Download Finding a new balance with alternatives

Asset Management
Finding a new balance
with alternatives
Introduction................................................................................................................ 1
Situation normal?.......................................................................................................2
Lessons from the origins of 60/40..........................................................................3
Diversification amid rising volatility........................................................................3
Weighing market exposure and active skill...................................................................3
Higher stakes in manager selection..............................................................................4
Due diligence that demystifies.....................................................................................4
Portfolio construction: Putting it all together..................................................................5
A multi-alternative approach...................................................................................5
Lowell Yura, CFA, ASA
Head of Multi-Asset Solutions
BMO Global Asset Management
Kristina M. Kalebich, CFA
Portfolio Manager
BMO Global Asset Management
Kristi Hanson, CFA
Managing Director and Head
of Investment Research
CTC | myCFO, LLC
John Lennox
Investment Writer
BMO Global Asset Management
Summary....................................................................................................................6
Introduction
Alternative investment options available to most investors present both challenges and
opportunities. They can appear vexing partly because, to some investors, they are newly
accessible in liquid vehicles. Many types, such as hedge fund strategies, have not been
available to the typical investor until now. They are also increasingly popular: Assets in liquid
alternative funds went from around $50 billion in 2006 to more than $300 billion in 2015, and
the number of funds available increased almost fivefold, from 132 to more than 600 in the
same time period (see Exhibit 1).
Alternatives are also complex and heterogeneous, in terms of the types of strategies
alternative managers use and the classification of those types of strategies. The relatively
recent availability of alternative strategies to retail investors — as liquid alternatives — has
resulted in category mapping mayhem (see Exhibit 2). No less complex are the methods of
adding them to a traditional portfolio.
Contact us
1-844-266-3863
bmoalternativestrategies.com
bmo-global-asset-management
Asset Management
What often gets lost when investors are sorting out all these
distinctions is the reason they turned to alternatives in the first place.
A better understanding of the role of alternatives in today’s economic
environment — and in tomorrow’s — can help guide investors’
decisions as they weigh their options in the alternatives space.
What follows here is a guide to framing an informed alternatives
discussion. It is intended to provide some much-needed perspective
on the topic, to outline the principles of a successful alternatives
allocation and to show how multi-alternatives in particular can help
meet today’s diversification challenges.
Exhibit 1: Growth in liquid alternatives
Assets ($B)
350
300
Number of funds
AUM ($B)
583
Number of funds
238
150
50
0
500
370
200
132
147
168
700
600
453
250
100
636
400
297
300
187
200
$50
$57
$46
$75
$137
$159
$193
$291
$327
$324
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
100
0
Situation normal?
As we move further away from the Great Recession, the traditional
60/40 portfolio faces headwinds that have not occurred for much, if
any, of its existence. This much-used paradigm allocates 60% of a
portfolio to equities and 40% to bonds, balancing over the long term
the growth (and higher risk) associated with equities with the stability
(and lower risk) associated with bonds. Yet a significant assumption
within the 60/40 paradigm — historically strong bond returns with
low volatility — is no longer realistic with low bond yields in the
current environment. Modest inflation and an accommodative Federal
Reserve partly account for lower yields, but a broader look shows
yields have been in a secular decline since the early 1980s.
Lower bond yields, combined with a sustained low-interest-rate
environment, should prompt investors to question whether a
traditional 60/40 approach will continue to work. Our expectations
are that even moderately risky balanced portfolios should expect
returns more than 4% lower over the next 10 years compared to what
a 60/40 portfolio delivered in the last 35 years. Investors will need to
find a way to adapt.
Source: Strategic Insight
Exhibit 3: Outlook for balanced portfolios
Moderate portfolio Conservative portfolio
Exhibit 2: Mapping mayhem
HFR categories
 Equity Hedge
9 sub-categories
Morningstar categories
Long/Short
Equity
Market
Neutral
 Event Driven
7 sub-categories
Historical return (Oct. 1981–Dec. 2015)
Bear
Market
Nontrad.
