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What Can Alternatives Do For Investors?

Nadia Papagiannis, CFA

Nadia Papagiannis: Hello, my name is Nadia Papagiannis. I'm the Alternative Investment Strategist here at Morningstar.

And today I have with me Rick Lake. Rick Lake is the Manager of the Aston/Lake Partners LASSO Alternatives Fund. Thanks for being here today, Rick.

Rick Lake: Great to be here.

Papagiannis: Great. Well yesterday was the First Annual Alternative Strategies Conference sponsored by FA Magazine and you spoke at that conference.

And this conference was intended to educate advisers as so to the new and innovative tools available to them in terms of alternative investing. So, how do you see advisers investing allocating to alternative investments today?

Lake: Well, first of all, advisers are looking for number one, tools to manage risk; number two, additional sources of return; and number three, diversification. How to you build portfolios with multiple strategies and multiple assets in a very complicated and ever-changing world.

Papagiannis: And hopefully, alternative investments do all those three?

Lake: Well, that's the hope and advisors are looking at which alternative strategies to integrate with their portfolios and then how much they should use in their portfolios.

Papagiannis: Well, let's some put some numbers around this then, so you have a fund that's a diversified portfolio of various alternative strategies? And so if you took a 20% to 30% allocation, let's call it 25% or whatever you want to say, how would that help? How would that improve a 60:40 portfolio?

Lake: Well, over the long haul that type of allocation could bring a 10% to 15% to even 20% reduction in volatility and over time at least in the last decade added almost a full percentage point to compound returns over that 10, 11 year difficult period.

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Papagiannis: So, do these alternative strategies perform differently in different time periods? For example, in 2008 and 2009, we saw investors lose lot of money in 2008, but then we saw them recover a lot in 2009. And if I had invested 30% in alternatives, what I have missed out on that 2009 recovery, should I just have never been invested in alternatives in the first place.

Lake: Well, it depends which alternatives you use. If you use the right alternatives in 2008, you would have seen much less downside and to the extent that your risk is under control in an upswing, you actually might participate less in the upswing. But the smoother ride through 2008 and 2009 means that across that two-year period overall you might have had a better risk-adjusted return, even though you may have participated less in the rally of 2009.

Papagiannis: And what particular strategies might have done better in 2008 than the overall market?

Lake: Well, there are a variety of strategies that might have done better. Long/short equity, which mixes together long stock positions with short positions, in general, did better than the long-only equity indices. One strategy that did very well in 2008 was in the realm of managed futures, where the managers are using futures contracts to exploit volatile moves in either direction and the upside of 2008 on managed futures would have helped diversify a traditional balanced portfolio and softened some of the results in the rest of the portfolio.

Papagiannis: So for example, how should long/short equity fund perform in a market such as 2008 and 2009?

Lake: Well, if you want to oversimplify, which is what we'll do today, if a manager is 90% long in his portfolio and 30% short, that means he has 60% in that equity exposure. So all things being equal, he will capture 60% of the downside and 60% of the upside. If that manager is picking the right long stocks going up and shorting the right stocks in the down, he might actually be creating alpha on both sides of the transaction and can outperform in either environment or provide a smooth ride with additional returns in excess of what you would expect from 60% market exposure.

Papagiannis: So there's two benefits here. So, one benefit is the reduced risk profile and the second benefit is the ability to capture alpha on both sides, the long and the short side?

Lake: Exactly. And it is interesting, 2010 could be a potentially productive environment for long/short equity managers. You are in a market now that distinguishes between winning sectors and losing sectors, winning stocks and losing stocks, and if managers can be long and short on the right side of both of those phenomenon then it can be a very profitable year.

Papagiannis: Well, thanks, Rick. Thanks for explaining this to us.

Lake: Great to be here. Thank you.