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By Kunal Kapoor, CFA | 01-21-2012 01:00 PM

Top Alternatives for a Well-Rounded Portfolio

William Harding of Morningstar Investment Management, head of alternatives research Nadia Papagiannis, and ETF analyst Tim Strauts outline smart diversification strategies in this 50-minute roundtable discussion.

This video replay, which originally aired during's January 2012 Individual Investor Conference, is an exclusive benefit of your Premium Membership.

Securities Mentioned in This Video



Kunal Kapoor: Good afternoon and welcome back to the second half of our investment conference. This is in fact, the panel on diversification strategies, where we are going to be talking about alternatives. In the auditorium here at Morningstar, for those of you attending, is a panel on securing your retirement paycheck. In case you would like to watch that at home, please look at the panel on the left and click on the appropriate link and you will be taken to that panel.

Also, if you would like to submit a question while you are online, you can do that, and we'll be certainly picking out a few of those to ask our panelists about it. And those of you here joining us at Morningstar's offices, we do have microphones, which will come around during the Q&A.

So, with that I would like to get started here today. My name is Kunal Kapoor. I am the head of Morningstar's Individual Software business unit, and formerly an analyst here at Morningstar for many years. Joining me here today are three of my colleagues. Right next to me is Bill Harding, who heads up manager research in our Investment Management unit. Bill was actually the architect, back when I worked with him, of our Absolute Return Portfolio, which he can speak a little bit about. Next to him is Nadia Papagiannis, and Nadia actually joined Morningstar originally to cover hedge funds and has since become quite an expert on different alternative strategies. So, she is going to be talking about some of her thoughts on where people can be investing today among other things. And all the way to my left is Tim Strauts; Tim is an exchange-traded fund analyst here at Morningstar. He also covers alternatives, but as well covers areas such as real estate investment trust.

So, we've got a broad range of topics that we can talk about today, and I hope you will join me in asking questions. We can take this in a lot of directions, but where I wanted to get started, because I think a lot of people often get confused about this, is what is an alternative today? It used to be that alternatives where oil and gas, but it seems like those are more mainstream investments today. So, in your minds, how should people be thinking about alternatives?

William Harding: I think alternatives at a broad level would represent investment strategies that are not going to be as highly correlated with your more traditional asset classes like stocks and bonds. Really the appeal of incorporating alternatives into a portfolio is to get some additional diversification benefits. So I think there are many forms and different types of alternatives, from hedgelike strategies to different types of managed futures or other types of asset classes that again are not going to be highly correlated with stock and bond markets.

Nadia Papagiannis: I would add to Bill's definition. I would agree with it, and I would also add that besides investment strategies, sometimes an investor's portfolio wouldn't have other asset classes in it such as commodities or currencies so that might be alternative for some investors. Finally, illiquid assets are going to give you that lower correlation as well just because they are illiquid. So, it could be the trading strategy, it could be the asset class that's different than your stock and bond portfolio, or it could be the illiquidity that makes it alternative, that gives it a different return stream.

More importantly, alternatives are going to be different for different investors depending on what's been traditionally in your portfolio, and then also it's going to change over time. So, as more investors adopt different strategies over time, it's going to become less alternative and more mainstream.

Tim Strauts: An example of that is real estate. I mean real estate in many cases has been thought as an alternative over the last 10 years, but today, I think most will separate real estate out on its own. Even just three or four years ago commodities were really a core alternative asset class, and now many firms are separating commodities out into their own allocation, separate from alternatives.

Kapoor: So, Bill, you hit on an important point I think, which is this notion of minimal correlation with stocks and bonds in particular, because I think that's where most of our subscribers have their assets. But when I look at what's happened in the last year, it seems like everything is correlated. And certainly if I go back to the financial crisis, everything seemed correlated, and everything lost money. So what's the deal?

Harding: That's true and a good point. In times of crisis, unfortunately, correlations tend to rise to one especially in times of financial crisis where it's a complete risk off-trade like we had in 2008 into 2009, and at that time maybe cash and Treasuries were really the only things that did not move with the market. But I still think that with many of these alternative strategies, although they kind of got a bad rap in that they were not completely immune to the financial crisis and decline, they still didn't go down as much as your broad equity markets. Although correlations did increase on some different types of alternative strategies, they were still much lower than other asset classes that people have rounded out their portfolios with, whether they'd be international stocks, international bonds, high yield, REITs, and so on. All those other asset classes still had much higher correlations than some of the alternative strategies that we looked at.

Papagiannis: I would agree with Bill on that. You have to look at not just correlation, but also beta. So with correlation, you ask "Is it moving in the same direction?"

Kapoor: Nadia, maybe you could just define beta for everybody?

Papagiannis: Yes, so beta would be how much it's moving in that direction. So maybe it was moving, maybe these alternative investment strategies were moving down with the markets that were correlated, but they weren't moving nearly as much. So that would still give your portfolio diversification.

