Player:
Media Manager
Video ID:
17665
Video ID:
5564d6f7140ba0f2618b459a
Basic Info
Video Image:
Description:
Balancing Portfolios with Liquid Alternatives
Liquid Alternatives play an important part in balancing a portfolio. Watch as four experts discuss how to position liquid alternative strategies in the current bull market.
Salvatore J. Bruno - Chief Investment Officer and EVP at IndexIQ
Thomas Swaney - Senior Vice President, Head of Alternative Fixed Income, U.S. at Pioneer Investments Global Asset Management
Shakil Riaz - Managing Director, Head of US Alternative Portfolio Management at Rothschild Asset Management Inc.
John Harnisch, CFA - Portfolio Manager at WHV/Acuity Tactical Credit Long/Short Fund
Duration:
01:00:30
Transcript:
Courtney: [00:00:19] Tom, we’re six years into a secular bull market fuelled by quite a lot of easy money. But it looks like interest rates are poised to rise, how do you characterize the role that Liquid Alts can play here?
Thomas Swaney: [00:00:29] Well, I think first and foremost we need to define Liquid Alternatives. And I think for … unfortunately in our market we’ve done a pretty poor job of defining them so far. And to me Alternatives must … can’t be defined by what they’re not. I think so many people define Alternatives as something other than stocks, bonds or cash. And in reality I think we need to focus on the correlation of Alternatives to the rest of our portfolio. So it’s really that correlation, that low correlation or negative correlation in some cases that really ends up benefitting the portfolio. And given where we are in terms of valuations and how far along we are in the business cycle, it’s probably never been a better time to add something that has low correlations to traditional stocks and bonds to your portfolio.
Courtney: [00:01:07] Absolutely. So this is the time for both low correlations as well as defining as you said, Liquid Alts, less is not anything … not stocks, bonds or cash, but relative to correlation, that’s a really good point.
Shakil Riaz: [00:01:20] Well, the typical retail investor, you know, if you think about the position he or she is in, probably have had a good stock market weighting in his portfolio already, it’s gotten heavier. He’s worried about fixed income because of the rate issue, can’t really go to cash because cash doesn’t pay anything. He probably has plenty of real estate and other things already. So I think if there’s a place to basically use as a parking spot for your money, while you wait to figure out what the world is going to do, and you can do it in a liquid format, that ought to have a place in most portfolios.
Courtney: [00:01:59] Right. And I mean, the opportunity to smooth out volatility, more yield than say parking money. People might even think money market, quite a lot more yield than there. And this is an environment where people are really looking for yield, right, John?
John Harnisch: [00:02:13] Yeah, absolutely. I mean if you look at what’s going on with the government bond markets or the investment grade bond markets, there’s just not a lot of yield out there. So people are using these Liquid Alt products to express their views and get yield in their portfolios.
Courtney: [00:02:24] And so what’s your sense of Liquid Alts role in this environment with rising rates, you know, at the end of a cycle?
Salvatore J. Bruno: [00:02:31] Yeah. We get that question all the time from our clients, you know, “What should I be doing? How do I think about your portfolio in my broader portfolio?” And we think of it almost as a fixed income replacement because if you look at sort of volatility profile of our portfolio, our fund has a very similar volatility profile to a typical fixed income index or a fund. But it actually diversifies you away with a very low duration risk, and sort of takes exposure across a number of different asset classes to help you reduce that correlation and get better diversification in the portfolio.
Courtney: [00:03:01] And diversification, low correlation is something, you know, that we keep honing in on. But when you mentioned something interesting about fixed income replacements it brings to mind fixed income proxies like MLPs, BDCs, REITs, Tom, what’s your sense of how they relate to Liquid Alts right now?
Thomas Swaney: [00:03:19] My sense is that they don’t, right. I think unfortunately they make very good Alternatives in portfolios, in other words, if you’re going to define it by the definition of something other than stocks, bonds or cash in many ways. And they certainly have a place in terms of enhancing the return profile. But all three of those are going to be very highly correlated with equities, you know, particularly in periods of financial stress. And I think also dovetailing into kind of maybe connecting the dots a little bit between the fixed income and the equity, I think is pretty important here. And that is if you think about where we stand today, right, I think with this inability to get safe income from developed markets really around the world, we really can’t achieve it anywhere. So we’re really seeing that grab, right, that risk down the, you know, drive down the risk [inaudible] for yield. So you know, more and more clients than ever have large proportions of high yield or bank loans or emerging market debt. And then on top of that because in many cases those don’t offer enough return or yield either we’re reaching into, you know, high yielding equities and so high dividend paying equities. So if you think about where we stand in general I think we’ve got more equity risk in our portfolios than ever before. And fixed income has never been able to do less for your portfolio. So we need to try to explain this maybe in two ways as well.
So everyone gets focused on the absolute level of rates, and that is a concern because 90% of the return in fixed income in any given year can be attributed back to its starting yield. So obviously with rates in developed markets at 1½/2% we’re going to have very low returns from fixed income and we know that. But when I say that never has been fixed income been able to do less, what I’m really referring to is the benefit from fixed income in times of stress in your equity portfolio, so if you were to think about, you know, the mid 90s, you know, 2000, you have a much higher rate environment. And you look at say a 10 year yield at 5, 6, 7%, when you look at what’s happened for a 10-15% correction in equities and you look at the change in rate on the 10 year, you’ve gotten anywhere between 60, 70, even 90 basis point of a change in rate on a nine year duration asset, which basically means you’re getting at 6, 7, 8% returns from fixed income from duration. But in this case with the 10 year at 2 plus, are you going to get 15, 20 basis point change in the 10 year? That’s going to equate to less than a 2% change in the value of your fixed income portfolio. And that’s even if the negative correlations between rates and equities hold given where we are in the cycle. So I think that’s why I want to just emphasize that fixed income has never been able to do less, it’s because the absolute level of rates is so low.
Courtney: [00:05:40] Yeah. Do you have that same sense as well that fixed income has never been able to do less?
