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What Investors Should Look for in Alternatives

Christine Benz

Christine Benz: Assuming an investor is convinced that they want to have some alternatives in their portfolio, my advice would be to keep it to a small slice of the portfolio. What else should they thinking about? Low costs? You obviously are an evangelist about that.

Cliff Asness: Yeah. First of all, I share that advice to keep it small. It would be wonderful if there were so many great things that you could do that you could make all of your portfolio high return with no correlation. I don't believe that's the real world. Low cost is certainly one thing. The average hedge fund fees are famous.

Benz: Famously high.

Asness: Famously high, yes. See, I don't even think we need to say that, I think people would have known what I meant.

Benz: It's obvious.

Asness: They're famously high. If you find the one out of hundred genius, maybe it's worth it. But you don't find that by looking over the last five years and seeing who was the genius. It's pretty hard to find who'll be the next genius. So finding these kinds of strategies at reasonable fees is one.

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Number two is economically intuitive strategies. You don't want to just chase whatever has worked, you should have a belief and an explanation.

I believe in mine, but you don't have to believe what I believe. I believe that if things are mis-priced, they'll fix themselves in an arbitrage way, and trends tend to continue, but you might have a different belief.

Whatever you do, though, you shouldn't be chasing what has worked. You should have a economic belief why you think it will work.

And finally and this is maybe even the most important of all. You should really look for strategies that can be run at a fairly low correlation to traditional markets. That's kind of the point of alternatives.

But one of the scary facts is, if you go out and buy one of each hedge fund out--that would be pretty hard to do--but if you actually bought one of each, there are a lot of published indices. You've kind of had a long-term kind of 0.65 or 0.7 correlations to markets, and for the last five years in the high 0.9s.

So you're buying something that's very, very similar to your equities and not very diversifying.

Benz: At a high cost.

Asness: At a high cost, exactly. That's a very bad witch's brew. So we're actually--it's not surprising because we do this--but we're actually optimists that you can--and this is not unique to us--build a portfolio that has low correlation, that is at a reasonable fee, but you're not getting that if you buy hedge funds indiscriminately. So you should these are things, whether you like simple or complicated, we can probably agree on: you should be careful.

Benz: And look for transparency.

Asness: And look for transparency. One thing that's kind of wonderful as we move to a more individual world: The very nature of the mutual fund structure has some constraints on what a hedge fund can do. But it also is a very naturally transparent and naturally liquid structure. You do get to see daily pricing. And because the managers have to run with daily liquidity, hopefully you have to investigate the managers to see if they're prudent about this, but if you do get reasonable managers, they better be running a portfolio that's not a giant illiquid bet on markets doing well over the long term. They better be running a truly liquid hedge strategy, or else they're not going to be around very long.

Benz: OK, sounds good. Thanks for you insights, Cliff.

Asness: Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.