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Sophisticated Strategies for the Masses

Henry P. Davis, managing director of Arden Asset Management, answers our questions about the utilities and misconceptions surrounding alternatives and the increasing availability of these strategies to advisors and individuals.

Morningstar Advisor, 06/17/2013

This article originally appeared in the June/July 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

1 Why invest in alternative investments?
Alternatives provide differentiated or “alternative” return streams from traditional investments. Alternatives may enhance portfolio efficiency and diversification, resulting in more attractive portfolio characteristics (e.g., higher risk-adjusted returns and lower overall risk). 

2 What is the biggest misconception investors have about alternatives?
One significant misconception investors have about alternatives concerns their riskiness. One often hears references to hedge fund managers “making bets,” “gambling,” and so forth, whereas in reality many if not most managers follow disciplined strategies that are designed to reduce risks associated with riskier assets. For example, certain hedge-fund strategies such as Equity Event employ
process-driven methodologies with hedges designed to mitigate risk.

3 Sophisticated alternative strategies are becoming more available to advisors and retail investors through mutual funds. Is this development a good thing?
Yes, I’d say it’s a great thing. It’s all about leveling the playing field by providing individual investors access to strategies previously only available to institutions and the very wealthy. It means more choice, more options for building portfolios, hereby increasing the likelihood of meeting one’s investment objectives in an environment of lower overall expected returns. I look forward to the day when my kids will be able to make diversified hedge fund investments in
their 401(k) plans. 

4 What’s the biggest drawback of this trend?
Some hedge fund strategies do not fit in a daily liquidity mutual fund structure owing to the less-liquid nature of some of their underlying holdings. 

5 Would you be interested in managing a mutual fund?
Yes. In fact, we have launched Arden Alternative Strategies I ARDNX, a multimanager mutual fund that invests in hedge fund strategies, and we are launching additional alternative mutual funds in the near future. Arden has 20 years of experience managing hedge fund portfolios for pension plans and other institutional investors and believe we can use our capabilities to create portfolios
with attractive diversification properties in a daily liquidity format.

6 What’s the most important attribute that you look for when selecting a manager?
Integrity, discipline, and judgment all tie for most important attributes in a manager. A close second would be “seasoning,” meaning a manager who has survived and thrived in the face of difficulties and challenging market conditions.

7 What’s the biggest challenge to investing in today’s climate?
The biggest challenge for investing today is the “financial repression” that has
been created by artificially low interest rates that places savers and particularly fixed-income investors at a disadvantage relative to borrowers. Fixed-income investors face significant risks in the event interest rates rise from current historically low levels. 

8 What is the biggest investing mistake you made?
Probably underestimating the severity of the liquidity squeeze that negatively impacted a number of hedge fund strategies during the global financial crisis in 2008. Yet, in a way, this paved the way for alternative mutual funds, as the demand for hedge fund strategies available in a daily liquidity format increased significantly and remains high to this day.

9 What did you learn from it?
In periods of extreme risk aversion, everyone seems to follow the same playbook
of cutting positions/exposures and buying T-bills/raising cash. Liquidity is a precious thing in a time of crisis. Less-liquid hedge fund strategies were vulnerable, but the more-liquid strategies fared well. 

10 What has influenced you the most as an investor?
Extreme market events such as stock market crashes have influenced me the most as an investor. In each of the events of 1987 (crash), 1994 (rate shock), 1998 (Russia/Long-Term Capital Management), and 2008 (financial crisis/crash), important lessons were learned. Learning how to avoid large drawdowns is the key to compounding high rates of return over time. One of the reasons I was attracted to hedge funds in the first place is their ability to mitigate risk in adverse markets.

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