Bond
 Relative Value
9 sub-categories
 Macro
Managed
Futures
Commodities
Multicurrency
Multialternative
12 sub-categories
 Fund of Funds
4 sub-categories
Source: Hedge Fund Research, Inc., Morningstar Direct, BMO Global Asset Management
Stocks
60%
Stocks
40%
Bonds
40%
Bonds
60%
9.6%
9.3%
Expected returns over next 10 years
4.5%
3.8%
Average annual impact over next 10 years
-5.1%
-5.4%
Expected equity returns over next 10 years
5.8%
5.8%
Expected bonds over next 10 years
2.6%
2.6%
For illustrative purposes only.
Equities are represented by S&P 500. Bonds are represented by Barclays US
Aggregate Index. Allocations do not include diversifying assets. Expected returns
represent index/strategy returns which can be efficiently executed under normal
market conditions. Returns are based on hypothetical performance and BMO
Global Asset Management Capital Market assumptions and do not represent actual
investment performance. Actual portfolio returns may be different. Expected
returns are gross compound returns. Expected returns are estimated and reflect a
long-term investment horizon (10 years). The returns quoted are not indicators of
the performance of any product managed by BMO Global Asset Management, and
performance may vary greatly from the asset class returns indicated. Estimated
results are not indicative of future results. Source: Barclays Live, Bloomberg L.P.,
BMO Global Asset Management.
Past performance is no guarantee of future results.
2
Asset Management
Lessons from the origins of 60/40
An environment of lower returns for the traditional portfolio should
prompt the question: Why expect this diversified portfolio, as it has
been traditionally applied, to succeed? To answer that, it may be useful
to take a quick look at the history of diversification and see what its
origins may tell us about its applicability today.
Most accounts of the birth of modern portfolio diversification begin with
Harry Markowitz’s 1952 paper Portfolio Selection, in which Markowitz
argued that diversifying assets can help investors build portfolios with
maximized expected returns for given levels of risk. Markowitz put
science behind the wisdom of not putting all your eggs in one basket.
Roughly 20 years later, along came the Employee Retirement Income
Security Act of 1974 (ERISA), which provides that anyone responsible
for managing or advising assets in a retirement plan has fiduciary
responsibility for their investment decisions or advice as to those assets.
As fiduciaries, managers and advisers must act in the plan participants'
best interest. ERISA also requires fiduciaries to diversify investments
and encourages managers of defined benefit plan assets to develop
well-thought-out reasons for their allocation decisions. As a result,
many institutional investors and consultants began to apply the science
of Markowitz’s principles of diversification.
Exhibit 4: Diversification timeline
1952
1981
Markowitz’s Portfolio
Selection introduces modern
portfolio diversification
1950
1960
U.S. 10-year Treasury peaks at 15.32%
in September and averages 8.38%
between 1981 and 2000.
1970
1980
1990
2000
1974
2010
2016
ERISA establishes fiduciary
responsibility and
diversification requirement
U.S. 10-year Treasury enters
year at 2.25% and falling
In this way ERISA served as a main catalyst for the widespread use
of the balanced portfolio — and with relatively high interest rates
and the help of a measurable decrease in the size of business cycle
fluctuations between the mid-1980s and mid-2000s, it worked. It also
succeeded because of relatively high bond yields, which in the last 30
years delivered 9%, nearly matching the 10.5% return from equities
during that period.
Exhibit 5: 60/40 balanced portfolio in context
Annual Return
15%
10%
5%
12.4
8.7
1.3
0%
-5%
-10%
?
Yet it worked so well that many investors may have difficulty
understanding the reasons why it may not work today. Interest rates
and yields have lowered slowly but significantly since the early postERISA days. The efficacy of independent central bank policy, thought
by many to have contributed to the Great Moderation of business
cycle volatility, now seems worth questioning. Few investors in the
2000s would have expected major central banks around the world to
be moving to or considering negative interest rates, as some began to
do as early as 2012. Perhaps more importantly, we believe continued
divergence of central bank policies and China’s transition from a
manufacturing-based economy to a service-based economy should
create more volatility. It should be increasingly clear that traditional
diversification is point dependent, and things have changed.
Diversification amid rising volatility
Weighing market exposure and active skill
Understanding how today’s challenges for the diversified portfolio
differ from yesterday’s can help guide a responsible alternatives
allocation. First, what are the options? By doing nothing, an investor
may risk missing his or her objectives. Tilting the portfolio to higherreturning assets may capture higher returns, but it will also increase
risk. Allocating to illiquid assets to capture the liquidity premium
may also capture higher returns, but at the cost of lower liquidity.
