Beating risk with alternatives

In an attempt to reduce tail risk, a large US west coast endowment allocated up to 15 per cent to a Man Investments’ portfolio of alternative strategies that includes global macro and managed futures.

Most institutional investors are coming to terms with the large amount of risk in their portfolios due to their high allocations to equities – it is how they choose to diversify the risk exposure where interest lies.

One way is to consider liquid alternative investment strategies that capture directional opportunities, both long and short, in a range of asset classes.

Head of portfolio management at Man Investments, Art Holly, says the major problem for many investors is they have embedded equity in their portfolios far too much.

“There have been 50 years out of the past 90 years where equities didn’t make a dime for you. Why should that be 70 per cent of your portfolio?” he says. “You can smooth your returns and get a better ride without that sort of volatility. We believe you can use hedge funds to achieve that – specifically equity hedge, global macro and managed futures.”

Holly says most investors build portfolios on two strategies – equity traditional beta and fixed-income traditional beta.

But, he says, hedge funds can expand that scope by considering traditional beta alongside alternative beta and primitive trading across various asset classes such as equities, fixed income but also commodities and foreign exchange.

In this way he says an “all weather” return-enhancing portfolio can be built with both long-only equity and liquid alternative investment strategies including global long-short equity (equity hedged), managed futures and global macro.

The giant alternatives manager did this for one client, the west coast endowment, which has been running a version of Man’s Proposed Refinement strategy since 2008.

“The endowment already had allocations to equity hedge and event-driven strategies, but in 2008 they were concerned and wanted to build something to alleviate left tail-risk, so we added global macro and managed futures,” Holly says, adding the latter two strategies are the best diversifiers of the downside.

Managed futures, in particular, he says are so diversified, and non-correlated, to equity.

“As equity markets go up or down they can make money, agnostic to the direction of equity markets.”

Holly says equity volatility and high-equity draw-downs can be reduced by substituting part of a pension fund’s long-only equity with directional, liquid alternative investment strategies: global long-short equity, managed futures and global macro. Its model portfolio, the Man Proposed Refinement, is made up of 21 per cent of managed futures, 44 per cent equity hedged and 35 per cent global macro.

“We build only customised solutions and our clients see us as being an extension of their research team. For example they see us as a 120-people extension to their own investment team. We literally hand-held them during the build of their portfolio,” he says.

The allocation, comes out of equities, with the amount varying from about 15 to 10 per cent depending on their chief investment officer’s view of the world.

Man Investments’ Holly says growth assets tend to show a return profile with cycles, while these suggested ‘liquid strategies’ display a dynamic adjustment of the correlation through time, which is an attractive diversification opportunity.

Man’s analysis shows that a balanced allocation to the three liquid strategies creates a portfolio with a strong track record – 10.5 per cent annualised return over the 10-years of January 1999 to April 2010, compared with a growth asset allocation of 7.06 per cent return. But it is also creates a portfolio minimising losses.

“It is a way to win without losing,” Holly says. “We wanted to come up with a better mouse trap, what would make people happy and satisfy their problems. We want two thirds of the upside and one third of the downside of equity returns and are trying to get clients to build portfolios with alternative alpha and beta.”

“Alternative beta is a relative beta game, it’s very liquid and transparent environment. Hedge funds fall over because they are: overly leveraged, overlay concentrated, or overly illiquid, they succumb to style drift.”

Holly categorises hedge funds into five groups:
1. equity hedge
2. event driven, including merger arbitrage, distressed managers and special situations
3. relative value, including fixed income arbitrage, credit arbitrage, equity market neutral, and multi-strategy
4. global macro, including commodities, emerging markets, energy and global traders
5. managed futures, including long term and short term trend followers.

Man Investments has 160 managers in its universe and 76 per cent of its assets are allocated to those in more nimble managers that have between $500 million and $1.5 billion under management, those Holly calls in “the sweet spot”.

The weighted average asset allocation of the endowment, which is made up of the individual campus endowments, is 18.4 per cent to US equities, 23.1 per cent to non-US equities, 14.4 per cent to alternative equities, 14.1 per cent to US fixed income, 3.7 per cent to non-US fixed income, 3.1 per cent to cash and 23.2 per cent to absolute return.