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By Nadia Papagiannis, CFA | 06-14-2011 11:26 AM

Which Alternative Strategies Are Right Today?

Long/short equity funds are some of the most compelling alternative investments today, says Aston Lake Partners' Rick Lake.

Nadia Papagiannas: Hello, my name is Nadia Papagiannas. I am an alternative investment strategist here at Morningstar, and today I have with me Rick Lake, manager of the Aston Lake Partners LASSO Alternatives fund, ticker symbol ALSOX. LASSO Alternatives fund is a multistrategy fund of all alternative mutual funds, and today Rick is here to tell us about his outlook of various alternative strategies. Thanks for being with us today, Rick.

Rick Lake: It's great to be here.

Papagiannas: So, Rick, what is your favorite alternative strategy right now?

Lake: Well, they are all my favorites. As you know, I'm a great fan of the entire spectrum of alternative strategies. But in terms of the largest allocation for the mutual fund our largest allocation is currently in long/short equity.

Papagiannas: OK. Why is that?

Lake: Well, it's designed to be a return driver for the portfolio, and long/short equity can be potentially effective in multiple environments. The past two years have been a bullish environment for equities in general, and now we're heading into a more choppy period. Either way the managers can adjust their long and short exposures to find ways to profit or mitigate risk despite whatever the climate might be.

Papagiannas: What might be another factor besides the equity markets going up?

Lake: Well, there's a couple of interesting factors at play with any long/short equity managers. Since they are long and short, it's important how the different positions do differently. So more recently for example, there's been great dispersion among industry sectors in the equity markets. We went through a period of time where equities and sectors are moving up and down together. During the past few months we've seen great dispersion starting to appear among winning sectors in the economic recovery and in losing sectors in the economic recovery, and that can be a fascinating opportunity for long/short managers.

We've also seen reduced correlation among stocks specifically. People had talked during the credit crisis and after about how stocks were all moving together in a pack. Correlation among stocks individually reached near an all-time high, and more recently correlation among equities has fallen below its long-term average of 0.26. So with differentiation of returns among sectors and low correlation among stocks, it can be a fascinating time for long/short equity managers to be long the winners and short the losers and find ways to find some profits despite the markets. Or find new sources of market hazard.

Papagiannas: Depending on how good of a manager.

Lake: Exactly.

Papagiannas: What about our long/short debt strategies?

Lake: Well, long/short debt is the second-largest allocation within the mutual fund portfolio, and we live in a world of cross currents whether it's on the credit side or among governments or among currencies. And with government bonds, currencies, and issuers again all moving in different directions, it can be a fascinating opportunity set for long/short bond managers.

Papagiannas: They are not all the same are they. There are a lot of different types of strategies?

Lake: They're very different; this is a very diverse area. So for example you might have a manager dedicated to long/short credit, who might look for high-yield bonds. When the companies are recovering, there's a great yield opportunity and an appreciation opportunity. And they may couple that with shorts, with companies in distress, where they may not recover, and there could be an opportunity for profit on the way down. So that could be a long/short credit manager.

You can also have long/short sovereign managers, who might be long the bonds of fiscally strong countries and short the bonds of weaker countries. One of our managers a number of years ago had shorted Greece, before the Greek credit crisis was even an issue, and they made a lot of money on that trade. And you see the same type of dispersion on the currencies side.

Papagiannas: So it seems like there is some opportunity in the long/short sovereign and currency managers. What about for the high-yield and the credit domestic managers?

Lake: Yeah, there are some interesting opportunities there. They are perhaps a bit more muted than they were one or two years ago. Coming off the credit crisis high-yield securities had huge yields and were very cheap, so there was a fat pitch of profit to be made there. Now credit spreads have come in. Coupons are higher than short-term yields, so managers have to be very mindful of the quality of the credits they have in the portfolio.

At the same time corporate distress has dropped dramatically. It's back to an all-time low, which suggests that there might be some good support for these higher-yielding securities even though the yields aren't as high as they were two years ago.

Papagiannas: What if interest rates go up? What does that say for these types of managers?

Lake: Well, this is an interesting time. We have massive government debt issuance worldwide colliding with an economic recovery even though it's a fitful process. For the long term, that's expected to drive rates up. In the short term, because of all the anxieties in the marketplace, people have been running for safety, and that's kept U.S. bond prices very tame. It's interesting, we have a couple of generations of investors who have not lived with duration risk. There was a time in the early '80s when interest rates were skyrocketing up, and every day investors would look at their portfolios and wonder: "Why were their Treasury bonds going down? Why were their muni bonds going down? Why were their corporate bonds going down?" So, the big elephant in the room of bond investors is when rates will go back again because of these very large macro forces occurring.

Papagiannas: Do these long/short debt managers tend to hedge duration?

Lake: They will. They will try to do in a very sophisticated nuanced fashion. They will take a look at their duration within each of the environments where they invest. So, country-by-country, they'll look at duration issues there. They will also take a look at duration from a very short-term point of view or an intermediate point of view or a long-term point of view and adjust their duration bets accordingly. So, they'll diversify not just across issuers and countries and currency but also over time periods.

Papagiannas: What about the nonequity and debt asset classes for alternatives? What about managed futures and merger arbitrage?

Lake: Well, managed futures has been a growing area recently in the mutual fund world. A number of product developers have figured out how to move managed future strategies into a mutual fund structure. The regulatory issues are a bit complex. The regulators have different types of regulations that apply to these strategies, and they will have to figure out how to harmonize all these regulations.

So, it's an interesting time in that innovative new tools are being created. Investors who used managed futures hope to find a source of low correlation, of low diversification in a different source of returns from the portfolio. So that can be the long-term strength. They have to keep in mind that over the short term, however, managed futures have their own set of idiosyncratic risks. For periods of time, they can correlate highly with other asset classes, and managers within the universe have high dispersion of return due to the different types of bets they might have on and due to the leverage. And period to period, they'll also have dispersion of returns. So, it's interesting from a diversification point of view but it's far more nuanced than many investors imagine.

Papagiannas: So, you have to be mindful of manger selection, but also that these are longer-term investments?

Lake: You have to be mindful of manger selection, and you have to be mindful that the diversification benefits are typically accrued over the longer term. And you've to be very careful in the short term.

Papagiannas: What about merger arbitrage?

Lake: Well, merger arbitrage is another interesting alternative strategy in the mutual fund world. It's one of the oldest of the alternatives strategies in the mutual fund world, and its spread-driven which has a couple of ramifications currently. Since interest rates are low, spreads will be low. So returns are kind of modest, but as the economic recovery gains power around the world there are more and more deals that are happening which means there is more and more potential deals for arbitragers to take advantage of.

Another interesting feature of merger arbitrage is that deals are all fairly short-lived. The average merger arb deal has about 100 days of life. So, in effect merger arb almost can function like a floating-rate fixed-income fund because as deals come down the pike and the portfolio in effect resets its spreads wide and if rates go up, they manage to take advantage of that. So, the alternative mutual fund rolled off is a fascinating array of strategies and funds to build the portfolio with.

Papagiannas: Well, thanks so much Rick for that outlook and explanation of all the different alternative strategies.

Lake: Thank you, Nadia.

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