Shakil Riaz: [00:05:45] I think at the end of the day you have to look at how risk has been balanced in portfolios traditionally. Traditional portfolio construction called for a certain level of equity, a certain level of bonds, a certain level of illiquid assets. And all that has been turned on its head by this incredible financial experiment that we’re all in which has led to zero interest rates. So that type of portfolio construction really doesn’t have as much relevance in an environment with zero rates. What will be really interesting to see is what happens to this environment when rates finally do start to rise and how well we provide diversification to clients through Liquid Alts because if we don’t do a good job of it, what happens when rates do go back to 5%? All this money could potentially move back into fixed income instruments. But if clients by that time really appreciate the fact that we have created true diversification, true lack of correlation then it will earn a permanent place in their portfolios.
Courtney: [00:06:44] Yeah. That’s a really good point, I mean if rates are back at 5% then they have to … but by the time that happens, since we’re only probably looking at 25 basis points.
Shakil Riaz: [00:06:51] That might be a very long time to come by the way.
Courtney: [00:06:53] By then they should understand it.
Shakil Riaz: [00:06:54] Yes. Yes, I don’t think we have to worry about that just yet.
Courtney: [00:06:58] And John, what about credit spreads, what are you seeing there?
John Harnisch: [00:07:00] Yeah. I mean in the credit spread market, obviously spreads are very tight at the, you know, latter half of 2014 with the crisis in the energy sector and credit spreads widened out massively to levels you hadn’t seen since basically 2012 in the European debt crisis. Subsequent to that credit spreads have definitely tightened, money’s flowed back into the space. So you’re trading at, you know, call it 500 basis points in what the treasury is now. Historically that’s not that great especially given the credit risks in the system, you know if rates start to rise or some of these credits were very poor [inaudible] standards, start to really deteriorate. So you know we don’t like all parts of the high yield market right now just given where spreads are. We like certain sectors. So we like the short duration part of the market where it’s not really spread dependent. And we like some of the really low quality names, if you do your real fundamental analysis you can really pick up that extra yield.
Courtney: [00:07:45] So looking at more short duration?
v
John Harnisch: [00:07:47] We’re looking at more short duration. So if you look at our portfolio right now, the duration credit book is about two and a half years. And again we’re very cognizant of if we’re wrong in the interest rate call our spreads are going to widen out with the move in interest rates. So we want to be protected from that.
Courtney: [00:07:59] Is that how you’re looking at it as well, trying [inaudible]?
Salvatore J. Bruno: [00:08:01] Yeah, exactly. I think it’s a really interesting point because when we think about Alternatives, it’s not so much the asset classes that you’re in or not in at the broad level. But it’s really even within there. So we’re going to have bonds and stocks and real estate and everything else in the portfolio, but it’s really what you do with it. So if you look at our portfolio we’re about 75% bonds. But a big piece of it’s very short duration treasuries, so there’s not a whole lot of duration risk there. A piece of it’s convertible bonds that actually should do well if interest rates go up because the equity market’s grown, so they’re getting, sort of picking up that equity optimum premium. Another part of it’s floating rate which can actually do well as interest rates rise. So you’re looking at it, there is a big fixed income portion of the portfolio but it’s really well diversified against different drivers that can do well even in a rising interest rate environment.
Courtney: [00:08:42] That’s such an important point. And interesting point, short duration, you as well Tom?
Thomas Swaney: [00:08:48] No. You know, we … there’s a kind of a difference between assets and strategies. And I think so far we’ve been so focused on, you know, the long only side of the equation. And when you think about long short or you think about a strategy, that’s when you have … you pay a short position with a long position. And that’s meant to sort of extract that market risk with the directionality from the position. So you don’t have to be as vulnerable to, you know, where the direction in the markets are going. You can sort of be right about your position even if you’re wrong about the direction of the market. And I think the ability to isolate a risk factor that’s uncorrelated with the direction of the market is more what we’re focused on. I think when you … I doubt 2008 is the next type of a bet, [inaudible]; we don’t have leverage building up in the system. I think everyone sort of points to this draconian scenario of 2008. We always want to compare it to where we are today. But I do think that when you look at short duration products in general they tend to be what I call negatively convex. In other words generally they tend to exhibit pretty poor characteristics in a really, really bad market. And I think, in general I think for, you know, not speaking for both, but that’s probably why it makes sense now. I think even if we weaken up a little bit, I don’t think anyone’s predicting you know, us going to the levels of the kind of scenarios we’ve had in sort of the last financial crisis.
Courtney: [00:09:58] Yeah. And everybody did though, as another point with that, relied on duration as a diversifier for almost the past three decades.
Thomas Swaney: [00:10:05] It’s been free, so actually it’s been the insurance that pays you. And if you really think about it, in fact you know, when you look at sort of the relationship between rates like I mentioned and equities in particular, we have gotten a lot of benefit particularly in the last 25 years from frankly, inflation expectations that never materialized in the bond market. So when you look at where rates were in the mid 80s, in the subsequent obviously freefall that’s all because we had inflation expectations that frankly were never met. And so when you look at where rates should be relative to where they are now today, it’s pretty clear that we’ve got one direction to go most likely, and it’s either up or sideways and neither one of those is going to be able to provide quite the scenario that’s going to provide the protection that you need from duration.
Shakil Riaz: [00:10:48] Put another way I think making the same point that the price … we paid the price for this with Mr. [inaudible] increasing rates to 15/16%, that set the kind of the foundation for this period which we have all benefitted from in a way. But on diversification I was going to make another point which was that it’s not just that stocks, bonds and real estate are the main components of a portfolio for a typical retail investor in the domestic market. But there are other very large markets that are being excluded from that equation; currencies are not part of most peoples’ portfolios at all, commodities much less so as well. And what happens with Liquid Alternatives, finally they can get some exposure with certain products to markets which they have never had an ability to participate in even though they’ve always had those risks. So US companies selling abroad is very subject to foreign exchange risk as we’ve found out recently. And every company in some way is affected by commodity prices. So we have the negative implications. But now you have kind of a proactive positive way to make those part of your portfolios.
