JENKINS & MAGNUSEN: ALTERNATIVE INVESTMENTS TRANSCRIPT

September 19, 2014

Worried about the stock and bond markets? Are alternative investments the solution? Alternatives, such as hedge funds now come in a liquid mutual fund form so they can be bought and sold daily on an exchange. They are regulated and transparent, so you know what they own – and the fees are considerably less than hedge funds. Most are available to average individual investors. These Liquid Alternative funds have taken off – their assets have increased ten fold since 2005. Lipper’s Robert Jenkins and Altegris Advisors’ Lara Magnusen discuss the risks and rewards of alternative investments.

CONSUELO MACK: This week on WealthTrack, once the domain of institutions and the uber- wealthy, alternative investments are now widely available in a new form, and are open to individual investors. Liquid alternatives investments experts, Altegris Advisors’ Lara Magnusen and Lipper’s Robert Jenkins guide us through this hot territory. Next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. After the financial crisis, which was a huge blow to individual investors psychologically and financially, everyone was asking themselves what is the alternative to traditional stocks and bonds? Where can I go for true portfolio diversification and protection from market volatility and downside risk?

For answers they looked to what institutions and high net worth investors have been doing for years, diversifying into what were known as alternative investments, which traditionally cover a multitude of products. Among them: hedge funds, which could short stocks, bonds and other securities and had unlimited flexibility to invest wherever and however they chose.

Private equity and venture capital funds which make sizable stakes in mostly privately held companies. So called tangible assets such as real estate, timber, farmland and commodities.

But these investments had their own set of problems. They were illiquid, you were either locked into them for a certain period of time and/or there was no market for them if you wanted to get out during the crisis. Many were opaque, meaning you generally didn’t know what was in them and they had very high fees.

Since then Wall Street has come to the rescue with a new class of alternative investments that is supposed to solve many of those problems. They are called liquid alternatives. They come in mutual fund form so they can be bought and sold daily on an exchange. They are regulated. They are transparent, so you know what they own and their fees are considerably less than hedge funds, although they are generally more than typical mutual funds, and most are available to average individual investors.

Liquid alternative funds have taken off. Their assets have increased ten-fold since 2005, from $33 billion, to $73 billion at the height of the financial crisis in 2009, to $123 billion in 2010 to $177 billion in 2012 to $308 billion in 2013.

Liquid Alternative funds also come in all shapes and sizes. At last count mutual fund analysis pioneer Lipper had identified 11 different categories, including the most popular by far, Alternative Credit focus funds, also known as Unconstrained Bond funds, Alternative Long/Short equity funds, the second most popular and Absolute Return funds, coming in at a close third.

What role should liquid alternatives play in a portfolio? Which ones, if any should individuals consider for their portfolios?

Joining us are two pros in this burgeoning field. Both are newcomers to WealthTrack. Robert Jenkins is the Global Head of Research at Lipper and has over 20 years of experience in the financial services and asset management industries including stints at Fidelity and McKinsey & Company.

Lara Magnusen is Director of Investment Products and Member of the Investment Committee at Altegris Advisors, an alternative investment management firm. She was formerly its Director of Research and Investments. She holds the designation of Chartered Alternative Investment Analyst, or CAIA.

I started with the basics. Asking them each to define what constitutes an alternative investment?

ROBERT JENKINS: Well, when we think about alternatives, and one of the important caveats here of course is that it’s still very much evolving, and for years I know a lot of asset management firms, a lot of advisors, they looked at anything that was alternative that wasn’t stocks, bonds, cash. That included commodities and pass-throughs like REITs, et cetera, and I would view those more as alternative asset classes because they kind of have a distinct value proposition to them. Nowadays what everyone’s really talking about are Liquid Alternatives, and we view these as alternative strategies. Often times they have hedge fund-like strategies kind of embedded underneath whether they’re using shorting or derivatives or leverage or what have you. Also often times they have multiple asset classes embedded within them as well, and the really nice thing about them, the reason why they’re so popular now is they contribute a benefit in terms of correlation and diversification to a portfolio.

CONSUELO MACK: So Lara, how do you define an alternative investment?