Kapoor: So let me put a twist on the question, and let's think about our typical Premium Member here at Morningstar. Generally, I would say that the members have a good portion of their assets in stocks or in fixed income, and they tend to also own their homes. Now suppose none of them have ever invested in alternatives, and they want to dip their toe in it. What's the first step you'd take?

Strauts: Well it's tough because alternatives are a little more complicated asset class. Most people are used to how equity investments work and how fixed-income investments work. Alternatives are very broad. Every strategy is different, and every strategy is unique. So there is little more research that needs to come into it. The first place I'd look is less on the trading strategies and more on the unique asset classes. So you might want to look at commodities, which is an asset class you can research on. The less so on the trading hedge funds, like stocks.

Kapoor: I am going to put you back on the spot. If you had to tell people to go to one area as a starting point, what would it be?

Strauts: I would think commodities.

Kapoor: What about you, Bill?

Harding: I think the first key question to ask is what role this alternative is going to play in investors' portfolios. Are they tilted more toward equities in their current portfolio and have a need to take the risk down a little, or are they very heavy in fixed-income and looking for something to diversify their bond exposure because I think you can look at alternatives for different uses. For example, I would look to a merger-arbitrage type of strategy as a fixed-income substitute because those tend to be lower-volatility, with risk more in line with the bond market but not as exposed to interest-rate risk. So that makes a nice way to hedge out some of that fixed-income portfolio.

On the other hand, if someone is looking just to say dial down the risk of their equity portfolio a little bit, looking for some long/short equity funds, maybe they'll have a little bit net long exposure of 40%-60%, which means that will be about the equity market sensitivity that they'll incorporate, which is one way to look at that. In terms of broad asset classes, Morningstar has a number of different categories in this area. The multialternative category is a good one-stop-shopping area, where it incorporates different types of alternative strategies in one fund.

Kapoor: Nadia, where should people not go?

Papagiannis: Where should people not go? I think people should not go to the very illiquid strategies. So, if you can invest in something like a hedge fund, if you have some kind of minimum for something that, I would not do that because I think that liquidity is a foremost concern of risk in this kind of risk-on, risk-off environment. And so sticking with mutual funds and ETFs is something I would recommend.

Kapoor: So, we've actually had a very timely question come in, and I am going to ask you, Tim, because I think it sort of pertains to what we were talking about. Bill Stewart is asking, could you really talk about some of the funds, the ETFs in particular, that employ leverage and how people should think about those, especially the ones that are 2 to 3 times leveraged?

Strauts: In general, we tell people to avoid these products because in general the investor experience has been quite terrible. Most leveraged funds that first came out were daily compounding leverage, which means is that if it was 2 times leveraged, it would reset the leverage every day. The effect of that is, is you don't get the same experience you might expect in a long-only investment. So, there was a case say with natural gas funds, where natural gas prices went up, but then the leveraged natural gas fund actually had extremely negative performance.

Kapoor: But the asset managers got their fees anyway?

Strauts: Of course. And the main reason to avoid these is just because of the volatility because natural gas is a very volatile investment, and as it was resetting the leverage, it always reset it and then it would go the opposite way. So, we in general, would tell people to avoid leveraged funds. If you are going to do them, avoid the daily compounding funds, which were pretty much all the funds that were initially launched. There are now products that compound monthly, which means they only reset the leverage every month, which allows better return experience. Now, you still have the problems of, when they reset it, it can kind of mess it up a little bit, but because it happens less often, it's a little better experience.

Kapoor: So just speaking about volatility, it also reminds me that as we were preparing for this, you mentioned that more and more people are looking at the VIX, which is sort of a measure of fear in the market, if you will. So maybe can you talk about the VIX itself, because it's been in the news so much, what it is and if at all people should be playing around with it?

Harding: Sure. The VIX, when you first look at it, it looks almost like the perfect hedge because on days when the market has risen dramatically, the VIX goes down, and the days when the market has fallen dramatically, the VIX goes up. So when you first look at it, you think, "This is great. I'll just add a small allocation to VIX, and that will help balance out my portfolio." The problem with VIX is that VIX is a volatility indicator, and you can't just own it. You can't own the VIX. We hear on CNBC, they call it the VIX number. Well, you can't just own that. How you own it is through VIX futures, which means you have to buy a futures contract on the VIX at some point in the future.

Now, the problem is, is that when you buy that contract, it expires at some point. When it expires, you'll have to sell it and then buy the next contract. Well, the way the VIX works is that the next contract you buy is almost always more expensive than the contract you're selling. So when you do this roll, as they call it, you actually lose money. So, if you look at the big VIX fund, it's VXX. It's a short-term VIX product. Since inception during the last three years, it lost 93% of its value. I would point out that we've had some volatile markets during that period, but it's lost 93% of its value. So, in general, it's not to buy-and-hold investment; these are investments meant for traders.

They have come out with recently what's called the Dynamic VIX product; the ticker is XVZ. I believe I got that right. This fund dynamically switches between long VIX exposure and short VIX exposure to try to get you the exposure that you want in which when the market is going down you get a little rise, but then when the market is doing well the, fund won't lose as much money, hopefully not 93%. But again this product is very new, and we still haven't seen enough of a track record to really recommend it.