Courtney: [00:11:58] Yeah. That’s such an excellent point, I mean people, especially I think retail investors on the surface might just think, oh you know, currency risk, strong dollar, you know, weaker currency Europe and elsewhere, and then, you know, the commodity complex really cratered and the energy complex as well. And then being able to get the right exposure to all of those elements, it’s such a critical point and you’re able to do that.
Shakil Riaz: [00:12:21] Absolutely. And we’re able to get that in a limited way both from the shorting component and benefit from the leverage component. And a typical hedge fund basically is only different from its long only [inaudible] in three ways. They use leverage to an extent, they use shorting to a great extent and they use derivatives to a great extent, optionality, right. Those are really the characteristics that make hedge funds different. Well, to a certain extent Liquid Alternatives have access to all of those capabilities, all be it in a lesser proportion in terms of the constraints of the liquids, the constraints of leveraging and shorting. But you still get that benefit as opposed to the long only. So there is definitely a diversification and a correlation argument to be made on asset class grounds as well as on risk process grounds.
Courtney: [00:13:15] Absolutely. And this kind of brings up another point, the democratization that we have seen through Liquid Alts, that really you didn’t have that before.
Salvatore J. Bruno: [00:13:24] Yeah. I think Shakil brings up a great point just on the breadth of the products that are available now. So you can get real … so you can get volatility, you can get short volatility, you can get almost access to almost anything through an ETF or an ETN structure at this point. You know, we think that is important to give end investors the same type of access that institutions have always had access to. And that’s why we came out with a series of products that sort of give you exposure to different hedge fund strategies and sort of standalones. So we have sort of a multi strategy, it’s an ETF, [inaudible] but almost as a synthetic hedge funded funds. But we also have all those individual sleeves available, four different sleeves available to give you exposure to the most popular hedge fund strategies. So the individual investor can actually almost become they’re almost funded fund manager themselves and say, “I want to go more on long short, I want to take some macro risk out, or maybe I want to go a little more market neutral in this environment.” So you know, we think that’s an important development to go along with the proliferation of just exposure across different asset classes.
Courtney: [00:14:14] That’s a really interesting point too because before advisors were just left with the tools of kind of just, you know, cherry picking funds here and there and hoping, you know, you have more of a look through than they had previously when it was, you know, just, you know, a 40/60. Or even I remember when Alternatives just had a 3% asset allocation for everybody, no matter your age or your risk profile. It’s really changed. I mean 3% just 10 years ago.
Shakil Riaz: [00:14:42] I think that the trend that started in the institutional world many years ago which is we went from trying to sell everybody a fund that we managed to sitting down with each client and understanding their risk profiles and their particular risk aversions and their portfolios needs and other parts of their portfolio and trying to custom tailor a solution to their requirements. That’s almost now migrating in a small way into the retail world. You’re now getting the capability of an individual sitting at home saying, “I’m comfortable with this type of risk. I’m comfortable losing this much money or making this my return target. I want to be in these markets” and actually building a portfolio that specifically is tailored to your own preferences.
Courtney: [00:15:28] That’s such an important point.
Thomas Swaney: [00:15:29] Yeah. I think the main difference too that we really … we probably should start to focus on is the reason why asset allocation hasn’t worked, or a traditional asset allocation hasn’t worked is that we haven’t been diversifying by the right factors. And so we’ve been diversifying by assets and unfortunately it doesn’t matter where those assets come from, it doesn’t matter what market those are tied to, if they’re all vulnerable to the business cycle and we become more global than ever, particularly post the financial crisis. So asset allocation really hasn’t worked. And so we have to start thinking more in terms of crisis correlations, in other words, what happens to our portfolio in times of stress when we really need diversification? And what are the average correlations? And I think we spend too much time in a mean variance type of optimization, focusing too much on the average correlations and not enough focusing on what happens to our portfolio in times of stress [inaudible], you know, 94, 98, 2002, 2008. I think in all those instances it’s been proven that asset allocation hasn’t quite stood up to, you know, it hasn’t really done what we’ve expected it to do.
Courtney: [00:16:28] Yeah. And correlations are such an important point, I mean they have the ability to really to dampen volatility, John, I mean that’s such an important thing that people need, we’re not really experiencing that much volatility now. But you know, in the next cycle we could be, it could be a great role for Liquid Alts.
John Harnisch: [00:16:45] Yeah, absolutely. I mean the Liquid Alt spaces gives you the ability to diversify a long only product if you’re just long bonds or stocks, it’s completely, you know, exposed to the business cycles or what’s going on with the global financial system. If you have the ability to, you know, hedge out some of those macro risks in a Liquid Alt product you can [inaudible] types of risk. So that’s why I think you know there’s a lot of excitement for this type of product. And you know when we run our books, we always try to, you know, hedge out the macro risks. Again that’s very, very important because you can’t tell when the next crisis is going to come. You know, if rates spike and the businesses start selling off or credit spreads start widening out, you have to be very protective against that. So hedging is very important in the Liquid Alt space.
Courtney: [00:17:21] Absolutely.
Shakil Riaz: [00:17:22] Correlations are interesting to talk about because I think in normal markets they’re very important to take into account when you’re designing portfolios or risk buckets. But you also have to design them as you were saying John, about the stress scenario, when you know, the market will always conspire to create situations where every smart person is losing money at the same time. That’s exactly how markets test the weak ends. And if you don’t design your portfolio for that moment in time I think you’re going to be surprised. So the stress testing for correlations in that sense is very important. The second point I would make is that in addition to understanding the threat of rising rates to what we are all talking about in terms of proving our value, the second piece of that is understanding the liquidity promise that we’re making to everybody. You know, daily liquidity is good up to a certain point. But as we all know if everybody goes to JP Morgan and asks for their cash today they cannot get it. And similarly the price of liquidity has yet not been stress tested. So even though we all say that you can get out at NAV, we have not really figured out what the slippage is going to be in a really stressed liquidity environment, and I think that will also be important for retail users to understand, and what role they want these Liquid Alts to play in their portfolios.
Courtney: [00:18:50] yeah. And that’s such an important point. I mean I think later in the program we’re going to get to the role that advisors will play and kind of catching up to where the institutions have been with this. We talked about events a little bit earlier, John, thinking back to when energy cratered, it caused a lot of indigestion in the high yield market, right?