LARA MAGNUSEN: The category is very big, but not all alternatives in those categories are created equal. So there’s some strategies that are more like long-only strategies that are simply hedged. That will fall in the alternative category bucket. I think our view of true alternatives, thought, are absolute return strategies. These are strategies that can trade in a liquid format and can trade long and short and have a lot of flexibility to do that and, more importantly, they don’t only hedge, but they can actually make money in the down side or at least that’s the goal. To us, those are real alternative strategies, strategies that can be typically or formally found in a private fund structure but are now available in a liquid format.

CONSUELO MACK: And why are these things so popular right now?

LARA MAGNUSEN: There’s a lot of reasons. I think the first reason is that everybody’s seeing what’s happening in the markets right now. You have equity markets at near all-time highs, and we have a fixed income environment where rates are going to eventually rise. We don’t know when. Our view at our firm is that they will rise sooner rather than later, but they will rise, and so you have all these dynamics going on in the market right now, and people are really looking to protect their portfolio, to dampen volatility and be invested in assets that aren’t as correlated to their traditional portfolio. There’s a second part to that, too, which is that there’s a lot of talent available in alternative investments where there wasn’t before. Previously, five years ago, a lot of real alternative investment managers, so not long-only managers who are now entering the space, but true hedge fund managers weren’t interested in this type of product, and now they are. Diversifies their asset base, they see where assets are going, and now they’re entering the fray, so you’re getting these top flight hedge fund managers who are now available in a liquid format. So retail investors are getting very similar access to what an institutional investor only had before.

CONSUELO MACK: What should we expect from an alternative investment? And I’m looking at some of the things that I read, you know, strong risk-adjusted returns for instance, low correlation traditional asset classes, reduced portfolio risk. I mean, do all alternative investments do those three things? Or you tell me.

ROBERT JENKINS: No, they really don’t, and the way we look at it at Lipper is I kind of break it down into two categories. We have risk diversifiers and return enhancers.

CONSUELO MACK: Oh, interesting.

ROBERT JENKINS: So the risk diversifiers are a lot like Lara’s talked about with the kind of absolute return strategy and market neutral, and these types of strategies … Managed futures in another one. These strategies are all looking to try to temper the market fluctuations as much as possible and really zero out market exposure altogether, and the good ones, the absolute return products in particular will generate kind of a cash plus component on top of that. So it’s kind of a steady eddy, if you will, for your portfolio. The return enhancers, these would be event driven, global macro. These are types of products that are really … You kind of put them in there to juice the returns in your portfolio. They’re not necessarily going to provide for you any sort of diversification benefit. If they do, it’s kind of happenstance, but they are very much hedge fund-like strategies still.

CONSUELO MACK: So for instance in a bull market like we’ve had, they would enhance even a bull market performance.

ROBERT JENKINS: They should.

CONSUELO MACK: They should?

ROBERT JENKINS: I mean, the point is that a lot of these things are not trying to necessarily hedge against market down side. They’re really shooting for the fences, if you will.

CONSUELO MACK: I know at Lipper you’ve got 11 different alternative investment categories and, Lara, I read Altegris’ research, and basically you’ve broken it down to five different categories. So what are the ones that we should really pay attention to?

LARA MAGNUSEN: Well, I think for us what we’re seeing in terms of popularity is the unconstrained bond category, and this goes back to the idea that rates will rise eventually. We don’t know exactly when. Our view at Altegris is they will rise sooner than the Fed thinks. That’s for sure, but if we know rates are going to rise and you know you have this risk in your fixed income portfolio, why not peel some of that away? We’re actually saying of your fixed income allocation, we’re saying to peel away 25 percent of that which ends up being about 10 percent of your overall portfolio and put that into unconstrained bonds.

CONSUELO MACK: And what is an unconstrained bond fund?

LARA MAGNUSEN: Well, that’s another good question. An unconstrained bond fund can be many things. There are several different types of approaches. There’s floating rate bond fund. There’s credit long-short. There’s funds that are literally designed just to reduce the duration in your portfolio. I think for us …

CONSUELO MACK: By duration, interest rate risk and maturity.

LARA MAGNUSEN: Interest rate risk. Exactly, exactly. So for us at Altegris, our view is that if you’re going to take risk right now, you want to take credit risk over interest rate risk, and you want to do it with hedge fund investments through a liquid format that allow you to do that in a way where you’re actually generating alpha, meaning that you have managers who are selecting the right credit instruments and are able to trade it in a long-short manner. So they’re not just protecting you from interest rate risk, but they’re also selecting the right securities, and I think that’s really important, too.

