Why manager selection is critical for alternative investors

The difference between the top and bottom performers can be significant

Apr 11, 2018 | Walter Davis

The recent (and long-awaited) return of market volatility has put alternatives back on the radar screen. But not only must investors familiarize themselves with the different types of alternatives that are available to them, they must also assess the skill level of the managers running these funds. Manager selection is a question that all investors face, of course, but it’s especially critical for investors in alternatives because these managers have greater freedom in their investment strategies. This freedom leads to a wide dispersion between the top-performing and below-average alt managers, and that dispersion is typically greater than what is found in traditional equity investments.

What might be causing the performance gap?

While the performance of any fund or security is never guaranteed and will fluctuate over time due to a wide variety of factors, we believe that there are two main reasons why there could be a wider performance gap in alternatives as compared to traditional investments:

1. Most alternative strategies aren’t tied to a traditional benchmark. In traditional long-only stock investing, the manager’s performance is typically benchmarked against the common index that best matches the long-only strategy. Furthermore, the index itself is comprised of a basket of individual stocks whose characteristics are consistent with that of a particular category. When investing, many managers will primarily invest among the stocks that make up the index, overweighting those stocks they believe will outperform and underweighting the ones they believe will underperform. As a result, performance tends to generally track the index, with the managers’ active weighting decisions contributing to outperformance or underperformance.

Like traditional long-only indexes, alternative investments have various performance indexes that seek to measure performance for various strategies (e.g. Long/Short, Global Macro, Market Neutral, etc.). Alternative indexes, however, differ from traditional indexes in that the index is typically an average of manager performance (as opposed to being comprised of a basket of underlying stocks). As a result, alternative managers have more freedom to define and pursue their own investment objectives (within the parameters of the fund prospectus). Such objectives tend to vary widely across managers, even among those using the same strategy. The pursuit of widely differing investment objectives understandably leads to a wide dispersion of returns across alternative managers.

2. Alternative managers have much greater flexibility than traditional managers with regard to how they invest. Traditional portfolio managers typically invest on a long-only basis within well-defined strategy classifications (small-cap growth, large-cap value, emerging market, etc.). Thus, these managers generally employ similar approaches and invest across the same universe of investments. The opposite is true for alternative managers.

While the strategy classifications for alternatives are also well-defined, alternative managers have much greater flexibility with regard to how they execute their investment approach.  Furthermore, depending on the strategy, alternative managers may have the freedom to invest on both a long and short basis across different categories of stocks (large cap, small cap, domestic, international, etc.). They may also invest across multiple asset classes (stocks, bonds, currencies, commodities, etc.) and use a variety of complex trading techniques. In addition, alternative investments are more technical in nature and use more complex trading techniques that are impacted by market conditions. To deal with these factors, the investment approaches employed by alternative managers tend to vary greatly. This can lead to a wide dispersion of returns.

Two ways to help address manager risk

For these reasons, manager risk (the risk of selecting an underperforming manager) may be greater for alternatives than for traditional investments. It is critical that investors be aware of this risk and the role it may play when considering an investment in alternatives. In my opinion, there are two actions that may help mitigate this risk.

1. Conducting due diligence on the manager before investing. This may help investors select a quality manager. When conducting due diligence, it’s important to consider many key factors, including (but not limited to) the experience and pedigree of the manager, the investment process utilized, markets traded, assets under management, capacity of the manager’s strategy and the infrastructure in place supporting the manager. As part of this process, it’s imperative to clearly identify the manager’s “edge,” namely, the unique aspect of the manager’s approach that could help him or her succeed.

2. Diversifying across multiple managers. This step further reduces manager risk by diversifying across multiple managers. This can happen through a multi-alternative fund (as highlighted in my previous blog) or by diversifying your alternatives allocation across multiple managers and/or strategies.

The two steps discussed are tools that may help investors mitigate manager risk. That said, conducting manager due diligence and diversifying across managers is a tall order for most investors and does not guarantee the investment will meet performance objectives. For this reason, I believe investors would benefit considerably from working with a financial advisor who is knowledgeable and experienced in alternative investments.

 

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