John Harnisch: [00:19:09] Yeah, absolutely. I mean the high yield market became illiquid basically overnight. Energy was about 17% of the overall high yield market, you know, guys had a lot of exposure to that, and all of a sudden they basically blew to the risk limits, now they had to sell everything. So anything that was not even energy related was for sale. So [inaudible] spread wind out, stuff got lower and lower and it just became an illiquid market very quick. So yeah, I mean that’s a real issue in the market. And I think, you know, just coming back to your point about 2008, we had liquidity until the fall of 08, and all of a sudden it was gone. So you have to really protect yourself and think about that, you know, two steps ahead before, you know, something like that happens to your portfolio.
Thomas Swaney: [00:19:45] You know, I think now more than ever, you know, we can probably debate about, you know, when rates are going to rise, you know, where we really are going to … whether we’re going to reach a [inaudible] velocity in the US economy or not. But I think one of the things we probably, you know, I think it’s going to be difficult to forecast is the fact that correlations I think are going to be very surprising this time around. I think there’s been a lot of excesses starting to build up. We’ve had obviously, you know, six years of zero interest rate policy and that tends to have some unintended consequences. And I think to rely on traditional correlations at this point, much less volatility and you could see all energy’s a good example, you know, you create a, you know, a cheap form of capital for a really long time, bad things are going to start to happen. So I think a lot of these relationships that we’ve relied on for a long period of time, we should start to at least question it. And I think it’s that that where, you know, Alternatives should play a much bigger role as well, because I don’t think we can rely as much on even those, you know, those average correlations that we’ve had for long periods of time.
Courtney: [00:20:39] Yeah. And then strategy, wise Sal, I mean global macro, long short; a lot of these have much lower correlations.
Salvatore J. Bruno: [00:20:44] Yeah. And that’s exactly the point I was going to make, I think you raised the point very early, that is a great point, that asset allocation has not worked. I think the new paradigm is strategy allocation where global macro managers are going to behave very differently perhaps than, you know, market neutral managers. And we are taking out that equity, sort of that beta premium, that equity risk, and you’re just sort of focused on risk premia. That could be uncorrelated because you’re taking that sort of either direction of the market. And I think that’s sort of the new frontier, that’s where Liquid Alts can really play that role, is having exposure to different strategies as opposed to different assets, I think is really next level of diversification will come from.
Courtney: [00:21:17] Do you see that as well, Shakil, as a global macro?
Shakil Riaz: [00:21:19] Well, it’s interesting that global macro has always been a very big component of every portfolio we have constructed for clients over time. And part of the reason for that has been that it usually provides the best protection in a crisis, in a macro world, in a crisis world. Number two; it’s usually got the highest sharp ratio of more strategies over time, if you look at all the other hedge fund strategies. And it also has over time the highest absolute return even though it suffered a little bit in performance in the last few years because of the level of Fed and other Central Bank involvement in the markets where prices are reasonably artificial today. So the question … interesting question to me is why does macro have that behavior, right? And it comes back to what we were talking about earlier, it’s because they are completely opportunistic, i.e. if you have a long short manager specializing in healthcare and all the action is in technology stocks you’ve kind of restricted him to healthcare. But if you have someone who can go from Argentina to Japan to yen, to bonds, back to energy stocks that gives him amazing flexibility to be where the opportunity is the best. And so this person basically becomes the vulture of the financial world waiting with capital for something to get really cheap and then pouncing in. The secret to that is staying liquid.
And because macro managers are always in the most liquid parts of the spectrum, currencies, interest rates, usually sovereign markets, equity indices and volatility as an asset class and so on. It gives them the ability to liquidity combined with the really wide mandate that you’re giving these people, enables them to have those characteristics. And now through the Liquid Alts they are available to the retail clients.
Courtney: [00:23:14] Yeah. That’s such a good point. I mean that’s the ultimate go anywhere approach, right?
Shakil Riaz: [00:23:18] The problem is not … because it requires knowing a lot about a lot, there are not many people in the world who know how to do it really, really well. And that’s why the ones that are really successful become sports cars.
Thomas Swaney: [00:23:35] I can’t say enough, I think that’s a great point to mention too, because I think so far, and I like to be very balanced all the time when we talk about Alternatives. It’s not that they’re risk free; it’s not that they can’t go down in value; you still need to have a lot of manager skill. And I think in particularly currencies and commodities, you know, when you think about the effects of, you know, zero interest rates for a long time, you’ve mentioned the dollar already and you’ve mentioned some of these emerging market currencies and how vulnerable they are obviously in some of these economies to the dollar. And you see some of these things unfolding, commodities, yet another good example. They’ve largely lost their diversification properties. They’ve become financial assets and you know, obviously with China, you know, the infrastructure, metals, oil, there is a large part of the commodity world that’s very vulnerable to just global growth in general. So you know, I think you have to … you really have to pick your spots. You still have to have skill. It’s not without risks. It just when you’re down in these types of strategies, it’s not correlated to the rest of your portfolio. So you’re better able to absorb that downside when it does come.
Courtney: [00:24:33] Absolutely. That’s a great point. And with China ratcheting down growth, I mean you said it perfectly. I want to ask you, what are you seeing in the leverage loan market right now, John?
John Harnisch: [00:24:42] Yeah. The leverage loan market to us right now is a very unattractive space. Leverage loans are supposed to be a floating rate asset. Obviously loans are based off of Libor, three month Libor which is trading at 28 basis points. Most of the new loan instruments out there have Libor floors of a 100 basis points. So unless three month Libor goes up basically over a 100 basis points, there’s really no floating rate aspect to it. Underwriting standards have been very poor. So they’re basically like bonds, except they’re acting as loans. So you’re getting a very low current yield for a loan that basically is a bond with no covenants, very low yield. And so we don’t find really anything to do in that market. What we like to do is move a little bit down the balance sheet, the senior unsecured part of the, you know, capital structure, [inaudible] return, [inaudible] turn and a half of leverage for basically the same covenant package with a much higher current yield. So that’s what we’re kind of focusing on right now, definitely not in the bank loan space right now. Now, that could all change, if three month Libor drastically moves up or there’s you know significant outflows to the bank loan market, where it reprices the space, that could be [inaudible]. I think another thing to think about in the bank loan market is since there’s been a lack of basically supply in the space, a lot of these issuers have been re-pricing their loans they came to market with, you know, three, six months ago. So when you thought you were getting a 5% coupon, now you’re going to get 3¾% coupon. So you’re losing a lot of value in that space as well.
