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How Alternatives Protect Portfolios

Investors got diversification wrong in 2008, say hedge fund veterans Cliff Asness and Andrew Lo. They have ideas on how to get it right.

Nadia Papagiannis, 12/29/2009

Traditional sources of diversification were put to the test in 2008-a year when there were few places for investors to hide. Stocks, corporate bonds, emerging markets, and real estate all went down together. So, how are advisors supposed to protect their clients' portfolios? Andrew Lo, Ph.D., manager of the new Natixis ASG Global Alternatives Fund GAFAX, and Clifford Asness, Ph.D., cofounder of AQR Capital Management, which launched the AQR Diversified Arbitrage Fund ADANX in January 2009, offer some answers.

Lo, who is a professor of finance at the MIT Sloan School of Management and chief investment strategist of the Alpha Simplex Group, offers individual investors an alternative to hedge fund investing in a liquid, low-cost format. Lo seeks to replicate the return and risk characteristics of a diversified portfolio of hedge funds. In 2008, the Morningstar 1000 Hedge Fund Index lost significantly less than the S&P 500 Index. Asness, a veteran of Goldman Sachs and a renowned hedge fund manager, started a mutual fund that combines several of the arbitrage strategies for which he is famous, complete with transparency, liquidity, and lower fees. Arbitrage strategies, which produce low correlations to the stock market, were some of the best perform­ing investments in 2008.

On Oct. 15, from Chicago, we held a conference call between these two investing gurus, who also happen to be friends. The two managers discussed how investors got diversification wrong in 2008 and what advisors can do to improve diversification in their clients' portfolios. They help to demystify the confusing world of alternative investing. The discussion has been edited for clarity and length.

Nadia Papagiannis: There has been a lot of talk by advisors and in the media about the failure of diversification. Did the concept of diversification fail, or were investors just not properly diversified?

Andrew Lo: Investors suffered from a disease I call "diversification deficit disorder." The issue is not that diversification failed. It's that diversification was not implemented properly. The financial system has gotten a lot more complicated, and it's more difficult to achieve diversification than it used to be. In the 1970s, you could be diversified by holding 100 NYSE stocks. But as we know, there are times when correlations go to one, particularly during times of distress. Even stocks and bonds have become correlated in ways that we never anticipated. Nowadays, you have to go farther and broader in terms of strategies and markets to be able achieve proper diversification.

Cliff Asness: People could have been more diversified in 2008, but I think it's important to note that when a year like 2008 happens, you just want to get through it with as little pain as possible. Sure, there are ways to do things better, and some of the things we're going to talk about today are going to help investors a lot. But nothing would have turned 2008 into a wonderful, fun year for people.

AL: The best-performing asset class in 2008 was government bonds, which is ironic, because there was a period during the crisis when U.S. Treasuries actually exhibited a negative nominal yield. What we ought to learn from this is that 2008 was a period of enormous stress and flight to safety, and during these periods, the standard risk/reward trade-offs that we know and love in modern finance go out the window. Investors get punished for taking risk; they don't get rewarded for it. We have to keep that in perspective and not overreact to it. But at the same time, we should understand that there are ways that we can address these situations more productively than the traditional 60/40 stock/bond mix.

CA: Andy, you're right that risk was punished. But this is why we call it risk. You don't get a risk premium just for doing something that always pays off because then it wouldn't be risky. That might sound really obvious, but I hear people say, "Gee, I did what everyone said and I took risk, and I'm supposed to get paid for it." That is over the long term. You get paid precisely because over some very painful periods it doesn't work.

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