CONSUELO MACK: And I know at Lipper, Bob, you call that alternative credit-focused funds. Is that correct?

ROBERT JENKINS: True, and I’ll back up Lara’s statement. They have been the biggest flow generators so far year to date and last year as well.

CONSUELO MACK: Right, 113 billion according to your most recent figures?

ROBERT JENKINS: Yeah, and by three-fold really, so the next two popular categories are long- short, kind of traditional long-short funds.

CONSUELO MACK: In equity, long-short equity?

ROBERT JENKINS: Well, long-short is typically an equity product, yes, and of course absolute return. They’re about even, running neck-and-neck, if you will, for second and third. So those are the ones where investors are flocking to, and really the unconstrained bond product as Lara mentioned is really the one that’s garnering the real lion’s share of flows right now and really for a good reason. When you look at the way a lot of these managers … Not all of them, but a lot of them are running these, they have a very good hedge component in there. Some of them are even negative duration, and also they have a very strong like currency management team as well. So they’re managing the currencies because they’re really going global in terms of finding opportunities for these funds.

CONSUELO MACK: Is the unconstrained bond fund, is that particularly important at a time now where we’re in a low interest rate environment? It’s hard to find return, plus we could be in this transition where we might be shifting to a higher rate environment.

LARA MAGNUSEN: That’s right. That’s right. Well, as cliché as the statement may sound, you don’t want to buy fire insurance when your house is on fire. You want to do it ahead of time. You want to do the homework, and you want to find that right investment that you can have for the long haul that isn’t just there to manage your duration risk but that you can have as a permanent allocation in your portfolio. So it’s really important to do that type of homework now. In terms of other popular strategies, we’re really seeing long-short equity, as you mentioned, gather recent flows, and I think that’s because of where we’re seeing the equity market right now. I think a lot of investors know this can’t go on forever. There is legs to the equity market, but they want that downside protection, and they also want to be invested with managers who can actually select these securities, and I talked about that with the fixed income side, but it’s equally important on the equity side as well where you’re replacing the beta in your portfolio, and you’re actually looking for alpha- generating strategies.

CONSUELO MACK: Because, but it’s interesting. I mean, my understanding is … And Bob, you tell me … That the long-short equity funds for the last five year have underperformed. Is that right?

ROBERT JENKINS: No, actually they’ve done pretty…

CONSUELO MACK: The S&P 500?

ROBERT JENKINS: Oh, they’ve underperformed the S&P 500 for the most part, yes.

CONSUELO MACK: No, that’s what I’m saying.

ROBERT JENKINS: Yes, they have. You’re right. You’re 100 percent correct on that, but they’ve done pretty well, and that’s the thing about alternatives in general. I think one thing I think both of us would like to get out there is how you actually measure and benchmark the success of an alternative fund manager, and people…

CONSUELO MACK: So how do you do it? Because you talk about it at Lipper now all the time. Right?

ROBERT JENKINS: We’re still working on it.

CONSUELO MACK: There is no benchmark, per se.

ROBERT JENKINS: No, there really isn’t, and the benchmarking piece is something that we’re all still working on quite a bit because it’s hard because a lot of them, again, are using multiple asset classes. They’re using derivatives and so forth and how do you actually create kind of a floating benchmark to kind of go along with the strategy of the manager.

CONSUELO MACK: So? How do you do it?

ROBERT JENKINS: It is difficult, but what people have to understand is, are they true to their objectives, true to the mandate? Are they adhering to what they should be doing? For instance a market neutral fund, they have performed horribly, not horribly but not well relative… CONSUELO MACK: A market neutral fund.

ROBERT JENKINS: Yeah, relative to what the market’s done over the past five years. They haven’t done great. Managed futures have not done great, but they’re doing by and large what they’re supposed to do which is kind of clip along at a nice even, tread water, a nice even pace over that time and not go with the market gyrations, and you’re going to want that if the markets start to tail down.

CONSUELO MACK: So that’s another interesting aspect to this. Of course, the popularity of alternative investments, they’ve occurred since the market crisis because people were looking for downside protection. Here we have a rip-roaring bull market and so you’re looking at your portfolio. Why am I invested in these alternative investments?

LARA MAGNUSEN: Why is this in here?

ROBERT JENKINS: Why am I in this?

