risk behaviors.  The desire for risk/reward balance is by no means new; the ability to deliver on it has become more difficult to achieve given the confluence of market volatilities when digesting news, good or bad. When compounded with investors’ desire for diversification, the narrowed range of opportunity to achieve both goals places the alternatives sector at the forefront of strategic market approaches with an ability to deliver on both objectives.

The largest alternatives players are often constrained by investment mandates and sheer size from exploring niche opportunities which will not yield sufficient scale to impact their large positions. Many of the more interesting investment opportunities in these niche areas are under-researched or essentially hidden to these large alternative managers, yet can provide interesting vehicles of diverse and unique returns. Smaller managers are free to explore and construct individualized investment strategies that suit their tailored objectives with far less curtailment on their investment decisions. In contrast, when one or more of the larger managers takes a position in the market, it generally becomes leading news the same day. 

Entrepreneurs do not have to compete with the bigger players and are able to establish positions early on and let their investment thesis develop with less coverage, or even awareness, by industry analysts and players, of the deals themselves. This “under the radar” covertness can work to the benefit of both the managers and their investors. The entrepreneurial alternatives manager who has created a business of identifying opportunities that deliver results with attractive risk tolerances can jump themselves ahead of the competitive pack by highlighting this ability.

And last, alpha is an objective investors are not prepared to ignore when selecting an alternative partner

Last, but certainly not least, is performance. It will never be out of fashion or undesirable for professional money managers to demonstrate performance value to their investors. What has evolved is how this alpha is measured and in what context it is evaluated in overall portfolio management. All the bells and whistles a manager can point to in their market approach cease to be compelling if they cannot combine those attributes with a repeatable practice of delivering value to an investor over a mutually acceptable time frame. The experienced managers who come out of prior institutional investing positions and have made the transition successfully to a smaller, more nimble but less efficient investment environment are one such category of entrepreneurial manager with a solid opportunity to obtain alpha for investors.

The new rule in alternatives: adapt or become obsolete

Alternatives managers need to be able to source opportunities, structure deals, attract and retain investors with aligned interests, and deliver alpha and results consistent with the objectives set forth. If they can also deliver this value within a solid institutional framework that enhances their investors’ ability to understand the objectives, partner with established and high-quality service providers and industry professionals, track and monitor performance along the way, and deliver attribution and reporting requirements that keep pace with the increased regulatory requirements, these entrepreneurs have the opportunity to become an established fixture in the alternative space delivering value to investors for years to come.