Assuming that lower returns, greater risk or reduced liquidity are
unsatisfactory options, a plan to find new sources of return should
involve choosing from a spectrum of alternative options. A good
alternative option should give the portfolio either a higher return
for the same amount of risk or the same return for a lower amount
of risk. Yet even distinguishing among strategies and identifying
their sources of return and risk is challenging. The categorization of
alternative strategies can be confusing. Hedge Fund Research lists
four broad categories and 37 subcategories (plus four types of funds
of funds); these do not always square with Morningstar’s system
of categories (see Exhibit 2). Investors may not know what they’re
getting.
To meet today’s diversification challenges, investors will need to
distinguish liquid alternative strategies that rely on new market
exposure, such as volatility and frontier markets, and those that rely
on manager skill, such as market neutral, 130/30, long/short equity
and macro strategies. Here it is important to note that many “new
market exposures” may already appear in investors’ portfolios —
REITs and commodities are two common examples. The difficulty
of finding truly new exposures, then, encourages a longer look
at active management, where sources of return and risk are less
dependent on market movement.
-15%
-22.1
-20%
-25%
Last 30 Years
2008
Avg: 2009–2014
2015
Next 20 Years
Source: Returns reflect a portfolio of 60% S&P 500 Total Returns Index and 40%
Barclays US Aggregate Bond Index.
Past performance is no guarantee of future results.
3
Asset Management
Higher stakes in manager selection
Key considerations when choosing a single active manager will
involve identifying the investment strategy, its fit within a portfolio
and its behavior in different market cycles. We must also ask: Can
this manager deliver on its stated objectives? Is the strategy easy to
understand, or is it a more nuanced style?
Distinguishing and then choosing active alternative managers
remains complex and research intensive. Given a range of options,
simply choosing the manager with the highest performance may
not mean you have the manager with the most skill. Consider two
managers with different levels of market exposure. Manager A has a
beta of 0.8, while Manager B has a beta of 0.2. Suppose the market
rises by 10% and Manager A returns 6% and Manager B returns 5%.
Exhibit 6: A case study in manager skill
returns among several strategies. The spread between top and bottom
deciles of returns among traditional large blend managers is 469
basis points. Compare that to the return dispersion of 860 basis points
among long/short equity managers. Missing on a long/short equity
manager pick risks leaving much more on the table in terms of return.
Perhaps more importantly, such dispersion among alternative
managers suggests diverse sources of alpha: Alternative managers
generate alpha using very different skill sets. Trying to forecast
future returns for these asset classes is even more difficult. Similarly,
Exhibit 8 shows the dispersion of beta among the same categories,
suggesting alternative managers are managing their risk profiles in
very different ways — by region, market or currency, for example.
Exhibit 8: Dispersion of beta
Morningstar category beta to S&P 500 Index – Trailing 5 years
Beta
Return given an up
market (10%)
Return from skill
Manager A
0.8
6%
-2%
1.0%
Manager B
0.2
5%
3%
0.8%
For illustrative purposes only.
Manager selection in the alternatives space is arguably more difficult
than in traditional long-only strategies because the stakes are higher.
This is because the dispersions of both returns and levels of market
exposure among alternative managers are greater than those in
traditional long-only managers. Exhibit 7 shows the dispersion of
Exhibit 7: Dispersion of returns
Morningstar category returns – Trailing 5 years
Annualized returns
12.9
8.2
5.0
5%
0%
-5%
Dispersion
0.9
0.8
0.6
0.6%
0.3
0.2
4.9
-0.1
Large Blend
Long/Short Equity
-3.3
Market Neutral
469 bps
860 bps
832 bps
Top 10th percentile return
0.3
0.2%
0.1
0.0%
-0.2%
Dispersion
Large Blend
Long/Short Equity
-0.1
Market Neutral
0.22
0.51
0.38
Top 10th percentile return
Multialternative
0.56
Bottom 10th percentile return
Past performance is no guarantee of future results. For illustrative purposes only.
Source: Morningstar Direct as of 12/31/2015.
