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By Jason Stipp | 07-18-2011 01:20 PM

Which Bucket for Alternative Funds?

Driehaus' K.C. Nelson says investors may consider alteratives such as his funds to diversify a segment of their portfolio or as part of a dedicated absolute-return-focused allocation.

K.C. Nelson is the manager of Driehaus Active Income and Driehaus Select Credit.

Jason Stipp: The risk and the return profile of your fund seems to suggest that it could be a good alternative for the fixed-income portion of an investor's portfolio.

As investors are thinking about how to incorporate a fund such as yours that has some alternative strategies in it into a portfolio, a broader portfolio, how would you suggest that this fund could be used by an average investor that has a pretty healthy fixed-income stake?

K.C. Nelson: Our investors tend to slot us into one of two buckets. The first bucket is as a fixed-income alternative. For that investor, they say, "OK, I like something that has bond-like risk, but I want some more diversification in my fixed-income portfolio, because all of my fixed-income managers tend to move and lock step with one another. And further I'm looking to bring down my interest rate risk because I know that over the next 10 years, I'd rather have less interest rate risk as opposed to more." So, that's why you use Driehaus products.

The second type of investor tends to slot us in a liquid alternative, absolute-return segment of their portfolio. In this segment of their portfolio, they are looking for uncorrelated returns and funds that strive to produce positive rates of returns in any market environment. And because we are a long-short fund that focuses on a variety of outright long, outright short, and arbitrage opportunities, we are all incented to make money in any market environment. So, oftentimes investors put us in their absolute return or liquid alternative segment in their portfolio.

Stipp: When investors are thinking about time horizon--different kinds of funds they might want to have a different time horizon for--I think they generally think that their time horizon for fixed income is shorter. What would you say your time horizon is when you're investing and then perhaps by extension what investors should think about as a time horizon if they were going to buy into your fund?

Nelson: A typical trade for us recently over the past couple of years has lasted about six to nine months in terms of duration. How I think about exposures like us is, they should be a permanent part of someone's portfolio.

... If you were to look at our results on a historical basis, you would see that we tend to muddle along with some slightly positive or slightly negative rates of return on a weekly basis, then oftentimes there is a volatility event that occurs in the market, and strategies like ours tend to do pretty well after that volatility event occurs.

So, if someone was considering investing in a strategy like ours, I would advise them to either wait for that volatility event to occur or certainly see it through at least one- to two-year period, so you get to capture some of those results, because in the past following those moments of crisis, strategies like ours--regardless of how the market does over the next six to 12 months--strategies like ours tend to do pretty well because volatility gets injected into the market, spreads move wider, and that all creates greater long/short opportunities and arbitrage opportunities for strategies like us.

Stipp: K.C. Nelson, thanks so much for joining me, offering your take on inflation, and giving us some detail on the workings of your funds.

Nelson: Thank you very much.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.

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