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Investors may be confused about what alternative investments precisely are, but there’s no confusion about the category’s growth – especially in assets flowing to alternative mutual funds and ETFs. Discussing the latest trends in liquid alternative investing, including strategies and portfolio construction suggestions, are moderator Evan Cooper and the following expert panelists:
- Dick Pfister, CAIA, Executive Vice President, Altegris
- Dan Roberts, Ph.D, Executive Managing Director and Chief Investment Officer of Global Fixed Income, MacKay Shields and Portfolio Manager, MainStay Unconstrained Bond Fund
- Charles Kantor, Portfolio Manager, Long Short Strategies, Neuberger Berman
- Stephen Sachs, Head of Capital Markets, ProShares
Bookmarks:
0|Liquid Alternatives
107|Alternative investing
612|The environment
1248|Portfolio construction
2067|Where is income
2412|Structure of investments
2911|Final thoughts
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00:56:45
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Transcript:
EVAN COOPER: Welcome, I’m Evan Cooper for asset.tv and Investment News and in today’s Masterclass we’ll be discussing alternatives and where they fit in current portfolios. Joining me in New York are our expert panellists. They are Dick Pfister, Executive Vice President Portfolio Manager and founder of Altegris; Charles Kantor, Portfolio Manager of Long/Short Strategies in Neuberger Berman; Stephen Sachs, Head of Capital Markets at ProShares; and Dan Roberts, Executive Managing Director and Chief Investment Officer of Global Fixed Income at MacKay Shields and Portfolio Manager of the MainStay Unconstrained Bond Fund.
If there’s one word that covers the universe of alternative investing that word is probably confusing. In the mindset of investors and advisors alike alternatives can mean an asset class, such as commodities, an investment vehicle, such as hedge funds or master limited partnerships, or an investment strategy, such as long/short or absolute return. To add to the fuzziness alternatives, however they’re defined, can be a way to mitigate risk, as well as a way to enhance returns. But since the stock market has been so forthcoming in its return so far this year, up about 16% on the S&P 500, for instance, the quest for alternatives in the equities market seems to have taken a backseat to alternative approaches to fixed income investing where investors are apprehensive about what will happen when the Fed finally takes its foot off the monetary gas pedal.
For a look at what investors should be doing alternatively in both the equity and fixed income worlds let’s turn to our experts. Dick, the financial crisis was certainly a pivotal moment in the evolution of alternative investing. We’ve come a long way since. So give us an idea of where we are now and where alternative investing is going.
DICK PFISTER: Sure, well demand for alternatives has really driven in evolution of the alternative investment landscape and demand was really created by the credit crisis, but not only the credit crisis, also the tech wreck. So in a 15-year period you got two major events that caused investment advisors and their clients to look elsewhere for diversification, for non-correlated return streams, and because of that that demand for the diversification non-correlated return stream has alternative managers taking a look at different strategies and how they get that into a retail investor’s client book.
Now advisors have been searching and hedge fund managers are saying okay I think I can take this to the retail investor via a mutual fund, or via a limited partnership, and that’s what’s happening and we’ve seen that evolution more and more over the last 15 and 20 years.
EVAN COOPER: So we’re looking for alternatives, things that aren’t so correlated to the market. Well what we’ve seen in the last couple of years, except in the wake of the financial crisis, only commodities weren’t correlated, everything else seemed to be more correlated than everybody thought. So let me put everybody else’s viewpoints about where things are in terms of the correlation, alternatives as a way to get non-correlation, and is that still is important today as it once was. Also in the light of the fact that equity markets have done so well, so non-correlation isn’t apparently what it’s supposed to be. So, Charles, give us an idea.
CHARLES KANTOR: Yeah. So within what you described we very much run one strategy, it’s a long/short equity bias strategy, and we try and spend a bunch of time with our investors, prospective investors to try and engage I mean in what’s the outcome we hope to achieve. And from that perspective we very much talk to them from this is the return potential, never promising anything of course, but it’s really a strategy where we’re seeking to protect and grow your capital. We try and engage them in a smoother ride so to speak. So for giving up some of the upside you’re taking on less of the downside.
So we describe very much a risk-adjusted return approach. I think that very much centres on everything that we, we talk about the nature of our strategy, I think it would be fair to say it would correlate to equities. I think that’s what a reasonable person would say, but we think about it, you know, what’s the volatility of a return stream as measured by standard deviation and then what is the beta of our portfolio against that of the market, and generally our strategy tends to have about on average half the volatility of the market as measured by standard deviations and maybe 40% of the beta of the portfolio.
So that’s something we feel that we hope to continue to be able to achieve, but we try and speak to them in terms of the less money you lose the less money you have to make back up to be the much higher prospectus. So we’re very much absolute return minded. We’re trying to give them on average a smoother ride so to speak, but in an environment like this year to the degree that investors would have invested in our strategy hoping that we would have done as much as the market, we’ve obviously attracted the wrong investor, because that’s not what we’re trying to achieve. In environments where you have meaningful pullbacks or you have volatility, we hope to preserve as much of your capital as possible.
EVAN COOPER: So, Stephen, this idea of a smoother ride and less risk, is that your view too?