CONSUELO MACK: Because they’re under-performing the market.

LARA MAGNUSEN: I think it all comes down to expectations. It really does. When you’re adding alternative investments to your portfolio, you are generally adding a benefit of lower correlation to traditional markets.

CONSUELO MACK: And just for our viewers, I think they know, but the lower correlation is if the market goes up, they don’t go up as much or they go down.

LARA MAGNUSEN: Right, which is what they’re supposed to do. So if you were invested let’s say in managed futures during the 2008 financial crisis, you were very happy you had that allocation in there because generally managed futures performed very well versus traditional equity markets let’s say, but the following years managed futures hasn’t performed as well, but that’s as expected. It is not designed to perform as well when the equity market is rallying. So you have to understand the intent of putting that type of alternative investment in your portfolio. Know why it’s there and have it in the right allocation size.

CONSUELO MACK: So what is the right allocation size for instance for a non-correlated asset that isn’t going to participate in a bull market, whether it’s the bond bull or the stock bull?

ROBERT JENKINS: The classic economic answer: it depends. So it depends on the risk profile of the investor, their goals, their horizon, et cetera. We find that even as low as like eight, nine percent allocation to say a market neutral product, you could see benefits in terms of risk return across the portfolio. So we recommend to get at least in that range. A lot of institutional investors are in the 20 to 30 percent range. So I think like retail investors and advisors should be thinking about anywhere from eight to twenty.

CONSUELO MACK: In alternative investments in general.

ROBERT JENKINS: Well, not in general again, because now we’re going to talk about some that are more return enhancers, and those will just add risk and maybe not necessarily help your portfolio. We’re talking about more of the ones that Lara mentioned earlier, absolute return-type products that are really trying to gain towards having zero market exposure.

CONSUELO MACK: What are the other major categories, Lara, that you at Altegris that you think we should consider as individuals?

LARA MAGNUSEN: Sure. Well, we look at it a little differently than Lipper does. We look at sort of three main categories and a few subcategories which is I think what you read in our recent paper which has five, but we look at alternative equity, alternative fixed income and then macro, and within macro you also have managed futures, and to us macro and managed futures are really divergent strategies. These are uncorrelated strategies that haven’t done very well with the advent of quantitative easing and markets all rising in unison, but they are designed to provide what we call crisis alpha. So when things start to turn a little bit, you know you have this volatility damper. You know you have the potential to actually make returns as well. Then you have alternative equity which we’ve spoken about and alternative fixed income, and these are really allocations that should come from your long-only equity portfolio and your long-only fixed income portfolio to provide enchantment, to provide diversification and to provide protection.

CONSUELO MACK: So again a portion of your long equity portfolio, a portion of your long bond portfolio should go into these alternative, these long-short funds.

LARA MAGNUSEN: That’s right, and to us all of that is absolute return. So our recommendation is actually a little bit higher, and it’s very similar to the institutional recommendation which is we recommend a 35 percent allocation to alternative strategies which are absolute return-oriented, the vast majority of which can be accessed through liquid alternative mutual funds, and we think that’s very synonymous …

CONSUELO MACK: Thirty-five percent.

LARA MAGNUSEN: Thirty-five percent, and that may seem …

CONSUELO MACK: That’s kind of endowment territory at least.

LARA MAGNUSEN: That is. It is, but now you have access. There’s no reason why a retail investor can’t have access to the same quality as an institutional investor now. The quality of managers who are sub-advising many of these strategies is higher than it’s ever been before. There’s no reason why my Mom, my Dad can’t have access to those same managers and in a liquid format.

ROBERT JENKINS: And I think also another thing to consider here is very good qualified hedge fund managers are coming into the space. They’re not able to replicate their strategy perfectly in this space.

CONSUELO MACK: And tell me about that, we can’t expect the same sort of return.

ROBERT JENKINS: Right. The bad part is they have certain liquidity requirements, transparency requirements and leverage-related requirements…

CONSUELO MACK: In the mutual fund space.