Courtney: [00:25:58] So a lot more opportunity you’re seeing lower down on the capital structure?
John Harnisch: [00:26:01] Yeah, absolutely.
Courtney: [00:26:02] Or with leverage?
John Harnisch: [00:26:02] Yeah, in the leverage credit space, you know, again we like to move down the balance sheet to the senior unsecure, even the subordinate part of the structure versus the bank loan, just given the fact that you can pick up excess yield if you do the right fundamental work on the credit.
Courtney: [00:26:17] Good point. Sal, tell me, active versus passive, I want to kind of get into that, tell me your thoughts there.
Salvatore J. Bruno: [00:26:23] Yeah, it’s an interesting debate. You know, I think it’s been mentioned earlier, there is definitely a lot of skill out there in the hedge fund community. Finding them, finding the managers that have the skill, accessing the managers and potentially getting into the LP structure where they may have limited liquidity can make that a little bit more challenging. So we think that certainly has a role in the portfolio for active hedge fund type managers. We also think that the hedge fund sort of as a standalone solution, just given the beta exposure of hedge funds, can provide a valuable piece of the portfolio. So we think of it in a core satellite approach. So you know, we think in the Alternatives, especially in the hedge fund space, that having sort of a core beta to a … we use a hedge fund replication which is sort of a synthetic hedge fund in our type strategy, we think it will form a nice core. And then you use satellite around that with the managers that really have most alpha and add the value. So we think that actually the two fit very well together and can play nicely together. Unfortunately they’re also, for all the good managers there are also a lot of managers that are sort of, by definition, below average and sort of paying the higher fees and the lack of a liquidity transparency, plus tax efficiency. That’s what we think those, you know, taking out those active managers and putting the passive beta piece in makes more sense to supplement, take them across structure relative to those managers.
Courtney: [00:27:32] And especially in this environment, beta has been very fruitful and inexpensive.
Salvatore J. Bruno: [00:27:36] Right.
Courtney: [00:27:37] Yeah. Do you think that will shift though if we see … I mean it seems in general, Alternatives kind of got a little bit out of favor in the past six year, you know, bull market when beta was plentiful, it was cheap. If we see a shift though in the next market cycle, do you think Alternatives are going to get more popular? And will that on the corollary apply to Liquid Alts?
Shakil Riaz: [00:27:57] Well, you know, you’re always supposed to get interested in something that’s coming out of favor and the more out of favor it becomes, usually it pays to pay more attention to it. So I kind of agree with the premise that given where equity markets are, given where interest rates are, that Alternatives certainly have an increasingly important role to play in most portfolios. But I think underlying all of that you have to understand how they create value. And if they’re creating value and diversifying the portfolio, if they’re creating value by using tools that others are not using, like shorting and options and leverage, if they’re getting you exposed to asset classes that others are not exposing you to like we talked about in currencies, commodities, perhaps even emerging markets then I think there’s a real source of value there. The interesting part about what Sal was saying, having a mixture of kind of active versus passive, I think the world is clearly moving in that direction because … and part of the pressure is coming from institutions who really want to understand and rationalize the fee structure of hedge funds and be able to say that, “Here’s a manager that really clearly has the alpha component that we ought to pay for. He’s the Michael Jordan of the investing world.” But here are other managers who probably want to just piggyback on his fee structure.
There’s nothing sacred about 2 and 20, it was just created by somebody because for lack of anything else. And now we’ve kind of accepted that that’s the fee basis. The 2 was never supposed to be a profit centre, the 2 was supposed to pay for your expenses. All of a sudden if you’re managing 30 or 40 billion dollars you’re certainly not spending all that money running your business. So the managers have some of them become conflicted. And I think having more and more products like replication, like Liquid Alts, like smart beta, like alternative beta, are going to force an equilibrium into the market that better crosses supply with demand on a price basis.
Thomas Swaney: [00:30:11] Yeah. When you look at the growth of this market already, you know, sort of let’s [inaudible] and take the non-traditional bond space for example, unconstrained bond funds, when you look at that space and you kind of add in some long short equity, I think there’s the number, something like 300 billion, 350 billion that have already … it’s already been allocated to this space. And that’s what equity markets have, 25/30% a year. We’re going into the seventh year of a bull market which I think has happened like twice since the war of 1812 or something ridiculous. So we’re getting a little long in the tooth. And when you think about the opportunity cost right now to go away from those asset classes that you’re most used to, so bonds, equities, the opportunity cost of going away from them has probably never been lower either, right. And if you think about where we are in the valuation cycle and where you are in yields, I think you know, you don’t buy a house and, you know, insurance on your house after it’s on fire. So I think now is the time to at least you know, dedicate a portion of your portfolio to sensible portfolio insurance and there’s certainly some Liquid Alternative strategies that would fit that role.
Courtney: [00:31:09] Absolutely. And I think that the opportunity cost is the best way to put it, the barrier is pretty low to just, you know. And what you said interestingly about institutions. When we saw CalPERS divest four million dollars out of hedge funds, you know, I don’t know whether that was attributable to fees or what, but you know, Liquid Alts could be, you know, and maybe that was an idiosyncratic move in the institutions. But they could be a way to fill the void where, you know, the institutions don’t want to pay 2 and 20 like you said. And it was kind of an arbitrary fee structure that just stuck.