STEPHEN SACHS: It is. It actually resonates very very well with not only myself but our firm as a whole, and really with the street in general and the investment community in general. Given as Dick said over the past, you know, really if you look back ten plus years, and not only US equity and fixed income markets but globally, we’ve been in a situation where investors are now faced with just in the last couple of years the first positive returns they’ve seen in their portfolios. You’ve got a really sort of large swath of the investing public out there, particularly the retail public and even the institutional community that has struggled for the better part of a decade or more with positive returns, whether they be absolute returns or even decent returns on a relative basis.
So smoothing out the ride is absolutely something that is resonating through the entire industry from an investment perspective and an alternative investment perspective. Really sort of the main focus if you will of the alternative investment strategies or asset classes that we see from our client base the biggest use is risk management. At the end of the day, whether they’re advisors, whether they’re wealth managers, whether they’re institutional money managers for pension funds and endowments, to Charles’ point, having strategies that help smooth that ride and help protect the portfolio in uncertain environments, whether it be geopolitical or economic, that really has been the key. And I think it’s been one of the drivers of the growth in the alternative strategies. Not just from the overall number of strategies, but the sort of vast array of products and wrappers now that encompass the alternative strategies.
CHARLES KANTOR: I would say before we get too engaged in this concept of a smoother ride, a smoother ride alone is not enough. So if you just give them a smoother ride and you don’t make them money that’s not acceptable to the underlying investor that we’re trying to attract. So a lot of folks invested in alternatives coming out of the 08 experience because of how alternatives did and they looked back five years later and they said you gave me the smoother ride but you didn’t make me any money, and the reality of life is if you don’t make people money they don’t buy more groceries and they care much more about making some money than simply the smoothness of the ride per se.
EVAN COOPER: Sure. Oh so Dan tell us your view of the smoother ride versus making money.
DAN ROBERTS: Our investment philosophy has always been to win by not losing, and that’s particularly the case in the asset class that we spend almost all of our time on, which is in the fixed income area, and why do we believe that? The reason is in fixed income bonds are issued at par and they mature at par. They don’t have a lot of upside, but particularly when you invest in corporates they do have a lot of downside. So our view is you win by not losing. So you look to chop off as much of that downside risk as you possibly can. So how do you do that? We think there are at least two ways to do that. First is from the top-down and the second way is from the bottom-up.
Now what about the top-down? The way we’ve always looked at the world is that the top-down is very important and it gives us a chance during periods of significant volatility to do really well, and traditionally that’s what we have done is we do the best when things get the most volatile and things get the worst. And so for example in 2006 we didn’t have an awful lot of risk going in to the 2008 period, because in 2006 we took off a lot of that risk. So we’ve been able to do very well in the most traumatic points, which are basically the turning points of the market.
But that isn’t enough, if you decide okay I’m going to take off risk the thing is well then what do you get into? Or if I’m going to put on risk what do I get into? So in the 4th quarter of 2008 we decided we were going to get back into the risk and you say okay well you’re going to get into risk, well what do you buy? And that’s where the bottom-up really comes into it. And in terms of the bottom-up we use filters as we go through the names of the kinds of corporates that we’re thinking about buying in order to kick out the ones that we think could have real trouble.
So win by not losing very much has been our mantra from really day one and we think within fixed income for our investment philosophy that’s how we manage using both a bottom-up and a top-down approach.
EVAN COOPER: So let’s take a look at the environment for the moment and not going into today meaning exactly this hour, but the current environment where equities seem to be recovering to some degree, the economy is okay, not spectacular, everybody’s anxiously awaiting what they think will be a rise in interest rates when the Fed stops tapering or stops adding to the monetary base. Anyway in this current kind of environment where do alternatives fit and what are you trying to accomplish given the fact that in the past alternatives were sort of an alternative to an equity market that collapsed, now the equity market’s back and the fixed income market has worries again as we discussed. So what do you think?
DICK PFISTER: Sure, I would say investors’ memories are short as we all know, but when you remind people that even though equities are measured by the S&P are up 140% since March of 09, that’s really just gotten people back up to breakeven or slightly above for the last 13 years. So you have to remind people that’s part of what we all have to do is in the alternative space we have to educate and remind and say this is why you want or potentially want this in your portfolio. But Charles is right too in that you still have to make money. So we look at the alternative landscape, we say don’t just buy one strategy over another, we like to combine them together.
So with interest rates where they are, with equities where they are, when you’re going to allocate to alternatives put in what we consider convergent and divergent strategies. And the way we define that as convergent strategies are strategies that typically work well in the alts world that are long/short equity, long/short fixed income. They work with a normalised market which just seems like we’re getting closer to. The divergent strategies are more the ones that deal when the shocks come to the market, like a global macro or managed futures. When you blend that together then you’re not missing necessarily a rally in equities, but you’re also not missing the protection you would get by having those divergent strategies in a portfolio.
CHARLES KANTOR: I think and sort of related to the environment I believe that because rates are so low, and I generally think about rates low, I think of ten-year bonds, and I’m fond of saying the traditional asset allocation model doesn’t work today. It wasn’t designed to work with rates so low and it’ll work again when rates are higher and so people can trade off a little bit more income or a little bit more equity risk premium until you can have a more normalised discussion. And so I think where alternative strategies fit today is in many more places than it probably would traditionally fit if we were in a traditional environment, and we’re not in a traditional environment.
