Content Provided by Shana Sissel, CAIA – Portfolio Manager

In today’s turbulent markets, more and more financial professionals are beginning to look to alternative funds for investment options. As a result, more investment managers are beginning to create alternative funds, and many hedge funds are registering their products under the 40 Act, making them more accessible to investors. As the interest in alternatives grows, so does the confusion. At many of the industry conferences I’ve attended lately, I’ve heard investment advisors ask “But where does it fit?” A review of the endowment model may shed some light on the issue.

In 1952, Harry Markowitz introduced the world to modern portfolio theory. Originally, modern portfolio theory focused on having a diversified basket of stocks to help spread out the risk in a portfolio. In 1958, John Tobin suggested introducing a risk-free asset into the portfolio mix to create a more attractive risk-reward profile. Five years later, William Sharpe introduced the Sharpe ratio and the efficient frontier. The idea was simply that with the right mix of stocks, bonds, and cash, you could create the optimal risk-reward profile for your portfolio. Over the next few decades, these ideas became even more refined, first suggesting diversification across market-caps, then across countries, and finally additional asset classes with the advent of real estate investment trusts (REITs) as investment vehicles in 1986. As you can see, the theory of portfolio diversification is constantly evolving to create the best risk-reward profile for investors.

As the media becomes more and more influential in our daily lives, we, as investors, are beginning to recognize the fantastic returns generated by the large university endowments, such as Harvard and Yale. The consistency of the endowments’ outpaced returns, even during difficult markets, has piqued the curiosity of many investors and led to increased research into their methods. As a result, investors are beginning to realize that these portfolios contain significant exposure to alternative investments, in the form of hedge funds, private equity, and real assets. The average endowment allocates between 60% and 80% of its portfolio to these investments.

So, the question remains, how do we enhance the risk-reward profile in our portfolios? Clearly, it is not feasible to allocate 60-80% of our portfolios to alternatives, simply because the liquidity needs and time horizon of the average individual investor are very different from an endowment. In my research, I’ve analyzed several different models to find the best mix, regardless of risk tolerance. That “optimal” allocation seems to be somewhere between 10% and 20%. In my research, 10% to 20% provides enough improvement in the risk profile without negatively affecting the excess return potential of the portfolio.

Recently, the Alternatives Broad Asset Class ETF (BACE) team at CLS met to review our current Focused Alternatives portfolio. We had noticed that despite the portfolio’s strong performance, it was not exhibiting the risk and correlation characteristics that we want our alternatives allocation to have. The portfolio had a correlation with equity markets that was simply too high, so we worked to make a change. We evaluated the landscape of alternative ETFs, and after completing an analytical review, we landed on AGFiQ U.S. Market Neutral Anti-Beta Fund (BTAL). BTAL provides exposure to the spread return between low and high beta stocks by investing long in U.S. equities that have below-average betas and shorting those securities that have above-average betas, within sectors. We chose to replace our allocation to ProShares Large-Cap Core Plus (CSM), a 130/30 fund. We chose CSM because it had a correlation of about 1 with the S&P 500 Index. By swapping CSM with BTAL, we could quickly and effectively reposition our portfolio to better meet our objectives for our alternatives allocation. It reduced our overall correlation with equities and significantly improved our CLS Risk Score.

Ultimately, that’s what using alternatives is all about: diversification and risk management. By using alternatives to improve both risk and diversification, it allows us to take risk in areas where the rewards can be more lucrative. I think that’s what many investors forget. Alternatives aren’t necessarily where you get the most bang for your buck; they are a tool to help you construct a portfolio with a better risk-reward profile. So, when you start thinking about using alternatives, consider it the seasoning to enhance the other ingredients you’ve included in your recipe for the optimal portfolio.