Shakil Riaz: [00:31:42] I think institutions have to do their own self-examination about what role they want Alternatives in general to play in their portfolios. And if there is a need for a liquid component in their bucket because pension funds really shouldn’t have need for daily liquidity. I mean there’s something not … unless that’s the way they’re going to manage some of their cash component of their needs. I think that would make perfect sense. But for pension funds, long term assets I think they really have to understand the role they want Alternatives to play. For most large pension funds the problem really boils down to the following, they’re managing so much money that for them to pick the really good hedge funds to allocate to they would have to have a whole team of people to do their research, their due diligence, their monitoring on the huge number of hedge funds they would need to be invested with. And those resources just aren’t available to most public pension plans.
Courtney: [00:32:42] They’re just too expensive.
Shakil Riaz: [00:32:43] So either they’re going to have to subcontract it which introduces another problem with another layer of fees, which trustees usually don’t like to see, or they choose the CalPERS route which you said this is way too much work for what benefit it gives us because we have a small allocation to them. And we can’t see it growing to very a meaningful allocation that it actually makes sense in those cases to get out. But at the same time you’ve seen all the billion [inaudible] endowments have significant allocations to hedge funds because they’re able to be comfortable managing those risks.
Courtney: [00:32:43] Yeah, absolutely.
John Harnisch: [00:33:16] And I think one of the things we’re seeing is sort of bar belling on the smaller side, smaller endowments that don’t have the stats to do and they don’t have the size of a portfolio or a resource to go out and do the manager selection and all the accompanying due diligence. I think they’re looking for Liquid Alts and say, “Okay, no, I need some hedge funds, I need some Alternatives, how do I get it in a cost effect manner without having to employ a team of 5 or 10 analysts and incur all of those costs?” So we’re seeing even on the lower end of the institutional are much more interested in these types of products.
Courtney: [00:33:40] Yeah, absolutely. And what about mechanical replications, Sal, are you seeing a lot of issuance there with things like Merger Arb?
Salvatore J. Bruno: [00:33:47] Yeah. That’s been like a really interesting strategy, certainly we’ve seen a big uptake in merger activity over the last year or so and that has boded well for Merger Arbitrage type strategy. Most of our strategies are factor based. We’re trying to just identify the common factors that are driving hedge fund returns. That one is actually mechanical implementation. So it actually is very much like a Merger Arb hedge fund strategy except it’s actually governed by a rules base process. So in terms of the infrastructure to support and do all the research, is actually very small because we actually follow all our rules in which deals to get into, which deals to get out of, when to get out of them and how to apply our hedge. So we’re running at 75 basis points and it’s actually, you know, performed quite well especially as we’ve seen the uptake in merger activity.
Courtney: [00:34:26] Yeah, absolutely, a lot of M&A activity.
John Harnisch: [00:34:28] Do you worry at all Sal about the sort of the proliferation of all these other factor based, you know, ETFs and other types, where they’re all trying to exploit the same Alternative risk premia? Do you think that’s going to diminish at all the availability of that or the attractiveness of it or sharp ratio of that over time or…
Salvatore J. Bruno: [00:34:41] Yeah. We haven’t seen too much issuance in the [inaudible] in the Merger Arb space. But I think you’ll probably get it a little more towards the smart beta, which we definitely have seen a big proliferation going on there. And really smart beta’s sort of a generic term that a lot of people use, right, that’s not market cap weighted. Then they eventually, you know, you could see potentially, you know, the arbitraging, a way of those premia over time. But given the size of the equity markets and the relative size of the assets it’s still small relative to the overall size of the equity market, and the amount that’s benchmarked against market cap weighted indices like the S&P 500 far outweighs by a huge multiple, the assets that are in smart beta strategies. So eventually perhaps we could get that, but I think we’re [inaudible] away.
Courtney: [00:35:22] Interesting, great question. And John, tell me about your sector focus.
John Harnisch: [00:35:27] Sure. So we manage our portfolios or our credit books a little bit different than a typical, you know, credit manager would. We’re very sector specific just given our backgrounds in certain sectors, so for example, if you were to look at our portfolio it’s generally in industrials, services, aerospace, defense, telecommunications, industries that have really hard asset coverage or a real kind of non-cyclical business model. Generally these credits will have very clean balance sheets, very strong covenant packages. So if the companies do get into trouble you have some claim on the assets or you have some, you know, downside protection. We try to stay away from, you know, industries that have a lot of goodwill or intangibles on their balance sheets where if they do get into trouble, lack a financials company like a Lehman Brothers for example, the bonds dropped 60/70/80 points on basically nothing. In addition to tho9se sectors that we focus on, we try to diversify a little bit more by trying to buy securities that are non-ETF eligible within our portfolios.
Courtney: [00:36:18] Why is that?
John Harnisch: [00:36:19] Well, given the fact that if you look at the retail inflows and outflows especially in the last six months in the credit markets, whether it’s in high yield or investment grade, the price [inaudible] of some of those securities has been very, very drastic, guys need to basically fund redemptions. They’ll sell bonds at basically any price they can get on the market and will cause paper to drop 2, 3, 4 points basically on nothing, no change in fundamentals. So we try stay away from that. So if we look at a company that has an ETF eligible security, we’ll try to buy the non-ETF eligible security. So if the ETF bonds are for sale, that part of the capital structure is not, it’s usually a little bit more insulated from bad swings in the portfolio.
Courtney: [00:36:53] Interesting. Okay. And I want to ask as well about liquidity, just to pivot to that.
Thomas Swaney: [00:37:02] Yeah, it’s probably good to pick up on, right, I mean we were talking prior, and you know, that’s one of my biggest concerns right now, I think. When you … we’ll take the high yield market and maybe sort of just generically why I’m a little bit concerned. I think there’s three primary, you know, three reasons why, you know, the market in high yield is a little … I’m a little worried about it. And that is, one, these ETFs, when you look at the size of the ETFs relative to sort of how much liquidity is available in the high yield market and how finicky these ETFs are, you know, how influenced they are by like retail flows and how finicky those flows are and how correlated they are with the equity market. That’s a really big concern. And when you add daily liquidity to and pretty illiquid asset class to begin with, I’m a little worried about how that is going to sort of work itself out. Two, I think is also a big deal which is the banks in terms of the regulatory environment, Dodd Frank, the amount of capital that they’re committing to trade their trading business and how much, you know, risk they’re willing to take on balance sheet in order to facilitate a normal market.
