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Alternative Returns Are in the Right Ballpark

Nadia Papagiannis, CFA

Nadia Papagiannis: Hello, my name is Nadia Papagiannis. I am the director of alternative fund research at Morningstar. Today, we're here at the Morningstar Investment Conference with Brad Alford, manager of Alpha Opportunistic Growth, ACOPX, and Alpha Defensive Growth, ACDEX.

Brad, thank you so much for being here with us today.

Brad Alford: Thank you, Nadia.

Papagiannis: Brad, we're here with a lot of advisors [at the conference], and there seems to be a lot of confusion as to what to do in these markets. It's a very volatile time. Bonds are down. Emerging markets are down. The only thing that seems to be up is stocks. What do you think is the biggest challenge for advisors these days?

Alford: It's definitely, I think, the fixed-income portfolio. A typical advisor would be 60% equity and 40% fixed income, and in the first time in 30 years, it looks like interest rates may finally be going up and staying up. There was a head fake in January, but they came back down again. But it seems to be a movement of higher rates, and advisors are very nervous about that right now.

Papagiannis: Some of the things that they've done to hedge higher rates--maybe they were in emerging-markets currencies; that didn't pan out. What are some alternatives to hedging fixed-income risk or the risk of rates rising?

Alford: It's a great question because now there are managers who go long and short bonds will actually bet that interest rates will rise and go negative duration [a measure of interest-rate sensitivity]. There are ways to actually make money in a rising-interest-rate environment, which is unique and that's where you go into the alternative categories, and the nontraditional bond managers that you cover do a great job. But there are ways to make money in a rising-interest-rate environment. I think advisors probably don't know that and they should look into that.

Papagiannis: Your Defensive Growth fund is meant to be a bond substitute. What kind of managers do you have in there?

Alford: We're running a portfolio that we want bondlike volatility, so a 3%-4% standard deviation. But we don't want this high correlation to bonds, or if interest rates rise then we try not to lose money. We have a lot of managers that are long-short credit. We have managers that are long-short currency, who do merger arbitrage. We have some commodities exposure in there, some convertible arbitrage. Really the strategies are long and short and not just pure long-only strategies.

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Papagiannis: If an advisor wanted to get into some of these alternatives. It seems that there are lots of different strategies, lots to learn about. It seems very confusing. How do you put it all together?

Alford: That's a great question. Because I've been doing this for 25 years now, and it's certainly not easy. We started at the Duke Endowment and Emory Endowment, and it's been a real movement into alternatives. At Duke we were at 50% in alternatives. Advisors are just dipping their toe into the water and [could be thinking], "Why am I going to spend so much time in this one category, where I may put 10% or 20% of my time or my clients money."

Because it's very complex, managers are using a lot of instruments they're not familiar with. I think, obviously, Morningstar is a great place to start. They break managers down, but it's really an educational process and just a lot of research. Morningstar has a category called multialternative, which are really funds of funds where a lot of different managers are doing a lot of different strategies. That's a great place to start, to look at those managers and let an expert pick those managers for you.

Papagiannis: How do you think about how many managers you put together and how to put the strategies together?

Alford: That's certainly the tough question: putting the strategies together. You've got to figure out how the managers work together because you've got to look at different environments, whether interest rates are rising, the stock market is going down, the currency movements, and a lot of different things that would affect the portfolio. It's complex; we use a variety of tools. We use Morningstar Principia in order to screen managers. We're also using another software that is really good, does the analytical side, and does a lot of scenario testing for us. And so that's two technical models we use.

Papagiannis: Basically you're looking for managers that are not going to work together in the same way?

Alford: Right. When manager is going up--say, we may have a manager doing long-short credit--and then we'll have a short-only manager, so a manager that's betting the market will go down. They need a very different scenario to work. We may have a commodities manager in there; if someone is going long and short commodities. You want managers that are not correlated to each other, and it takes a lot of analysis to figure out how managers will work. We do backward- and forward-testing scenarios, trying to look forward to what a lot of the smart people are saying, what will happen in the markets over the next 10 years, whether it's J.P. Morgan's or Goldman Sachs' scenarios, then we'll back-test or forward-test those within our models.

Papagiannis: What do you say to advisors whose clients are asking them, "The market went up 14%, but why aren't I up 14%? You've had me in these alternatives and I'm not making the 14%."

Alford: Alternatives are really hitting singles and doubles, trying to earn 7% to 9% a year. If an alternative fund is up 20% or 30% then it's certainly doing something that it shouldn't be doing. They're hedged; they're betting a lot of different scenarios, which way the markets are going to go. They are really more of an 8%- to 9%- to 10%-type of a vehicle, and that's what they've been doing. The market has gone straight up since 2008 and compounding the S&P 500 at over 16% a year. And that's just not sustainable. Alternatives right now, people say they're only up 6% or 7%, and that is just too boring [for many investors]. But when the market corrects, you'll be glad that you have those in the portfolio to really bring down the correlation and to diversify your portfolio and lower your risk.

Papagiannis: Why do think diversification is important?

Alford: You need what I call that three legs of the stool: your equity component, your fixed-income component, and your alternatives component in order to act different from those other two components. We like to have alternatives because for the other two components, you need equities to go up for your equities and you need really interest rates to go down or at least stay level for your fixed-income component. Alternatives don't need those kind of binary outcomes. They can work in any type of environment; a merger-arbitrage fund is what we're really focused on. Acquisitions are going on in the equity markets, and so it doesn't really need the market to go up in order to make money. Individual investors get terrified, and they make knee-jerk reactions when the market is down a lot. They'll go to cash, and it's just the wrong time to do it. Alternatives might be like watching paint dry, but at Duke and other places that have 40%-50% in alternatives, it's worked for them for decades and has been a great asset class.

Papagiannis: Basically the value-add for advisors for alternatives is they help keep their clients in the market and stop them from making those bad behavioral decisions, those tactical decisions?

Alford: Absolutely. I know that our clients say every day they can look and maybe the market might be down quite a bit. It was down quite a bit [June 13], and both our funds were flat. The market was down well more than 100 points, and [our clients] get excited [and say], "Gosh, I didn't lose money when the market was down 100 points yesterday."

Just having something in the portfolio if the equity market is down a couple hundred points that it doesn't lose money or at least you stay flat, people get excited about that. Losing money is the most painful thing in the world. I think the studies say people are 3 or 4 times more upset by losing money than making money.

Papagiannis: Thanks so much, Brad, for your insights today.

Alford: Yes, thank you, Nadia. I enjoyed it.