Kapoor: So let us shift gears a little bit and focus on a couple of issues that I think are top-of-mind for people as they build their portfolios today. I'd like you guys to maybe think a little bit about how alternatives would play a role in some of these situations. The first situation I'd like to talk about is income. In fact, if you picked up Barron's this morning, the big headline is how do you generate 4% income? They sort of talk about equities, which obviously is not an alternative, but let's say 4% is a target that somebody wants. How might you go about employing some nontraditional asset classes, again leaving out equities and fixed income, and maybe trying to generate some income to your portfolio?

Harding: Well, I think when you are looking at income and what you are doing with that income, you want a return stream that is going to be not as volatile so you can depend on that income. So what we've done in the portfolios we managed in the past--and they're meant for more conservative investors looking for income--is that we've incorporated, again, some of those more conservative alternative strategies we mentioned like a merger-arbitrage strategy. It might not look like a very high yield, but if you look at the return you can expect to get off that--if you are going to get a mid- to high-single-digit-type of return stream and just draw that return down--I think that's a good alternative rather than chasing yield in an environment where volatility might be a little bit high.

In addition, during the last couple of years there have been a number of strategies launched in the alternatives space that's more credit- or fixed-income-oriented. So in the past really a lot of the long-short strategies were more focused on the equity markets. Now we have got some products in which managers are utilizing fixed-income securities and kind of going long and short there. So there are some good opportunities there to look for some alternative products that use underlying fixed-income investments. It might throw off some income, as well, but maybe hedge your portfolio a little bit from interest rate risk or some other risks.

Kapoor: It sounds good, but I think we need some names, Bill.

Harding: OK, you want some names. So on the, I guess the merger-arbitrage side of that there are two funds: Merger as well as the Arbitrage fund. The Arbitrage fund is actually closed to new investors, but that firm launched a new fund. arbitrage-event-driven, which combines and merger-arbitrage approach with some other debt-type of situations, so you can go long and short credit, as well. So it's kind of merger-arbitrage plus credit-arbitrage opportunities.

Kapoor: Is it dependent very heavily on merger activity in the market because that's obviously slowed down a little bit?

Harding: Right. So many of the funds dedicated just to merger arbitrage, their universe is going to be dependent on mergers and acquisition activity and to the extent that there is more that, that tends to be better for those managers. But if you go with a fund like the Arbitrage Event-Driven where there is a piece of it, where there are fewer opportunities, merger arbitrage they can go to credit and to some other areas, as well.

Nadia: I have some additional recommendations. So another way to generate income, that kind of alternative is a covered-call writing strategy or an option writing strategy, and there are a number of alternative funds that employ these strategies. One that I like is Schooner Fund. The ticker is SCNAX, and the manager is Greg Levinson. He does dividend-yielding stocks, plus covered calls, but then he will buy puts to protect against the downside when volatility warrants it.

Going off of what Bill was saying, there are some fixed-income managers who are now hedging, so they are not quite taking on as much duration risk or credit risk, and they are still investing in the securities that generate income. One of those would be Forward Credit Analysis Long/Short and the ticker is FLSRX. That's one in our new non-traditional-bond category that I like.

Strauts: I would just add, if you're interested in merger arbitrage in the ETF space, there actually is a good fund; the ticker is CSMA. And this fund is nonactive strategy. It's actually an index approach because merger arbitrage is a relatively mechanical strategy. You wait for the mergers to be announced and then you arbitrage the issuer and the buyer of the firm. So, you can do this through an index product. So, this fund is very similar to the merger and arbitrage funds Bill mentioned earlier, but they have a more mechanical, lower-cost strategy.

Then if you want actually some real income that actually pays out a dividend, I like master limited partnerships, an ETF AMJ. The yield is little over 4%, and you get exposure to what I consider an alternative asset class because MLPs are not included in the broad-based S&P 500 Index or any other indexes. So you are getting exposure to something you don't have in other parts of your portfolio.

Kapoor: Is there a risk that MLPs in general have kind of exploded in the past decade, and there seems to be more and more of those? If you're not buying just the ETF and maybe you are looking at MLPs to buy them individually, what should people be looking at to make sure they are getting into the right ones?

Strauts: I am not an equity analyst, but as far as looking at the whole space, I mean definitely there has been a huge amount of growth and interest in MLPs. The main reason that people didn't own them in the past is that the tax consequences were a little bit screwy. It's very difficult to own them individually inside in an IRA, but with the ETN structure--which is AMJ is, an exchange-traded note--it eliminates those tax consequences. But again, because its exchange-traded note, you do take on some credit risk. There is a concern of massive growth in this space, but energy pipelines are a growing business and there is still enough room to grow.

Kapoor: We've got a question here from Paul Groening, which I think is pretty relevant to some of the discussions we're having. Paul asked specifically about the Guggenheim BulletShares Fixed-Maturity Corporate Bond fund as an alternative to cash in a portfolio. Maybe you guys could talk just specifically either about that fund or alternatives to cash that people can be thinking about?