And the third is that really high yield has never been tested by really a systematic rise in rates. If you think about the, you know, when the high yield market started late 80s, we’ve been on a freefall in rates ever since then. And a lot of people think it’s the duration aspect of it that I’m referring to. But it’s really not, it’s the composition of return. So if you were to think about, you know, going back to 2000 and we were to look at the sort of the ratio of credit spread to sort of risk free treasury rate, you know, kind of thing, you know, that was 3, 4 to 1 in favor of duration at one point. And now we’re 3, 4, 5 to 1 in favor of credit risk relative. So the compensation for risk has drastically shifted over the years. And I think those three, you know, three things just at least give me reasons to, at least in the near term, to be a little bit more cautious on high yield.
Courtney: [00:38:46] Yeah. Go ahead.
John Harnisch: [00:38:47] Yeah. No, I think it’s a very good point. It’s not just trying to sell a position. You can’t buy or sell, it goes both ways. So liquidity will dry up either on the, you know, buyer side or sale side. I think a very good example, you were talking about is in 2013 when the 10 year treasury went from 1.63% in five weeks, the liquidity in the high yield market dried up immediately. In the first 25 basis points there was no market for duration paper. So you have to be very, very careful about that. And it’s something we try to really stay away from, again being, you know, non-ETF eligible securities, it takes a lot of risk out of your portfolio.
Courtney: [00:39:19] Yeah. It’s such important points. I mean I think the fixed income market, didn’t it dry up to a quarter of what it was since 08, just through, was it Dodd Frank and…
Thomas Swaney: [00:39:30] Yeah, the very reasons we were talking. But I think this brings up to me the most important point which is gap risk. And that’s the risk I’m most worried about which means that for someone else, who’s going to be the marginal buyer of high yield and at what price when we start to get this freefall? And it’s that which I’m most concerned with, because I know most real money is sort of, you know, mutual fund kind of managers, they don’t want to sort of catch a falling knife. So they’re going to wait for things to settle out. And given the flows, that could be pretty persistent from these ETFs. I think that could pose, you know, at least something to worry about on the horizon.
Courtney: [00:40:01] Enormous, ETFs have just crossed the two trillion mark in AUM. I mean it’s growing like a weed, ETF inflows.
Shakil Riaz: [00:40:08] That’s really the shifting of risk from the proprietary desks of financial institutions and insurance companies and certain specs to the retail world, it is a remarkable transformation. And those two pools of capital behave very differently in a crisis. And I think we’re right to talk about what could happen to liquidity in a very quick and sudden gapping fashion as you put it, because these people are heard behavior kind of investors whereas any proprietary desk of a bank you always are sitting as the liquidity provider, that’s your function. So you’re waiting for something like a macro manager, you are waiting for something to get really, really cheap. And you already have a price in mind that you would buy it at. This is not … there’s no such capital exists today other than if central banks continue to do what they’re doing. So I think liquidity risk is the elephant in the room that we have to really worry about. And I think that will be the test for a lot of our products.
Courtney: [00:41:19] Yeah. It’s huge, I mean in some cases, things that are thinly traded already, the market maker is no longer the market maker, it’s really a huge paradigm shift.
Thomas Swaney: [00:41:28] And John mentioned before, even, you know, the investment grade market, we don’t even consider that to be some, you know, usually it’s very, very liquid. But even now that’s…
Shakil Riaz: [00:41:36] Managers are complaining about the liquidity in all markets to be honest.
Courtney: [00:41:39] All markets.
Thomas Swaney: [00:41:40] I think it’s because, you know, we have a tendency, I think, as investors to run from the last crisis. So leverage was the cause of the last crisis. And so I’m amazed how many people are willing to take on leverage but now the new thing is, well, we’ll take illiquidity and place it. So be careful what you wish for, there’s, you know, you’re going to pay a price I think when you come to some stresses in the financial market, whether it’s leverage or liquidity. And I think it’s funny how this pendulum has kind of swung the other way. But I think it’s still a concern one way or the other.
Courtney: [00:42:08] But is the flipside that investor demand has really grown because they got, you know, kind of scared in a way, the retail investor. And they weren’t … they’re the people that are driving this demand for daily liquidity.
Salvatore J. Bruno: [00:42:18] Yeah. They really are and it’s interesting because when you look at sort of the ETF marketplace, you know, it derives … ultimately derives its ultimate liquidity from the underlying assets because of the whole creation reduction process. What’s really interesting is that it also has that whole secondary issuance. So a lot of times you’ll see, you know securities trade, ETFs trade in multiples in terms of the dollar’s traded on the ETF relative to the underlying securities. And there’s sort of this breakout level. So when the ETFs are small they’re deriving a little liquidity from the underlying because of the creation redemption mechanism. As they reach a certain point there’s no hard level of where it is. But sort of once you get to that certain point that ETF actually becomes much more liquid than the underlying in a great example. And the equity world is sort of the emerging market equities where, you know, you can easily trade VWO or EEN which are two of the largest ETFs out there much greater than if you actually go and trade the underlying basket and that’s [inaudible] on any given day. So there’s sort of you become the beneficiary of that secondary market liquidity. Now, in a real liquidity event where you go in sort of one direction ultimately, sort of, you know, the buyer or seller of last resort, that’s where … back to your point, that’s what we’re really concerned about, but that sort of normal [inaudible] liquidity is sort of in that secondary market so you become the beneficiary of the greater of the underlying liquidity or the secondary market liquidity on the ETF.
?: [00:43:43] Well, Courtney, thanks for having me. And my question would be with Liquid Alternatives, understanding that the underlying investments, Alternatives by their nature are not liquid, what level of liquidity premium are investors paying to have access to illiquid investments inside of a Liquid Alternatives fund?
Thomas Swaney: [00:44:03] There’s an assumption there that I have sort of a bone to pick which is that believe it or not the underlying assets are actually usually very liquid. So I think there is an assumption that everything’s illiquid but in reality the underlying is liquid, for the 40 ECC it pretty has to be.