I think underlying investors of all strategies have to get comfortable that it’s not just one strategy that solves the alternative [unclear 13:01], it’s a variety strategies, but I think more importantly they have to get comfortable with the fact that you’re not in a normal environment. And so the normal answer of what would alternatives make up or what would fixed income make up or what would equities make up over an overall asset allocation model, well it’ll work again one day, but it’s not going to work currently. And I think you’ve had a very good window into that this year where what has traditionally been called your safest assets, those asset classes that have performed amazingly well for the last 10, 15, 20, 30 years, things linked to rates, and they’re defined as safe, because of this pull to par concept.
But are they safe today if you care about making money? Maybe they are, maybe they aren’t, that’s a judgement for other folks to make, but it shouldn’t be lost on anyone that in this environment so far this year the safest asset classes, those most tied to treasuries, are down 1, 2%, maybe they’re flat, and the things that we think of as risky, because you can lose unlimited amounts of money and you don’t have the pull to par they’re up a lot. And I think the question is what do you do now until we get to a normal environment? And then when you get a normal environment alternative’s a permanent allocation as the large endowments have decided or is it just flavour of the month stuff. We as a firm probably think it’s permanent, but it’s not one simple strategy.
EVAN COOPER: Stephen, what’s your view on that?
STEPHEN SACHS: Yeah. No, I agree with that and backing up for a moment to your point about just the general environment that we’re in. The fact of the matter is is that we’ve got GDP in this country growing at let’s call it 2½-3% somewhere in that ballpark, which even as investment professionals it’s sometimes tough for us to get our heads around the fact that from a long-term historical perspective there’s absolutely nothing wrong with that. The odds of us going back to 5 and 6% GDP growth on a sustained basis in this country and certainly globally I think are very very low odds.
So the fact of the matter is that from an equity market perspective when you look at the fundamentals underlying that the picture actually looks pretty good. We’d all like employment to be a little brighter picture, but again the fact of the matter is that 4½% overall unemployment in this country is just not sustainable from a long-term historical perspective if you go back and really dig into the data. The fixed income market’s the issue, right. The fact of the matter is that we haven’t seen a bond bear market in this country in a very long time. I would argue save possibly a few brief months in the early 90s, no-one in the US has really experienced a sustained bear bond market, and I think we’re faced with that. We believe that we’re faced with a long-term rising rate environment coupled with a demographic in this country that could inflict some fairly significant pain from an investment return perspective.
So as Charles has pointed out we as a firm believe that the sort of landscape has shifted to a better asset allocation if you will and really by that what I really mean is a better portfolio construction. We as investment professionals and portfolio managers have spent our whole career focussed on portfolio construction, and it really feels like for the first time the more retail oriented investment public is focussing on the same thing, and we think that there’s been a long-term shift from the standard fixed income and equity asset allocation to a broader portfolio construction that includes alternatives as a permanent part of that portfolio.
Again from the perspective of not only enhancing returns or generating the absolute return that we’ve talked about, but again back to risk management and risk mitigation, and we think that that’s going to be a major focal point over the next two to five years in the fixed income markets, and that’s driven not only by our view of the world and what we see, but the conversations that we have with our client base, the professional investors that are using ProShares’ exchange traded funds, we have a lot of conversations with advisors and institutional clients about what tools do you have to help protect my fixed income portfolio, because right-
EVAN COOPER: Well I want to get into the portfolio construction in a minute, but first I want to ask Dan who has unique perspective of being an economic advisor in the Reagan administration, we were talking about what the current environment is like economically. So, Dan, I wanted to ask you your view of the current economics with a dollop of politics that is certainly shaping what the economy’s like these days. So give us your view.
DAN ROBERTS: Right. That is the question that because of my background that’s a question I’m asked a fair amount in and politicians will never pass up a good crisis.
EVAN COOPER: They’re certainly helping to create one this time.
DAN ROBERTS: Yes. So if there isn’t a crisis they’ll create one, and I think that’s basically what we’re seeing today. And one of the reasons for that is that politicians get a lot of free publicity out of crises and they have sort of a leadership style that they can project to their constituents. So crisis from their perspective they would like to have these crises last for as long as they possibly can, and that’s why we are where we are today, that’s when we look the fiscal cliff, you know, they’ll take it to the very end, because that’s great publicity. From our perspective though these kinds of crises are made up and there’s nothing fundamentally economic that’s changed and the politicians have caused this to occur.
Interest rates from our perspective are still going to go up. We still think the economy is going to continue and improve slowly, but continue to improve over time, and that’s why we’re all talking about what we’re talking about, and that is that in this kind of environment with rates rising, getting to the discussion we were just having, with rates rising traditional solutions to fixed income are much harder to justify than they were in the past, and that is because traditional solutions used longer duration benchmarks; for example the Barclays’ Agg, that’s probably the most used duration. And that forces a manager like us into a longer duration kind of position, and when rates are rising that’s not a place you really want to be.
So clients are smart and a lot of them are saying look we have an 8% actuarial rate we’ve got to make for our pension fund clients and how can we make that when interest rates are rising? And it’s really tough on the fixed income portion. So their solution and what we believe is a very good solution for this is to give us the flexibility to widen our guidelines, give us the flexibility to do things that in the past we couldn’t do, and from our perspective that’s one of the reasons we’ve rolled out what we call the unconstrained bond fund, which is to give us that flexibility, to give us that ability to not be too hamstrung by a long duration fixed income investment.