Harding: I don't know much about the Guggenheim fund specifically, but I think you do have to be careful when you're looking for alternatives to cash. I think just in general, a lot of people made some mistakes a few years ago looking for some of these ultra-short funds and then piled in some because they had these enticing yields. But they did blow up in the financial crisis. So, I think for cash investments, cash yields are virtually nothing now. So, that's not a good thing for people who are saving and trying to build up their nest egg that way, but I'm just weary of taking much risk in cash. I mean I think people have cash because they want the liquidity, they want the safety. Unfortunately, I wouldn't go too far out a limb there. If anything, stick to some pretty conservatively managed short-term bond funds, something like FPA New Income is a great example of a manager who has a very strong track record of never losing money in a calendar year and who manages the fund very conservatively. Right now, I would actually use that as kind of a cash substitute in the portfolio. It's very short-duration right now and very conservatively positioned.

Kapoor: So, in general, don't mess around with the cash portion of your portfolio, but circling back to just the merger-arbitrage thing for a second. Now let's say somebody does want to invest in a strategy like that, where do they source the money in their portfolio from? Would it be sort of more the intermediate fixed-income area? Would you take some amount of equities? How would you do it?

Harding: Well, for that particular fund I think it's probably a better hedge for the fixed-income portion of the portfolio. Again going back to what I said earlier, it tends to have more bondlike volatility. So we would use that as more coming from the fixed-income portion of a portfolio. But realizing that, it might not be as conservative as just owning an all-Treasury type of portfolio, but then again you also are not going to be exposed to the interest-rate risk. So you have different types of risks involved there, but I think in general something like merger arbitrage is probably better to be sourced from your fixed income or in some cases a combination of fixed income and equities depending on what your overall objective is.

Kapoor: So, I think that's a good lead into this question we have here from Dan Heredia. He says, "I have 35 plus years before retirement and can deal with a lot of volatility in the market. How aggressive should I be and when should I be really considering alternatives as part of my portfolio?"

Papagiannis: I do agree that the closer you are to retirement, the less risk you should take in your portfolio. But I don't necessarily think just because you are 35 years out means you should be taking on all kinds of risk in your portfolio. For example, if you lost 50% during the recent financial crisis, which many investors did, you need 100% return to recover that, and many investors have not recovered that or they have just recently recovered that several years later. So that puts you back significantly toward any kind of goals you have, whether it's retirement, whether it's buying a house, or whether it's paying for your kids' education. So I would be very hesitant in piling on risk just because you have a very long time frame. So I think that everybody needs some kind of diversification, some kind of downside hedge in their portfolio.

Kapoor: Do you guys have anything to that?

Harding: Yes, we build portfolios for clients within Morningstar Investment Management. I would say as we are building those portfolios, we've essentially carved out a portion of the asset allocation to alternativelike products. So we look at it again as being represented in many different types of portfolios for clients with different time horizons, risk profiles, and so on. Then on average the allocation we've set for alternatives has been between 5% and 20%, and kind of depending on the overall objectives of the portfolio and so on.

Kapoor: The more conservative, the higher the allocation?

Harding: Yes, we tend to use a little bit more in the more conservative strategies and a little bit less in the more aggressive, but even then a growth-oriented strategy having a modest allocation to alternatives again can provide a little bit of a hedge when the markets go south on us.

Kapoor: There is also a question from Jack Schapiro about whether you should count the value of your home toward the alternative portion of your portfolio. Would you think of it that way, or would you think of it as more core allocation?

Harding: Personally I don't consider the value of the home as part of an investment, because it's not liquid. I guess you don't intend to sell it tomorrow if you need to. So I wouldn't consider that a liquid type of investment. It's not really an investment but just kind of where you live.

Kapoor: So you've all sort of given us some ideas in terms of your thoughts on the merger-arbitrage space. What are some other investment ideas that you think are worth looking at in this space. Nadia, maybe since you have a sheet in front of you with some ideas you can begin?

Nadia: I need a cheat sheet because I can't remember anything these days. We haven't talked about a couple of things yet. One asset class that we haven't talked about is currency. So we haven't talked about the fact that this is an asset class in and of itself. So there are basically four asset classes: stocks, funds, commodities, and currencies. And most people have two, a lot of people have three, but most people don't have four asset classes in their portfolio. So, if you are really going to be diversified, you really need to diversify your currency risk.

And the reason is because if you are a U.S. investor, all your income is in U.S. dollars and most of your investments are in U.S. dollars. Even if you have foreign stocks and whatever, most of the consumers for those stocks are U.S. consumers. So, having some kind of foreign currency exposure would help to diversify any kind of risk we have of the U.S. dollar losing purchasing power through inflation basically, which may not be a very short-term concern, but it might be a concern in the long term.

Another type of investment, which is not an asset class that we haven't talked about is, managed futures. So, this is getting a lot of interest from the individual investor space because now there are managed-futures strategies available in mutual funds and in fact in ETFs. And the price has come down significantly, the amount of money you need to put up is very minimal, and also the liquidity is high.

