Don't overlook these hidden risks.
Any investment entails risk. A stock investor takes on equity market risk, while a bond investor endures duration and credit risks. When investing in alternative strategies, most advisors know that they have to pay attention to more exotic types of risks, such as those from commodities and currencies. But some risks are more hidden and could be easily overlooked--for example, the unintended fixed-income exposures when investing in certain managed-futures and currency mutual funds.
What to Do With the Cash?
Unlike traditional stock and bond funds, which are usually fully invested, some alternative funds, particularly managed-futures and currency strategies, trade mostly derivatives. To execute these strategies, portfolio managers do not need to invest most of their fund assets up front. Instead, they only use a small amount of cash to establish large positions (because futures and forward contracts are traded on margin), while the majority of fund assets sits in cash.
Although some of the cash is used as collateral to cover
mark-to-market losses in a futures or forward account, there is plenty to
spare. Therefore, the portfolio managers of managed-futures and currency funds
(in most cases) have the freedom to determine what to do with the cash.
Some managers choose to take a conservative approach and
invest the cash collateral in short-term U.S. Treasuries, money market funds,
short-term repurchase agreements, and other cash-equivalents. For many years,
conservative cash management reaped ample rewards, but as cash yields have
dwindled towards zero, some managers have opted to take on credit and duration
risk to boost the returns of their futures or currency forwards strategies. To
do this, they invest in riskier fixed-income instruments, such as high-yield
corporate bonds, asset-backed securities, and mortgage-backed securities.
Both cash management approaches have pros and cons. The conservative method may forgo a few percentage points of yield, but it is largely risk-free. The riskier tactic has the potential to juice returns, perhaps when the primary managed-futures or currency strategies are down, but with extra returns comes risk one would not expect in a managed-futures or currency fund.
Strategy Purity Matters
Some managers argue that letting the bulk of fund assets sit in cashlike instruments is an inefficient way of deploying capital. But investors should keep in mind that any positive excess return is always a compensation for taking some kind of risk. In the current zero-interest-rate environment, yield-chasing could be a dangerous game. In search for slightly more return, investors are pushed further along the yield curve, which might prove disastrous when interest rates eventually rise, and lower on the credit quality scale, which could backfire in the event of a liquidity crisis or during periods of macroeconomic uncertainty.
Furthermore, taking too much risk in managing the cash collateral to some extent weakens the purpose of investing in alternatives in the first place--low correlation and diversification. The purity of the strategy matters. Many investors already hold a decent amount of bond exposure. If managed poorly, the "cash" portion of a managed-futures or currency fund could take down the fund alongside the rest of the portfolio.
Take Lord Abbett Emerging Market Currency LDMAX, for example. This fund invested in currency forward contracts benchmarked to the JPMorgan Emerging Local Markets Index Plus currency index (it has recently changed its benchmark to the Barclays Global Emerging Markets Strategy Index), and management has historically invested the cash collateral in risky assets, such as asset-backed and mortgage-backed securities, to enhance returns. In 2008, management allocated two thirds of the cash portfolio in commercial mortgage-backed securities, which led to an 11.9% loss for the fund, while its benchmark index only dropped 3.8%. Although the fund jumped 20.5% relative to the index's 11.7% rise in 2009, this type of volatility is not something investors would expect for an unleveraged currency strategy.