EVAN COOPER: So I want to get into the how you do all these things. So that people know what’s going on under the hood, but let’s get back to the portfolio construction part. Now obviously in the business of constructing portfolios for individuals on a case-by-case basis and each person’s different, we know all those caveats, but basically if there’s somebody let’s say approaching retirement or sort of the typical, if there’s such a thing as a typical 55, 60-year-old investor who’s had a diversified portfolio. Given the importance of alternatives now where does it fit? Give us an idea of where it fits and where the money comes from to take the piece that should be in alternatives.
DICK PFISTER: Sure. So we hit on this a little bit earlier in that endowments in pensions have already made this shift. They have whatever it is, 7, 8, 9% liabilities they have to meet. So they’ve shifted their portfolios. They’ve taken what used to be a core allocation to domestic stocks, international stocks and typically bonds of 60/40 blend, and they’ve increased their call on absolute return and alternative investments dramatically, whether that’s 10, 20, even 40 or 50%. Now individuals or individual advisors didn’t necessarily have the capacity or the access points that their pensions and endowments used to have, but that’s part of this evolution of alternatives we’ve been talking about. They’ve become more available in mutual fund format, SMEs, even limited partnerships with lower minimums. So it’s become much more accessible. Now that’s driven by demand, but it’s also driven by the need for investors to have it in their portfolio.
So we’ve gone back and done some studies on what percentage of a portfolio should be in a portfolio. What liquidity obviously is needed and the age of the individuals is obviously important, but if you’re going to look at long/short equity, which I’m sure Charles will talk about too, or long/short fixed income we believe you should be taking it from that passive part of your portfolio. So if you get passive long-only benchmark stock portfolio, take it from that piece, put it in long/short equity. If you have passively managed fixed income portfolio, take it from that, put it in long/short fixed income. You’re really shifting from a passively managed portfolio into an actively managed portfolio.
EVAN COOPER: The question of course is how much. I mean of course the how much depends, but is 5% too little, is 30% too much?
DICK PFISTER: It’s a difficult question to answer, but here’s what I would say, there are certain strategies that did well in the credit crisis. Managed futures, macro, there’s certain ones that did well and held up during when you needed them the most. We had investors who had 3%, 5% pieces in managed futures, and they did well, they made 15, 20% while the stock market was down 40%, but it didn’t impact their portfolio enough because they had 60% in long-only equities. So we start with saying if you have at least 5 to 10% in any given strategy in alternatives that’s a good starting point. Then you go from there based upon who you are, what liquidity needs you need to have, what kind of actual yield or dividend payout you need to have. So then you start building from there, but less than 5% is not big enough from our perspective.
EVAN COOPER: Charles, how much and of what?
CHARLES KANTOR: I think again I’ll come back and say that how much you’re asking me right today and I’m saying today’s not a normal environment. I mean large endowments I think it’s fair to say based on the public available information we gathered that over the last 50 years folks that run these places have come to the determination not because of an environment that a 30/30 split equities globally, fixed income globally, alternatives globally seems to make sense. I think the question is why isn’t that sensible for the underlying investor that only has $1,000 dollars to put into a publicly traded mutual fund, and I think the answer is you’ve got to get engaged whether you believe the combination of all these alternatives together with this other $70, forget about whether it makes you more money, does it actually make the right trade off in terms of less risk for a very similar outcome? And I think clearly those that have gone there and have been committed to that believe that.
In the retail environment today I would say folks generally believe it’s a one and done strategy, which is oh we like long/short equity, oh we like long/short fixed income, my branch manager’s forcing me to buy an alternative, I’m buying one strategy. And we think that that would be like saying I have a corporate bond strategy for fixed income and I don’t need anything else because I have one strategy. And so it’s our role, all of us on the panel and others to make the education. But if you ask me right now I think it has to be very different, because we’re in a different environment, and I think the challenge we all face is fixed income over the last 10 years, 30 years have given you very close to equity like returns with very little volatility. And who cares about the past, the question is what does the future look like? And it will be my view that it’ll be very hard mathematically, because fixed income unlike equities it’s just math, it’s just simple math.
Mathematically if you believe that rates are going higher over time mathematically I think it’ll be very hard for fixed income to make that contribution to your overall portfolio that it’s made over the last ten years. And so for us I guess we would say more today, but the challenge is that you’ve got to understand the different strategies and how they work out. But we’ve seen demand, because of how unusual the environment is from traditional fixed income, because people that want to lose money, and we’ve seen demand luckily from the equity side, because people say because we’re long/short equity is this a tiptoe approach back into equity? So we’re very fortunate because of the environment, because we have more conversations than we would otherwise be if we were in a normal environment.
EVAN COOPER: Okay, Stephen what?
STEPHEN SACHS: Yeah, and again excellent points made by Charles. So I’ll just continue to follow him throughout the entire panel, make my life easier.
EVAN COOPER: We’ll let you go first.
STEPHEN SACHS: Absolutely, no, so I’m going to stay in my place, you know, and again a couple of really good points there. In particular to your question about what’s the right amount? At the end of the day you can’t answer the question right? Because at the end of the day we’re all individuals. But I think to Charles’ point that he was making you really do have to look at it on an asset class basis. The issue that again we’re faced with equities versus fixed income is critical and it’s key at this point in the sort of where we’re at in the macroeconomic environment.