Kapoor: So, Nadia, some people may not know what managed futures are. Maybe you could explain that.

Papagiannis: Sure. Basically, managed futures invest in primarily futures contracts across all asset classes, so stocks, funds, currencies, and commodities. What they are trying to do is follow price trends in each of those asset classes. In fact, in 2008, this was the only alternative strategy that made money, and it made money northward of 10%.

Now, that's not to say that every single time the stock market is down, these managed-futures strategies are going to make money. But over time they have shown to be a very good portfolio diversifier when looking at these strategies and hedge funds because the track records of those kinds of strategies date back to the '70s.

Kapoor: Since you've touched on currencies, before you get to a recommendation, it seems like a tough game to play. I can't really think of anybody I've known even professionally who can consistently figure out the way currencies are going to move.

Papagiannis: Well, I like one guy, Axel Merk. He runs the Merk Hard Currency fund, ticker MERKX, which has several-year of track record. It was incepted in 2005, and he only does currency investments. Most of his products are mutual funds. It's basically a short U.S. dollar basket against many currencies. So the problem with going with like an ETF that's a bearish U.S. dollar fund is that basically you're just getting the euro and the yen. Whereas if you go to a more actively managed basket, you're going to get a more broader basket, with the Australian dollar, New Zealand dollar, Canadian dollar, Swiss franc, and all kinds of different currencies. I would recommend that, rather than taking a stance like, for example, if you think the Swiss franc is going to outperform the U.S. dollar because I think that's very hard if you don't study these markets.

Kapoor: I'm curious what's his current positioning though in the portfolio?

Papagiannis: I'm sorry, I don't have his current positioning, but he generally diversifies across the Group of 10 nations currencies.

Kapoor: What about in the managed-futures space?

Papagiannis: In the managed futures space, I like Natixis ASG Managed Futures, the ticker is AMFAX. This fund is managed by Andrew Lo. He is a professor at MIT, and he has done a lot of research on hedge funds. Basically, he has looked at all the managed-futures strategies across hedge funds and he has basically distilled it into a cheaper form where he controls the volatility of it. He doesn't take too much leverage.

Strauts: I'd say in the ETF space, if you want to look at the managed futures, the one fund would be WDTI. It is a managed-futures fund; it follows the S&P DTI index, which a whole host of other funds track. It's a very simple trend-following methodology. The one problem with it is that it has great returns in '80s and '90s, but because people have been investing in the index actively the returns have kind of tailed off. So, it's not a bad diversifier, but the returns will never look as good as the back test shows.

Kapoor: Sounds like a familiar story.

Strauts: Yes. The one fund I do like is VQT. I would consider this more of an equity alternative because what it does is it invests in the S&P 500 when volatility is flat or declining. And then when volatility is rising, it actually takes a small position in the VIX. It does this dynamically based on whether the VIX is rising or the VIX is falling, and over the last year, it was up 18% because the recent volatility that we saw in the market. When volatility spiked up, it got a small exposure to long VIX, it rose up. And then when volatility started falling, they got out of VIX and went long S&P 500. So it's a mechanical strategy. It is volatile, though. It has a similar volatility to your equity portfolio, but it's a little more noncorrelated.

Kapoor: Bill, before you jump to your ideas, I think there is a good question that's come in that's sort of tailor-made for you. What's the best way to invest in commodities, and which commodities do you personally think are well-positioned for the long run?

Harding: Personally, I think it is very difficult, as we are talking about currencies, it is very difficult to predict which commodity is going to outperform in the future. At times people may rush to buy gold or silver, some years cotton may be the best-performing commodity, and other times oil. I think that is very difficult to try to gauge. So what we advocate and what we do with the portfolios we manage is that we invest in a fund that tracks a broad index of commodities; we utilize the PIMCO Commodity Real Return Strategy.

So that provides exposure to many different commodities, including those in the oil and energy landscapes. It has got exposure to oil and natural gas; it's got exposure to precious metals such as gold, silver, as well as to the soft agricultural commodities, such as cotton and other. So I think that's kind of the best way to try to play that instead of trying to get too cute and trying to predict which one commodity is going to outperform in the future. Have a broad basket and get the diversification benefits of owning commodities.

Kapoor: That sounds like a familiar theme we're hearing in general regardless of what you are trying to do, whether it's currencies, commodities, or managed futures, is to try to invest with someone who can give you breadth of exposure versus very narrow exposure. I see some nodding heads there. So there is another question here from Abhi Vaishnav.

Bill, you sort of said that you thought about 5%-20% in alternatives would make sense, but he is also going a step further and asking how might you allocate that percentage of your portfolio.