ROBERT JENKINS: In the regulated mutual funds space constrain them a little bit. The good side is they do have actual experience doing this, and this is the other caveat we have to think about. Right now alternatives are a very popular space for asset managers in general, traditional asset managers primarily because…

CONSUELO MACK: Because…

ROBERT JENKINS: It’s got a very nice fee structure. They’ve seen a lot of their more lucrative active management fees particularly in equities move towards passive and ETF. They need this new product line. So a lot of folks are stepping in to this side of the business who have no experience, and I can tell you really a value manager can’t run a growth fund. A long manager can’t run a short fund. A manager who has never really dealt with a lot of derivatives can’t really just go into a fund and start running a managed futures fund. So there’s a real problem there, and you have to be very careful about who you pick to run your fund.

CONSUELO MACK: So tell us about Altegris’ criteria, because what you do is you manage the hedge fund. So you pick hedge funds to put in the funds that you are selling to clients. So how do you pick your managers?

LARA MAGNUSEN: Very similar to Lipper. I mean, we’re looking at these track records. How did these managers manage these portfolios in a period of crisis? Because that’s how you can really tell how a manager can manage his portfolio. If you’re looking at an equity long-short manager that’s very net long and has only managed since 2009, it’s very hard to interpret what his skill set is. You want a manager who’s managed through the dot com bubble burst, managed through 2008. You want to be able to see that track record and understand how they’ve traded, and you want to see in the majority of cases that they’re running these strategies that we call pari passu. So they are running it in a very similar format and, to your point, not all do that. So it’s really important when you’re looking at potential investments, you’re looking under the hood, and you’re seeing if these managers actually have that kind of track record and that they’ve run this strategy in a very similar format prior to.

CONSUELO MACK: A couple of years if I talked to an investment consultant for instance, they would tell me that it’s only the inferior hedge fund managers that are opening themselves up to individual investors and that are going this liquid alternative route, because the ones that are really good don’t need our money. They have the money from the institutions and high net worth individuals. Has that changed? What’s the inducement for a really successful hedge fund manager to expose themselves to the scrutiny of the SEC and if they’ve got the public investing with them.

ROBERT JENKINS: Well, it’s another pool of assets to get a hold of, number one.

CONSUELO MACK: Right. Okay, so that’s money.

ROBERT JENKINS: Yeah, and in some cases, depending on where you’re able to position that vehicle, it can be a very stable pool of assets. So if you find yourself, for instance, with a target date fund in a 401(k) plan, you’re going to have a very steady stream of contributions coming in, that is nirvana for an asset manager to have a predictable, steady stream of new cash flow coming in to an account. So that’s one reason why they’re very interested in it.

CONSUELO MACK: Caveats of fees. Bob, I know that you feel strongly about this because I’m looking. I think the average for an alternative, a hedge fund of funds for instance, is 1.85 percent for a multi-alternative strategy, and so you’re paying not only for the Altegris’ of the world, your management, but also you’re paying for the funds that you’re investing in. So does the performance make the difference? I mean, is it worth it?

ROBERT JENKINS: Well, that’s still kind of the jury’s out a little bit, and we talked a little bit about the fact that some of these are fairly new since the crisis, and I would say that you can’t necessarily say that just because we’ve only got five years to look at, we can’t pick good ones. One of the things that sticks out in my mind is if you’re way above like the peer group in terms of your performance, in a lot of cases you’re probably not doing a good job. If you’re a Market Neutral and Absolute Return product and you’re double digit returns through this time period, there’s a chance you’re probably taking too much risk. So I think the ones who aren’t running it correctly are showing themselves even during the bull market.

CONSUELO MACK: Right. What’s your response to the fee structure that you’re seeing in a lot of these alternative investments which are quite high?

LARA MAGNUSEN: Yeah, I think it’s really important to compare them to the private fee structure first which is you’re typically paying two and twenty. So a two percent management fee and a twenty percent performance fee.

CONSUELO MACK: Of the profits.

LARA MAGNUSEN: So an average of 1.85 percent is actually much lower than that, and you’re getting in a liquid format. So I think you’re actually getting a very good deal, but you’re not performing as well as say the S&P 500, but again it goes back to expectations. Now when you’re looking at these alternative strategies versus a passive ETF that’s a much lower fee, what you have to do in your analysis is look at net of fee returns and the intent of that investment in your portfolio. Because at the end of the day, all that matters is the performance after your fees, and that’s what we encourage investors to look at, and again look at those track records. I know I sound like a broken record, but if that track record can be repeatable, it’s worth it. It’s a tradeoff. It’s a talent trade-off, a fee for talent tradeoff that we think is well worth it.


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