With fixed income in particular I think that generally speaking the assets that we’re seeing flow into the alternative fixed income strategies, for example we recently launched an interest rate hedged high yield product, which effectively we’re seeing advisors and having conversations with advisors about they’re taking their core fixed income exposures in the high yield asset class, transitioning it to this product, because they can hold it is a core and it’s a duration hedge product, it’s a zero duration product. So they still get the yield, they still get the exposure to high yield, but they don’t have the sensitivity to the rising rate environment. Because here’s the key, if we all strip off of our investment professional hats for a few minutes and just think about ourselves as individuals and particularly ageing individuals like myself, the fact of the matter is from the demographic perspective.
If I don’t like equities, if I don’t like the fundamental picture I’m pretty comfortable just reducing or selling equity exposure right? As a fixed income investor I don’t have that luxury, I am holding fixed income for the actual income generation, you know, particularly as you reach retirement age and start moving through that path. So the key to the alternative investment landscape these days we think in fixed income world is going to be finding a lot of replacement strategies for those core fixed income holdings, because I can’t reduce my exposure, I need the income. So I have greater need for ways to hedge my fixed income risk in my exposure in that particular asset class.
EVAN COOPER: I’m going to get Dan who’s Mr Bond here.
DAN ROBERTS: Yeah, and maybe I’m going to take a little bit of a different slice at this, because a lot of our clients are pension funds and remember when interest rates rise liabilities fall and therefore what percentage you should have in one or the other is very dependent from pension plan to pension plan. Rising rates on the liability side help you, they’re a good thing. So a lot of our clients have taken their liabilities and at least matched off part of them with their assets, that’s a smart strategy. So if they can do that.
So it really very much depends on what your situation is. However for those plans that are really looking for more alpha generation within their plan then I think the kinds of things that we’re talking about now make an awful lot of sense. And if you really need to earn that extra rate of return and you feel that interest rates rising are not going to hurt your plan then the kinds of things that we’re talking about today really make sense where you need to have flexibility. You need to be able to think about the world a little bit differently and hedge your interest rate exposure.
EVAN COOPER: Dick?
DICK PFISTER: Yeah, I would say I’d just follow on that I agree with you in a sense, but what happens sometimes at least from our investor base is that they’re looking on a day-to-day basis. As much as we don’t want them to necessarily look on a day-to-day NAV pricing, they’re used to doing that, and especially if you get into the more liquid alternative solutions they’re looking at their NAV. So as yields rise or as they did in May they spiked they’re going to be looking at their bond holdings and even though their dividend or yield is actually staying the same or constant their NAV might have taken a hit.
So they get nervous right and that’s what we’re seeing and part of the reason why we launched a long/short fixed income mutual fund which actually does hedging, it goes short high yield credit, that part of has up hedged that spike, whether it’s a spike or whether it’s kind of a slow bleed higher. We think that you need to have that protection for the end investor that they’re sitting there looking at their statement and talking to their advisor and saying well my NAV took a hit, now explain to me how I’m going to collect that yield, and that’s part of education, it’s part of just protecting it day-by-day.
CHARLES KANTOR: I think it will be very important for the folks watching to understand who the underlying clients are and what the rationale is and when I generally speak I’m speaking for the underlying retail individual.
EVAN COOPER: The end investor.
CHARLES KANTOR: Or high net worth folk. I’m not speaking to smart institutional investors who I would possibly argue already have thought through the conundrum of equities and fixed income and alternatives. But on the topic of income for the individual investor I get quite nervous with the nervous that you have to seek income. We’ve taught them to seek income, and that’s been a convenient conversation, because your bond portfolio has risen because your net asset value’s gone up as rates have gone down until you’ve got comfortable spending your income, because the bonds have produced enough income and the value’s gone up, so you actually haven’t seen diminution to your NAV. And I don’t think that is going to exist like it has going forward. In fact I think it’s quite easy you’re going to spend the same, your NAV’s going to go down, because you’ve taken out maybe $5 every year and possibly your bond portfolio doesn’t go up and then over three or four years your $100 of investment is quickly $80 simply because you spend four years at $5 and folks that have been spending $5 in the fixed income haven’t actually seen the values of the portfolios going down.
So I’m trying to get folks to understand that assuming the same risk which I don’t think you can always, but we should always question what is risky, but most folks have been in the world if I give you 5% in income and 5% in capital appreciation or total return everyone wanted the 5% income, and I think we should be able to engage clients in really what I’d call total return solutions and get them off the notion and get them off this belief that they still need the income. They’re not going to like the income when their NAVs and their fixed income portfolios go down 20% over four years.
STEPHEN SACHS: I don’t disagree with that point at all, but to your point again the fact of the matter is that either we as an industry or just we as a sort of culture have ingrained into the older demographics that income and income streams is important. And again you’re actually making the point that I was trying to make in that there’s a real shock value coming for the American investor and the global investor for that matter in the fixed income space. If in fact rates do rise the fact of the matter is that investment regimes when they shift they don’t shift in an orderly fashion, volatility tends to increase, there tends to be a high degree of angst and uncertainty.
So I think that we haven’t faced that yet. We got a little taste of it in late May, early June of this year. We had a very sharp backup in rates over a very, very short period of time, but that didn’t translate to the end retail investor statement. We as individual investors didn’t see the effect on our NAVs and our bond portfolios. So ultimately that’s what concerns me from an investment professional perspective is what is the reaction of the investing public and are they prepared for that type of environment?
EVAN COOPER: But sort of speaking people whose age I’m approaching in terms of wanting to get income and despite the fact you’re saying that they shouldn’t be looking for income as the population retires and ages and they need income where should they be looking? Is there an alternative solution or approach that would help achieve the income needs?