Harding: Right, that's a good question. We have matched a portfolio where it's completely made up of all different types of alternative strategies. So I think at a broad level again harping on the theme of "make it broad and diversify," you want exposure to different types of alternatives if you have enough assets. So you can get that pretty easily today in some of these multialternative funds, where they invest in all different types of alternative strategies, such as the Absolute Strategies Fund, AQR Diversified Arbitrage. So there are other funds out there that are multimanager and multialternative that will provide you exposure to different types, whether it be long/short equity, they might also have exposure to merger arbitrage or convertible arbitrage. So, that's good place to start. Again, we do this just to make sure you have exposure to some different types of alternative strategies.

Then when we build that portfolio we are also mindful of the overall risk-and-return properties of this strategy. So, again, you want to make sure that's consistent with what you're trying to achieve. So, try to look at what that potential portfolio would have in terms of volatility, downside, downside risk, and beta relative to the broad market.

Kapoor: Do you guys want to add anything to that?

Papagiannis: I think it's pretty complicated to look at these strategies and to allocate to them. So, I think if you're pretty novice, I would recommend going to an advisor. If you don't feel that you are a novice, if you think that you are more advanced, I think a good way to start is maybe to pick three strategies and whatever you feel like your allocation is that you are going to start with--let's say you are going to start with 15%--I would pick three funds. I would pick a long/short equity, I would pick a managed futures, and I would pick market-neutral or an arbitrage-type fund. And I would just equally divide my allocation of 15% to three funds. Just make it simple.

Strauts: I agree with that.

Kapoor: There is a good question here also just about fees and how should people think about fees when it comes to these funds because they are certainly higher than what you are used to in a traditional actively managed sort of strategy. So, what's acceptable and what's not acceptable in your minds?

Harding: You are correct, and if you look at the alternative mutual funds available, they are definitely going to sport higher expense ratios. I would say 2% and under is kind of a good benchmark to use. I also think it's important to focus on fees in some of those areas that are maybe less volatile, more conservative. We have been talking lot about merger arbitrage, but that's a strategy that is more conservative in nature. The same goes for a market-neutral strategy. Because of that they're going to have less potential for very high return. So you don't really want to spend 2%-3% on a strategy like that just because those fees are going to eat too much into the return potential, especially in the mutual fund universe, where these managers aren't employing the leverage. Hedge fund managers can get away with a conservative strategy like merger arbitrage because they lever it up, but many of the mutual funds don't do that. So you want to be particularly careful on fees within market-neutral and other conservative strategies.

Kapoor: Are ETFs cheaper in this space in general?

Strauts: Alternative ETFs are more expensive than most of the ETFs we look at. Now, the typical stock and bond ETFs, you can find them for 10-20 basis points. In the ETF space, alternatives are going to be more like 60-100 basis points, which is still a lot lower than 2% threshold actually in mutual funds. So if you're comparing an ETF versus a mutual fund, the ETF is going to be little bit cheaper, but it may not be an active strategy. It may be more of an index approach to alternatives, so can you kind of weigh the pros and cons there.

Kapoor: We're going to start taking questions from our in-house audience as well, so if you have a question, raise your hand. I'm going to ask one more quick question, but the mics will start coming to you in the meantime. A quick follow-up to that last answer from all of you: What about from a tax perspective, how should people be thinking about some of the strategies? Should they be in tax-deferred accounts or taxable accounts?

Harding: I think it depends on the nature of the strategy and the actual investment. So, I think like many investors would evaluate their equity funds and other types of funds for their tax efficiency, I think you also have to do the same thing. There are some funds that are going to be less tax-efficient. If a lot of the return comes from income or comes from short positions, which gains on shorts are taxed as ordinary income, it will depend on the particular strategy and how it's managed.

There are other funds in this space that have done a better job in terms of managing the tax implications. Before Nadia had mentioned covered-call writing strategies: the Gateway fund for example has been pretty good at being fairly tax-efficient in this space as well. So it's something you definitely want to look at the underlying strategy.

Papagiannis: That's pretty rare.

Kapoor: Would you say use a tax-deferred account in general?

Harding: For the most part probably, but again personally in my personal portfolio, I do own some alternative strategies, and it's a taxable account. Again I think there are some that do a little bit better job of that.

Strauts: I would just add is that in the ETF space a lot of the ETF alternatives are actually ETNs, and ETNs have the key advantage in that they distribute no income. They don't need to distribute income, and so you get very tax-efficient treatment. So you can own them in a taxable account and even if the strategy is high turnover, you don't experience that turnover through distributions or capital gains; you're only going to pay taxes when you sell the fund.

Kapoor: Let's take our first question from the in-house audience.

Speaker 1: I was wondering are REITs considered alternative strategies? I am also asking a question about Annaly Capital Management, which has gotten a lot of press lately, and I know Morningstar followed it some years ago, but then stopped. And I was wondering what your position on that is?

Kapoor: So I am going to let you take that one, Tim. The question is really whether REITs are considered an alternative investment class? There is also a question about Annaly Capital Management. I am not sure if any of you are familiar with it, but if anyone is, you can comment on that, as well.