Due diligence that demystifies
The due diligence process in such an environment should take into
account the above sources of differentiation among managers. It
should understand the structural differences across managers and
strategies and in doing so understand the alpha achieved and the
beta relied upon. Moreover, it must often do so when there are
no clear benchmarks to rely on. Active and informed due diligence
of alternative managers should look at strategy, performance, risk
management, organization and structure, among other items. We’ve
outlined some of the key ingredients of a due diligence analysis that
will lead to such an understanding below.
Portfolio construction: Putting it all together
8.8
10%
1.1
0.4%
Judging solely from their returns, you might think Manager A is the
more skilled manager. But with a beta of 0.8, with no effect from
skill, Manager A should have returned 8%. Manager A’s skill actually
generated a 2% loss. Manager B, on the other hand, received only
a 2% return from the market, and the remaining 3% is the return
from Manager B’s skill. This is a simplified example. Now imagine
the managers differing not only in their level of beta, but also in the
source of their beta — for the source varies from manager to manager
— as well as their alpha or skill.
15%
Beta to S&P 500 Index
1.2%
Multialternative
507 bps
Bottom 10th percentile return
Past performance is no guarantee of future results. For illustrative purposes only.
Source: Morningstar Direct as of 12/31/2015. Returns are net with dividends reinvested.
Building a portfolio with the results of such due diligence requires
creating the right blend of unique and complementary managers
in a particular category as well as the right blend of strategies. Our
research indicates that searching for alpha across many different
markets leads to better outcomes. Doing so offers diversification
benefits, as opportunity sets in different markets vary significantly
over time. Some environments might be more conducive to long/
short equity strategies, others to different types of macro strategies,
for example.
4
Asset Management
Exhibit 9: Key research questions
Investment
Strategy
& Process
•
•
•
•
•
Investment philosophy
Strategy execution
Portfolio construction
Sustainable competitive edge
Durability/sustainability of strategy
Historical
Performance
•
•
•
•
•
Performance history
Risk/return statistics
Regression analysis
Correlations
Audited financial statements
Risk
Management
•
•
•
•
•
•
Risk management and monitoring
Position limits and concentration
Gross/net exposure
Liquidity
Non-investment risks
Factor analysis
Organization
•
•
•
•
•
Firm culture
Ownership structure
Quality of manager and team
Accessibility of investment professionals
Background checks
•
•
•
•
Governance
Firm AUM
Capacity constraints
Vehicle types and terms
Structure
This is not an exhaustive list of due diligence topics.
Decisions regarding the number and styles of strategies in an
alternatives allocation should be made from the perspective of the
total portfolio. That is, they should take into account the size and
role of the alternatives allocation as well as the types of traditional
managers in the portfolio.
We believe that, when used within a larger portfolio as a
diversifying allocation, a portfolio of liquid alternatives managers
should be fairly concentrated, with roughly six to 10 underlying
managers (this number may be higher in strategies outside the
liquid alternatives universe). The key is to avoid diluting the
contribution of any individual manager to the portfolio by using too
many managers, thereby giving each only a small allocation. At the
same time, too much concentration undercuts the diversification
benefits alternative investments are designed to deliver in the
first place. A 10% allocation to eight managers, given an equal
weighting, would provide each manager roughly 1.25%. This would
be enough to make a difference yet not enough to have a materially
negative impact on the total portfolio.
A multi-alternative approach
A multi-alternative fund can offer access to a concentrated portfolio
of alternative managers. A multi-alternative fund combines frontend due diligence, portfolio construction and management, and risk
oversight, all performed by experienced, professional managers. It
also helps answer key questions any allocation to multiple managers
necessarily poses:
• Will the minimum investment for each strategy create a hindrance
for building a diversified portfolio?
• How do all of the strategies correlate with one another?
• What is the right time frame and process for rebalancing
the portfolio?
• How much time and what resources are necessary to fully
research and understand multiple complex investment strategies?
• What is the appropriate risk management philosophy?
• How should overall portfolio and individual positioning
be monitored?
Moreover, the built-in diversification of multi-alternative approaches
helps answer the fundamental question that began the search
process in the first place: Is the portfolio diversified by manager
and strategy? An alternative allocation that combines expertise on
manager research, asset allocation, portfolio construction and risk
management should offer a flexible, portfolio-ready option.