CHARLES KANTOR: There is no safe way to make 5% today, because treasuries are 2½%. In a world where treasuries are 5% the conversation around I can retire and invest in treasuries and get supported by the full credit of the US government is the right conversation. It doesn’t exist today. So I think the first conversation is if you want me to try and make 5% in fixed income I have to take on risk, because my great bonds, my granny’s portfolio full of consumer staple bonds, you know, you smoke it, you drink it, you watch it, those bonds provide you very little income. So there’s very little income in fixed income today and I think luckily for all of us that it’s an environment where a conversation and an out of the boxed thought is so right.
EVAN COOPER: Okay, go ahead.
DICK PFISTER: You know, what’s interesting about this time window it was somewhat similar in 06 and 07 in that what happened with rates it wasn’t exactly the same, but people started stretching for yield. And what’s happening we’re seeing now is people are looking for that 5, 6, 7, 8% yield, well they’re taking on more credit risk to do it, and that this low rate environment forces people to do it, you have to, well at least they think they have to. And what we’re trying to say is that with an alternative investment you don’t necessarily need to have the yield, why don’t you just go for a total return or at least protection of capital. With an alternative investment you can get the protection, that’s going to protect your NAV, and you might get a return on top of that, might equal your 5 or 6%, so you can take some distributions on that.
I think the advisory world is getting smarter and smarter, the more times we’ve seen this the more used to it, they’re saying okay, you’re not going to fool me again, right, I understand we rallied a lot in equities and I know I need to diversify, so I’m going to start looking at the alt space to do that.
EVAN COOPER: But do you think in the minds of some advisors and their clients that alts equals this kind of magic that you can get the better return, not regardless of what’s under the hood, but even not knowing exactly what you’re doing you’re getting that kind of return that’s not, because they know that the fixed income markets can’t generate it if treasuries are yielding practically nothing.
STEPHEN SACHS: I think magic’s the wrong word, I think as an industry, you know, as an investment industry we have an obligation to continue what we’ve already done from an education perspective, and it varies. It’s very very different from an active manager perspective versus a passive manager perspective and from a mutual fund, you know, wrapper, ETF wrapper perspective to a limited partnership or separately managed account perspective. So I don’t think that they believe it’s magic or it’s the cure all, but there’s clearly a high hurdle for education, responsibility’s on the industry, the responsibility’s on the register, the register of investment advisers, the responsibility’s on the broker dealer community and the responsibility ultimately also falls to the end investor.
The fact of the matter is that it’s no doubt infinitely more difficult to invest today than it was when I started my career, than it was 50 years ago, than it was 70 years ago. The fact of the matter is is that we have more information, we have more transparency, but that creates again that higher hurdle for education and for us as individual investors and everybody in the chain has a part of that responsibility.
DICK PFISTER: Yeah, I want to add to that, if you look at the alternatives world today, mutual funds were new, right, in the 80s that was a newer vehicle, what’s going underneath of that? And when you look at ladder bond portfolios it’s hard to say that every investor that’s in a ladder bond portfolio up and down the credit spectrum really understands the risk that’s been taken in that. Now their advisors might and their advisors probably took 10, 15 years to really understand it too.
Alternatives are same thing. There’s not really a mystery, there’s no magic behind the scenes. When you look at a sophisticated strategy in long/short, if you peel away the layers, you can figure out what’s going on. They’re shorting out of favour stocks, they’re going long typically undervalued stocks in their mind, it’s not rocket science. But the advisor community and the clients need to understand it so they know what they’re getting into, and we’re in the early innings of that education, but it will get there. And you might hear that alternatives aren’t going to be alternatives in the next five years, might be just actively managed versus passively managed.
EVAN COOPER: Dan?
DAN ROBERTS: In the retail space things are different now and fixed income as we’ve all been talking about is different this time around. So I think you have to manage it differently then you’ve ever had to manage it before. As we’ve all been talking about interest rates can’t go much lower. In the past, you’ve been able to use equities and fixed as a balancing mechanism. That’s pretty much gone, to have fixed income being balanced you’ve got to have rates at such a level that when equity gets killed interest rates can fall and you can make money on your bond portfolio. Well clearly we can’t do that anymore.
So the space we have to be in right now is we have to think about things differently and when you think about things differently you need a portfolio that isn’t the sort of traditional kind of bond portfolio that you’ve been talking about before. There has to be more flexibility. You have to think about hedging more carefully, winning by not losing becomes even more important. It becomes critical relative to what we’ve seen in the past.
EVAN COOPER: Let me bring up just a little bit about the structure of these investments that we have representatives here of people who do these things in a fund format, a conventional 40 Act Fund and also ETF format, what’s the difference between doing it one way or the other? Does the structure affect what you can do when the results and costs and things like that? So let’s hear from the fund side of things first and then we’ll go to the ETF side of things.
DICK PFISTER: So at Altegris we actually have both sides of this. We work in limited partnership format, which typically has quarterly or monthly liquidity, and sometimes even semi-annual liquidity, and then we also work in the liquid alternatives mutual fund space, which have daily liquidity just like any other mutual fund. And we’ve also investigated the ETF space. So there are definitely some strategies that are in alternatives that don’t fit in a daily liquidity format and when you try to fit them into a mutual fund erroneously you end up making a mistake.