Strauts: As far as the real estate aspect, I think real estate was a better diversifier before it was added to the S&P 500. So I forget what year it was added, but it was little over 10 years ago. It was added to the S&P 500, and the correlations have risen since then, because if you own the S&P 500, you own REITs. So it still is a diversifier because you own property, but it's is not as good a diversifier.

As far as Annaly Capital Management, I can't speak exactly about it, but it's a mortgage fund. I would say it pays a very high-income, usually over 10%, but I don't know what it's paying now. So it's usually very attractive to people looking for yield. They see this over-10% dividend. The problem with it is that the dividend gets cut a lot when the volatility increases, especially in the mortgage market. There is a lot of uncertainty there. So you can't count on that dividend. So it's going to be a very volatile security.

Kapoor: The next question, please?

Speaker 2: I am just curious from an information-resource basis, there is nothing more frustrating than to say you want to diversify your portfolios, and then all of a sudden you are getting a K-1, which complicates your income taxes because you weren't anticipating a K-1 rather than getting a temporary thing. And the other side of it, say you buy a commodities fund because you have looked at what the noncorrelations are between the commodity fund numbers. And then you buy a commodity fund, but it doesn't really track the commodity because you have the roll issue, which you talked about. So I understand what all the caveats are, but I do not know how to look at an individual investment and to know whether it has that risk or it doesn't have that risk. Are you providing that information within Morningstar?

Kapoor: So the question really is around how you can protect yourself from some of the caveats that a lot of you have brought here today. So obviously I'd like to hear your views on that, as well. is a great place to start, but what else do you use as resources.

Harding: Well I think in the case of the commodity investments and whether they track or not I mean you can look at the returns generated by a particular fund relative to the commodity index it's meant to track and see if it has a done a reasonable job of delivering that return stream or not. I think that's kind of the easy thing. Then in terms of other sources of information besides the returns and the risk statistics we have on, I would suggest the Analyst Reports, and I think that would maybe get into some of the nuances involved in whether you are going to be prone to a K-1 with a particular investment or if there are other kinds of tax things to think about. A lot of those issues tend to be addressed in the Analyst Reports that are written.

Strauts: I would just say that on, in the operations tab, if it's a limited partnership, it's likely buying futures contracts, so it's likely going to give you K-1s. But again with our Analyst Reports, if we cover it, we'd also tell you that. Then as far as the tracking issue, a lot of people had concerns with some of the ETF commodity products where, again, I mentioned natural gas. For people who bought say regular a natural gas fund, there was a year I think it was 2008, 2009, where natural gas was actually positive for the year. But the natural gas fund loss like 30% to 40%, and it's because of this roll issue.

So, what they've done in the space is that new products have come out that try to mitigate the roll issue with the contango. So one fund I like that's in the broad commodity space is USCI, United States Commodity Index, and it actually tries to mitigate the contango by not buying just the front-month contract, but buying contracts further out in the curve, so it doesn't have to roll as much. And it also looks for commodities that are in backwardation, which means that when they roll, they actually make money versus contango, when you lose money when you roll.

Kapoor: What are some of those commodities?

Strauts: The commodities that are in backwardation change all the time. This fund just dynamically will allocate more money to commodities in backwardation.

Speaker 3: I have a question about hedge funds; they used to be regarded as more of a personal one-on-one high investment-type of vehicle. Now you folks actually mentioned hedge funds and talked about them. Could you give a summary of where they stand today? I also want to follow-up on that gentlemen's question, if you buy a hedge fund, do you automatically get the K-1 to complicate your income taxes, and just where do they stand now?

Kapoor: So that's a broad question just around hedge funds, and accessibility of hedge funds, and tax situations of hedge funds. So, Nadia, it seems like a good question for you. Maybe you can also sort of address who can invest in the hedge fund?

Papagiannis: Sure. So, hedge funds, there are still a lot of them out there. The number of funds that are good that are accessible to smaller investors are few and far between, basically the funds that are good have a ton of money in them already, and they don't need individual investors' money. They only take money from very large institutions, and many of them are closed already. So, first of all, trying to find a hedge fund period is difficult because there is no one source of hedge fund information. Morningstar does have a hedge fund database if you are an accredited investor that you can go and look at. But I mean there are thousands of funds, and it's very difficult to sort through. They don't have to report portfolio holdings and things like that. So finding the hedge fund is the problem number one.

Then once you found the hedge fund, finding one that's going to take less than $1 million just in one hedge fund's investment, $1 million. I don't know that you want $1 million of your net worth tied up in just one hedge fund, because not only do you have this investment risk, which is with any investment, but you also have operational risk that the hedge fund manager could just take off with your money or they could blow it up because they are taking a lot of leverage and a lot of illiquidity bets.

Kapoor: Are hedge funds of funds an option?

Papagiannis: Hedge funds of funds are an option. The problem there is fees, layers and layers of fees. If you add them up, it's probably close to 6% in fees.

Kapoor: Almost Cook County sales tax.

