To Selectivity and Beyond

Alternative strategies and active management

To Selectivity and Beyond

Security selection and the flexibility to make tactical allocation changes have long been hallmarks of successful active management. Those traits are even more important when investors venture into the complex world of alternative strategies.


Alternatives—including fund of funds strategies—require deep knowledge of diverse markets and managers with the specialized skills necessary to successfully implement the distinct investment techniques needed for this asset class, including the: 

Ability to sell an asset short in anticipation of a move down in price instead of just omitting the asset altogether; thereby potentially profiting from, rather than merely avoiding, an adverse market move.

Ability to take leveraged positions, as a method to increase the impact of long or short positions. When applied to non-correlated positions, leverage can substantially reduce overall correlation.

As such, careful scrutiny of investment opportunities becomes critical to make optimal selections and correct decisions about market direction and a flexible investment mandate is essential for managers to move rapidly and opportunistically as asset prices change and market sentiment shifts.

Alternative realities

While alternative strategies work quite differently than conventional ones, the underlying asset classes involved can be similar. For example, an equity long-short strategy can focus on the same stocks as a traditional long-only equity strategy, but it also seeks to add return by taking short positions in stocks judged to be overpriced, in addition to seeking opportunities in underpriced securities.

The importance of expert research and analysis—something an active manager can bring to the table—is obvious given the specialized nature of many of these strategies. Consider the distressed credit strategy: it invests in the debt of companies that are under bankruptcy protection or potentially heading in the direction of default or bankruptcy. Clearly a thorough understanding of company fundamentals in such situations is vital, because even though distressed securities may be purchased at values well below par, offering attractive return potential if the company improves, there is also heightened risk of zero recovery.

Or consider event-driven strategy: it seeks returns based on corporate or financing events such as mergers and acquisitions (M&A), spin-offs and share buybacks, which can affect both stock and bond prices. All such opportunities require advance identification of buyers, targets and other catalysts that could bring these factors into play.

The global macro strategy is a good illustration of how an active manager with global scope and expertise may be best positioned to apply alternative techniques to a world of opportunities. Abrupt changes and shifting trends are common in the numerous economic and political environments worldwide. Alternatives managers seek to benefit from these shifts, but this requires an extensive focus on—and knowledge of—macroeconomic factors, including central bank and government policies that can direct influence on the direction of commodities prices, currencies, interest rates and other asset prices.

Unparalleled diversification

Because they work differently than traditional strategies, alternative strategies also tend to behave differently. Indeed, as the table below shows, alternative strategies exhibit relatively low correlation with each other and with traditional asset classes. For example, over the past five years, the HFRI Macro Total Index—which focuses on investment managers which trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables—has shown a negative correlation to major U.S. equity indexes and the HFRI ED Distressed/Restructuring Index—which focuses on corporate credit instruments either in formal bankruptcy proceeding or perceived to be heading that way—has exhibited almost zero correlation to global bonds, while correlation between the two alternative indexes was also very low.

 

Alternative strategies may add stability to your allocation

5-year correlation of monthly returns

Source: Bloomberg, as of 4/30/17.  Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Academic research has long demonstrated that, over the long term, adding uncorrelated asset classes to a portfolio of stocks and bonds enhances the portfolio’s mean-variance profile. That means adding alternative strategies to your portfolio mix might help smooth your ride through the inevitable ups and downs of financial markets.

Conclusion

Investors who choose to move beyond the limitations of traditional asset classes may find actively managed alternative strategies a useful way to diversify risks, as well as enhance income and appreciation opportunities.  With such a variety of alternative strategies available to choose from, active managers become essential to combine various strategies into effectively diversified allocations designed to meet specific goals and objectives, and deliver optimal diversification.


This is the last in a series of articles about active management in specialized sectors of the market.

For insight on infrastructure and active management see “Build it and they will come

To learn more about real estate and active management see “Life, liberty and the pursuit of property

See “Closing gaps; expanding choices” for information on direct lending and active management.

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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.

Diversification does not guarantee a profit or protect against loss.

Outperformance does not imply positive results.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

Leverage increases the volatility of investment returns and subjects investments to magnified losses and decline in value.

Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, limited regulations and relative lack of liquidity. Alternative investments include hedge funds, managed futures, real estate, commodities and derivatives contracts.

Hedge funds are considered to be complex investment products which have specific risks associated with them, and may not be suitable for all investors.

Active management does not ensure gains or protect against market declines.