So we’ve stuck to what we believe our strategies actually can fit. They have daily liquidity instruments that they trade are mark-to-market every single day. They have a lot of liquidity, whether they’re G7 currencies, whether they’re equities, whether they’re fixed income, liquid fixed income. Those are strategies that can actually fit well into a 40 Act registered mutual fund. But when you get into complicated derivatives where you get into swap transactions or use highly levered strategies those strategies still need to be in a limited partnership, because you don’t want a liquidity mismatch where you’re saying you really can only afford quarter liquidity, but I’m going to put it in a daily liquidity format.
So those strategies will, in our mind, always stay and should always be in a less liquid format. The errors we see sometimes when people put less liquid in a 40 Act usually end up in some sort of debacle.
EVAN COOPER: Charles?
CHARLES KANTOR: I would wholeheartedly agree with that. I would ask the underlying buyers of the different strategies do they understand the strategy? As described I run a long/short strategy, I try and buy companies that I hope will go up and short securities that I hope will go down, and that’s what I do. And I do it in the equity markets predominantly. But I’d ask because our industry’s so innovative and I think because the demand is so great, because the endowments already sit there with 30% and the individual really has the same liability maybe even without the inflow of funding all the time that endowments may get because folks that go through business schools that feel good about it give back after they leave. The individual already doesn’t have that, their source of salary and benefits and bonus disappears. And so because I think over time it’s a sensible idea and because we’re in this unusual environment there’s tremendous demand and I think the buyers of these strategies really need to, I would say, understand the strategy, what is it that they do? Do I understand that? Understand if it’s credible to do it in a daily liquid vehicle.
So for us I’m running a daily liquids long/short strategy, I’m buying stocks and selling stocks that have to be liquid and by definition and we have pretty tight risk parameters around that. Where does leverage sit in the source of returns? We’ve generally run what we would call fully invested, which is a longs plus a short equals roughly within a few dollars 100. It doesn’t say we can’t have leverage. It doesn’t say the 40 Act vehicle doesn’t allow for leverage; it’s just what degree is leverage an important source of returns? Then I’d go to does the manager actually have a track record of experience of executing that strategy? Because you’ve got to like the returns.
You may like the liquidity, you may like the fact that there may not be a performance fee, which there isn’t in the 40 Act structure, but if you don’t like the investment returns and the process don’t invest, because the daily liquidity and the no incentive fee by itself I would argue shouldn’t be enough to get you to invest. And finally does your fund company and does your firm provide you with credible scale advantages to run these strategies? And the danger’s going to be because of the demand our industry’s so innovative that they’re going to come up with a lot of things. And the folks out there, it’s not just filling a bucket, it’s actually filling a bucket that they believe to be credible within the space that’s going to attract a lot of growth.
EVAN COOPER: Stephen, of the value or the pros and cons of different structures, you’re in ETF mainly.
STEPHEN SACHS: Yeah, absolutely. So ProShares being a leading alternative ETF company, you know, obviously we focus our entire business on providing these types of strategies inside the exchange traded fund wrapper. Strangely I actually don’t disagree with a lot that’s been said here; the fact of the matter is is that we obviously have both levered long and levered inverse strategies and exchange traded funds. We make use of exchange listed derivatives as well as over the counter derivatives to gain that leverage, but the answer’s not wrong. There are certain asset classes and certain strategies that do not lend themselves well to the daily liquidity of an ETF wrapper, the daily needs of a levered or inverse and levered strategy, but the point is that right capital markets evolve. Capital markets evolve very quickly at times. Things have changed rapidly just in the past ten years that has given the opportunity to actually explore a lot of these asset classes, asset classes that were previously sort of unavailable in the retail wrapper, particularly the exchange traded fund wrapper, whether they be merger or private equity hedge fund replication, things of that nature.
So the fact of the matter is that the point that was made earlier is actually a very valid one. If you are looking for a passive approach to some of these alternative asset classes or alternative strategies the exchange traded fund format can actually be a very advantageous format for you, right? It’s very transparent, it’s low cost, it’s tax efficient, it provides daily liquidity and it gives you the retail investor or the advisor or even the institutional investor access to places that you may not have had access to before. But the fact of the matter is there are a lot of really great active fund managers out there in the world doing both traditional as well as alternative investing, and if you have the ability to do your due diligence to understand what those portfolio managers are doing, what their investment strategy is and what they’re holding, you should absolutely gain access to those managers, because that’s a great source of absolute return and alpha.
Generally speaking right we don’t try to build a house with just a hammer, in most portfolios there’s usually a place for both the exchange traded wrappers that give you all of those things like transparency and liquidity and low cost along with the active managers who are actually out there generating what is actual good absolute return and outperformance.
EVAN COOPER: And Dan, any thoughts on the structural question of how to approach investing in alternatives?
DAN ROBERTS: What we invest in mostly is quite liquid kind of investments, for a portion of our portfolio we can go long/short, but most of the underlying investments that we make are pretty liquid or relatively liquid. So that from our perspective that the structure is less important. I think what’s more important from our perspective now is the kinds of instruments that you invest in in order to try to outperform and how you put the portfolios together and in that sense what we’re trying to do is we’re trying to look for natural hedges and also like for example in the credit markets their natural hedges that you don’t have to pay for those hedges, but they’re implicit into the instruments themselves. High yield would be an example of that, or using futures as an instrument that could help balance off the downside risk so you could continue when you’re investing to win by not losing.