Courtney: [00:44:55] Yeah. And that’s another interesting point, I mean there’s 15% limit in 40 ECC funds.
Shakil Riaz: [00:45:00] For illiquid investments, yes. I think for … in answer to the question I would say you have to examine each vehicle separately for the underlying instruments that causes, the 40 ECC funds that I have looked at have varying degrees of instruments that could be illiquid or liquid, the instruments that we utilize we think are all salable within a day. But the question that I raised before is salable at what price? And that price will be determined, if there is a gap it will be a worse price than if it’s a normal market. But in our design assumptions there’s always the criteria that they should be salable within a day.
Courtney: [00:45:47] Salable within a day.
Shakil Riaz: [00:45:48] For macro and other investors that we put into the 40 ECC product.
Courtney: [00:45:54] What about for some of the other strategies?
Salvatore J. Bruno: [00:45:56] Yeah. I think really it varies by strategy, that was a point I was going to make. Clearly if you’re doing a venture capital type investment where you know you’re buying, and putting money into a company that’s going to be purchased and ultimately sold three or five years down the road. We know there’s illiquidity. But I think for the types of strategies that we’re talking about, it is liquid instruments just applying hedge fund type strategies. And I think I sort of articulated some of the three things that hedge funds do differently than long only managers. So it’s really applying those portfolio construction tools to a liquid universe, I think is sort of how we’re thinking about liquid alternatives as opposed to really trying to get at, okay, we’re going to give you venture capital returns. You just can’t do that, if obviously you’re tying some money up for five years.
John Harnisch: [00:46:32] What we probably shouldn’t overlook is the fact that we’ve had a lot of standardization of derivatives post the financial crisis so, and the collateralization of them is also very different. So prior to the crisis you could post, you know, corporate bonds, you could post other types of collateral that obviously could go down in value at the same time, you know, with a crisis obviously because assets are going to be highly correlated, whereas now you’ve got to post treasuries. So there’s been a lot of standardization, a lot of regulatory changes. And again, that is going to improve the liquidity ultimately in the market. And I think that’s one of the areas where the more we get to, the more these derivatives get cleared the more we’re using a clearinghouse, the more some of these sort of secondary risks get removed from the equation, and a greater price discovery we can get in terms of trading them. I think liquidity ultimately down the road is going to improve greatly.
Courtney: [00:47:20] So improved price discovery will improve liquidity in derivatives?
John Harnisch: [00:47:24] Exactly. And make people that are right now maybe a little bit hesitant to trade them a little bit more comfortable. So some mutual funds for example don’t trade a lot of single name credit default swaps because they’re just a little worried about the price discovery, you know, what kind of market, are they going to get a good price relative to some others. And I think the more we can standardize the market the greater … the greater price discovery. And then that’s going to just bring more players to the market.
Courtney: [00:47:45] Yeah. And with standardizing the market I mean it kind of begs the question, this seems like it will be the perfect product, Liquid Alternatives for a 401K. They’re not there yet but it seems like it could be, you know, a great product for 401Ks.
Shakil Riaz: [00:47:59] That is the ultimate opportunity for someone who is trying to manage their retirement money in a fiduciary sense. So if you think about 10,000 people a day are retiring in this country today. And if you use the example of a target date fund which originally was designed on the basis that as you get older we’re going to put more of your assets in a bond portfolio because that’s safer. Well, that whole logic has been turned upside down. So as you approach your retirement age, where do you go, from stocks to what, because you clearly don’t want to go more into bonds at this juncture, maybe someday later but not today. And I think Liquid Alts happened to be in the right place at the right time for somebody who’s worried about that particular problem as an example. It also applies to insurance company invariable annuity contracts, you know. If you look at variable annuities that some of us still buy, you can see all the offerings are stock and bond offerings. And there are no Alternative Liquid offerings. That could be another place where these play an important role.
Courtney: [00:49:08] Absolutely. And target date funds are in 401K plans. And as you mentioned, if you’re in a 2050 fund and you have a lot of fixed income and cash and cash equivalents and you’re retiring that’s maybe not as attractive as a scenario would have been if you were in Liquid Alts.
John Harnisch: [00:49:22] Yeah. And I think it dovetails into something we were talking about prior too, right, which is the education of the investor. And I think that’s where that … you mentioned that fiduciary responsibility. I think you’re very unlikely to see them outside of target date funds any time soon because of that, you know, so the nature of what am I getting and, you know, does the investor really appreciate their role in a portfolio. But I think you bring up a good question with these target date, why are there not a much larger proportion of target date funds is a really good question because I think that needs to expand. The universe needs to expand, include Liquid Alternatives.
Courtney: [00:49:51] Yeah, absolutely. Well, what do financial advisors do you think, what do they need to know that they don’t know yet about Liquid Alts?
Thomas Swaney: [00:49:59] I think one of the things they need to think about, it’s just not a long only product. Definitely the correlation between a long only product in the markets is very high. I think Liquid Alts is definitely a lot different though much lower correlation. I think in the Liquid Alt space it’s a very liquid product in the investments as we’re talking about, that are put in these products are very liquid so you can sell them or you can liquidate them if you need to. So it’s diversified, it’s just not a long only strategy. It’s not a beta strategy. It’s really, you know, taking advantage of different asset mispricing and liquidity and that’s the product. So you know we really like the Liquid Alt space right now.
Salvatore J. Bruno: [00:50:34] Yeah. I think the most important point to sort of educate people on is that hedge funds and Alternatives in general don’t necessarily have to … or are not really designed to increase risk. I think everybody sees, well such a manager was up 75% last year so that’s the hedge fund I want. But that’s probably really not the one you want because they’re probably not going to be likely to repeat that going forward. But it’s really sort of the steady Eddies, the guys that are clipping off you know, 3-6% over the risk free rate, steady every year low volatility, those are great additions to the portfolio. So I think that’s sort of been part of the problem for hedge funds, especially since we’ve gone to the zero interest rate environment since 2008. You know, they’ve returned 4 to 6 to 8% which has not been the 10-12% returns that people were us