Summary
Post-crisis returns have done little to motivate changes to the 60/40 paradigm of the balanced portfolio. But in a continuing low-rate
environment, there are indications that this paradigm, which has seen investors through the last 35 years, will face challenges. While there are
other approaches to addressing the low-rate environment, allocating to alternatives is an appropriate option for many investors. Multi-alternatives
in particular can help meet today’s diversification challenges by offering easy access to the resources needed to:
• Separate market exposure from manager skill
• Create an effective blend of managers
• Identify the appropriate style of manager skill
• Manage the blend from a total portfolio perspective
• Screen a large number of managers across several qualitative,
quantitative and risk-related factors
• Achieve portfolio breadth, differentiation and complementarity
5
Asset Management
All investments involve risk, including the possible loss of principal.
You should consider the Fund’s investment objectives, risks, charges, and expenses carefully before investing. For a prospectus and/or summary prospectus, which contain this
and other information about the BMO Funds, call 1-800-236-3863. Please read it carefully before investing.
BMO Asset Management Corp. is the investment adviser to the BMO Funds. BMO Investment Distributors, LLC is the distributor. Member FINRA/SIPC.
Index definitions: S&P 500® is an unmanaged index of large-cap common stocks. Barclays U.S. Aggregate Bond Index is an index that covers the U.S. investment-grade fixed-rate bond
market, including government and credit securities, agency mortgage pass through securities, asset-backed securities and commercial mortgage-based securities. To qualify for inclusion,
a bond or security must have at least one year to final maturity and be rated Baa3 or better, dollar denominated, non-convertible, fixed rate and publicly issued.
Investments cannot be made in an index.
Additional definitions: Beta is a measure of a portfolio’s volatility. Statistically, beta is the covariance of the portfolio in relation to the market. A beta of 1.00 implies perfect historical
correlation of movement with the market. A higher beta manager will rise and fall more rapidly than the market, whereas a lower beta manager will rise and fall slower. Alpha is the
incremental return of a manager when the market is stationary. In other words, it is the extra return due to non-market factors. This risk-adjusted factor takes into account both the
performance of the market as a whole and the volatility of the manager.
This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date
and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. This presentation may contain forwardlooking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”,
“estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on
such statements, as actual results could differ materially due to various risks and uncertainties. This publication is prepared for general information only. This material does not constitute
investment advice and is not intended as an endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular
needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed
or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will
fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.
Past performance is not necessarily a guide to future performance.
CTC | myCFO is a brand delivering family office services and investment advisory services through CTC myCFO, LLC, an investment adviser registered with the U.S. Securities and Exchange
Commission, a Commodity Trading Advisor registered with the Commodity Futures Trading Commission (“CFTC”), and a member of the National Futures Association (“NFA”); trust, deposit
and loan products and services through BMO Harris Bank N.A., a national bank with trust powers; and trust services through BMO Delaware Trust Company, a Delaware limited purpose trust
company. BMO Delaware Trust Company offers trust services only, does not offer depository, financing or other banking products, and is not FDIC insured. Not all products and services are
available in every state and/or location. Family Office Services are not fiduciary services and are not subject to the Investment Advisers Act of 1940 or the rules promulgated thereunder.
BMO Global Asset Management is the brand name for various affiliated entities of BMO Financial Group that provide investment management and trust and custody services. Certain of
the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries
and regions and may not be available to all investors. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and
regulations. BMO Financial Group is a service mark of Bank of Montreal (BMO).
BMO Asset Management Corp., BMO Investment Distributors, LLC, BMO Private Bank, BMO Harris Bank N.A. and BMO Harris Financial Advisors, Inc. are affiliated companies. BMO Private
Bank is a brand name used in the United States by BMO Harris Bank N.A. BMO Harris Financial Advisors, Inc. is a member FINRA/SIPC, an SEC registered investment adviser and offers
advisory services and insurance products. Not all products and services are available in every state and/or location.
Investment products are: NOT FDIC INSURED — NOT BANK GUARANTEED — MAY LOSE VALUE.
© 2016 BMO Financial Corp. 4393708 (4/16)