EVAN COOPER: We’re reaching the end of our session, but I wanted to check in with each of you for some final thoughts, last words, the kind of takeaways that advisers/investors should take away from our session here today on alternatives. So Stephen, we’ll start with you since you’re always following, why don’t you be the leader at this time in the takeaways? Give us your takeaway.
STEPHEN SACHS: You know, I think this has been a great conversation today, particularly given the different lenses that we all look through on a daily basis, but I think ultimately one of the things that’s resonated with me over the last hour in the conversation is really just sort of the long-term shift that’s taken place in the investment landscape and the fact of the matter is that alternatives are really no longer just sort of the purview of the institutional investor or the sort of wish we could have in the retail investing land. It’s a permanent fixture at this point and the fact of the matter is is that investors need to make sure that they’re rethinking their portfolio construction from a global perspective and understanding how they can use alternatives.
And again I would reiterate from a usage perspective the one that resonates most with me really is risk management, particularly given what we’re faced in the macroeconomic environment these days and what we’ve been through in the last ten years in this country first and foremost I look to them as risk management tools. Certainly they have the ability to enhance performance, there’s no doubt about that, but I think the main value there really is the risk management tool perspective.
EVAN COOPER: Charles?
CHARLES KANTOR: Yeah, my takeaway I think quite frankly three or four weeks ago Mr Bernanke gave everyone in the market a mulligan. The mulligan was you knew how your safest assets had performed to that moment, and they’re all down on the year, and the mulligan is after he delayed the tapering treasuries rallied and so it’s given everyone another chance to rethink the question. They may choose to do nothing, but I think it gives everyone another chance to rethink the question around is my portfolio at a construction level positioned for the next ten years. And I think if you have any view that the first seven months of the year could look maybe not as dramatic just because of the muse in rates, but if the first seven months of the year from a direction of rates perspective could look like the next five years you may be sitting with a very large part of your portfolio that on a total return basis may produce you almost nothing, and it’s produced you over 6% over the last 10 and 30 years. And the question is if your spending hasn’t changed or if your investment objectives haven’t changed where are you going to go to make that up? And we’re running a strategy that’s long/short predominantly equities, we try to make you money, but it’s not riskless, and that’s why I come back. You’ve got to understand the standard deviations of these return streams are betas tend to be about 40% of that the market.
So it’s not we’re always going to make you money, it’s not that at all, but it is, is this strategy, is it legitimate to believe that my strategy or strategies that we’ve discussed have the potential within the world that you look going forward to overcome the drag that we may be discussing from fixed income. And then my final point would be everything we’re speaking about is not a one and done strategy. I think there are really good reasons why the endowments have moved permanently to a more balanced fixed income equities/alternatives mix. There’s good reason for that and to believe that by picking long/short credit or long/short equity or futures to believe I can just pick one strategy and make that a 2% allocation or a 5% allocation and I’m done, I think that’s a grave mistake, because what are you doing with all that stuff sitting there that is either in cash that may get eaten away by inflation or was in fixed income that may not make you money.
So it’s not one and done and there’s no shortage of the amount of education we all need to do to explain to clients the outcomes that we hope to achieve for them. The outcome we hope to achieve for them and if they get the outcomes they should be happy.
EVAN COOPER: Okay, Dick?
DICK PFISTER: Yeah, I would parrot a lot of the things that were just said. I would say don’t wait. You know, the time to do this is now, and a lot of times advisors and clients they wait to buy their fire insurance after the fire. And I think that the alternative world has grown up, it’s evolved, it’s become accessible. The endowments, the pensions, the institutional investors have already made that choice, have already made that allocation. Now the retail investor, the retail advisor can actually implement it too. So the equity markets have tended to bail people out right. Right now learning about alternatives is not so important as it was maybe learning in 09, but take the time now to read, understand, understand the strategies that we’ve talked about and implement them in your portfolio in a meaningful way.
Our view at Altegris is that you want a diversified alternatives portfolio. You want a piece of long/short equity, you want a piece of long/short fixed income, global macro, long/short and event driven, blend those together, because what our mantra’s been is participate, but also preserve. So you’re going to hopefully participate in the equities right, hopefully if bonds continue to rally, if that can happen participate, but preserve on the downside. You’ve got time to do it now, the equity markets and as we mentioned the bond market is giving you that extra time window to do it, and get ready to do it now. It’s something that should be in everybody’s portfolio.
EVAN COOPER: And Dan, you have the final word.
DAN ROBERTS: Okay. We think that rates are more likely to go up, and in that kind of environment like we’ve just all been talking about we think you need to be focussing on risk management, as we’ve all been talking about, or the way we describe it is winning by not losing. And there are a couple of different ways to do that, but we think in the environment that’s coming, being able to reposition yourself both from the top-down and the bottom-up are going to be critical.
The top-down what’s going to be really critical is can the portfolio manager during times of extreme volatility do well? Because we think we’re going to be facing those times again and maybe not too far into the future and the next five years we’ll probably face something like we faced before, but you also need the bottom-up, and that is you need to have the ability to cut off the downside risk by looking at the securities, looking at the corporates that you’re buying and being able to throw out and filter those securities that you’re thinking about purchasing. So you need to have both. Risk management is the key, winning by not losing we think is the key to this.
EVAN COOPER: Perfect, gentlemen, thank you so much, and thank you all for being with us and the insights on alternative investing. We look forward again to seeing you on our next Masterclass. This is Evan Cooper for Investment News and asset.tv.
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