Papagiannis: The ability of you to be able to find a good hedge fund manager after fees that you can afford and that you can have a decent allocation to is very unlikely for the 99% of us. So, I would say pretty much stay away. Then the tax consequences, they're limited partnership, so it flows through. So whatever they trade you get the tax characteristics of that. So if they're trading futures contracts, that's actually a tax-efficient characteristic at 60% long-term capital gains. But you do get the K-1. A lot of advisors I've talked to say sometimes the K-1 is a problem, and sometimes it's not a problem at all. So maybe you get them one month later than you have to do your taxes. Some advisors complain about six months later. I would think that for funds of funds you get them later because not only do they have to get everything from all of their feeder funds, they then they have to send it to you. So it's probably more of an issue with funds of funds, but some people consider that an issue, and some people don't. In general if you are an individual investor I would stay away from hedge funds and other illiquid things like nontraded REITs and things like that.

Speaker 4: As alternative investments become more popular, won't there be more and more correlation?

Kapoor: The question is around correlation.

Speaker 4: Correlation with the stock market; won't they become a crowded train?

Kapoor: So I think, Bill, you tried to address this earlier saying that it tends to be the case that the correlation peaks when there tends to be very market-moving types of event. But what about over longer-term periods?

Harding: I think if we looked at various hedge fund indexes that have been around for quite some time, we can look at rolling correlations over time. I think while they may spike in times of crisis, in general over a longer period time they haven't really risen too extensively. And you make a point that if money is chasing into these alternatives, I think it's more about will the opportunities still be there rather than will the correlations increase? Because a lot of these strategies are using arbitrage-related strategies. It is really idiosyncratic risk, meaning its risk that's not tied to market movements or it shouldn't be. Merger arbitrage, it's really about that particular event and the possibility or probability of that event unfolding. So it's not as much as correlations; I think as more money piles into these different strategies at times you may have less opportunities, maybe spreads compress a little bit. So that will lead to maybe a little bit lower return potential. Sometimes we've seen managers in certain areas like convertible arbitrage. They are going to be influenced by the overall supply-and-demand dynamics. The convertibles market has had little supplies, so some managers have taken steps to limit flows into their strategies. They are definitely more capacity-constrained right now. So I think there are definitely things to look out for in terms of the growth of these areas, but I think it has more to do with opportunities than correlations necessarily rising just because the assets are going there.

Kapoor: We'll take one more question from the audience and wrap it up then with a final question.

Speaker 5: My question is related to an asset class that may fall out of favor and may become very illiquid. The one result of that could be that due to the illiquidity, prices fall. And one asset class like that right now is real estate. And my question is outside of buying real estate directly, how would you go about analyzing the potential investments such as REITs or other investments to decide how to participate?

Kapoor: Tim?

Strauts: That's difficult question because real estate investment trusts are commercial properties, and so yes, some of them are distressed, but most of them have already kind of come off the bottom. So they're not quite as distressed, and they are much more liquid today. I think a space that actually is more like what you mentioned is mortgage bonds. So the mortgage bond space is a space that can be very liquid, but there are lots of opportunities because many of these mortgage bonds are trading for $0.50 on the dollar. And if you analyze them correctly, you are maybe able to get a nice return there even though there are lots defaults and lots of foreclosures happening. So, you really need to find a manager that can really do that. One manager who is very good is Jeffrey Gundlach. He runs DoubleLine Total Return, DBLTX, and he's very good in that space.

Kapoor: One final question, I thought somebody was going to ask a question about gold and nobody did. So, I am going to ask it here to wrap it up. Gold is getting a lot of attention. What should people think about gold and how that should play in a portfolio?

Harding: My dad still likes gold; he's made good money on it. So good for him. I guess I should have listened to him couple of years ago. I'll go back to I guess the difficulty of knowing what the right price is for gold. I think gold is a little bit tricky, and it's hard to access what its fair value is. There are some kind of rules of thumb out there where gold trades relative to the Dow or this and that, but at the end of the day, it's about supply and demand, and I think maybe Tim could speak to this more that gold has really risen partly due to increased demand, and in particular within the ETF marketplace, where the gold ETFs are getting a lot of assets and that's caused the ETF to go out and actually physically buy the gold. So, that's led to prices going higher and higher.

At some point if that trend reversed and if you have people pull money out of their gold ETFs or hedge fund managers kind of reverse that bet, that could lead to additional supply and maybe some pressure on the price. I'm not smart enough to know ultimately what the right price is for gold, and that goes back to I'd rather invest in a broad commodity fund that has some exposure to gold or other funds where the managers might utilize gold to some extent in their portfolios as a hedge, such as IVA Worldwide, which is a great global manager, that own a little bit of gold in their portfolio as a hedge.

Papagiannis: I just wanted to add sometimes currency managers use gold as a currency essentially and use it as one of their currency bets.

Kapoor: We're out of time. So, unfortunately, we are going to have to wrap up here, but hopefully, you enjoyed it. There's a lot of opportunity here in this space, but use your common-sense rules. Be diversified as, I think, what the panel is saying, about 5%- 20% of your portfolio maybe makes sense depending on your risk tolerance and where you are, and watch those fees. Thanks for joining us.

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