Why Individual Investors Should Consider Alternatives

Scott Burns: Talking alternatives in your portfolio. Hi, there, I'm Scott Burns, Morningstar's director of exchange-traded fund, closed-end fund, and alternatives research. Joining me today is Joanne Hill, head of investment strategy with ProShares, part of the ProFunds Group.

Joanne, thanks for joining me.

Joanne Hill: Great. Thanks for allowing me to be here today.

Burns: So, Joanne, you've had a pretty storied career. You actually wrote one of the original papers about hedge fund replication, and you've been participating, prior to ProShares, at Goldman Sachs and looking at the concepts of alternatives and alternative strategies. What do you think is the real reason for even retail investors to consider alternatives for their portfolios?

Hill: Well, actually, if we look back at what was the motivation for endowments and pension funds to move into alternatives, it's really the same thing for retail investors. The idea is to improve the return/risk trade-off, to try to find some strategies that have more attractive Sharpe ratios than traditional asset classes. I think that in the last decade of investing with two bear markets in 10 years in equities--the dominant asset class--has really encouraged investors of all stripes to look for things to complement their equity and fixed-income exposure, and alternatives are front and center in that space.

Burns: I think, one of the big questions on investors' minds--whether institutional, advisor, of retail--is what are alternatives? How do you define alternatives?

Hill: Well, there's probably a 100 definitions of alternatives out there; they come in a lot of flavors. My simple way of explaining them is they're strategies that are not stocks and bonds. So, they can have elements of a multiple set of risk factors, or some people even include commodities as alternatives. But if you think of the dominant components of investor portfolios--such as a fixed income allocation where you have strategies that set to a fixed-income benchmark, and the same thing as with an equity allocation--an alternative strategy would just be something that isn't a 100% stocks or a 100% bonds. And often, alternative strategies also have lower correlation to those dominant categories of stocks and bonds. So, a lot of things fit that criteria, so I have a very broad definition.

Burns: Very broad. So, Joanne, in your career, working with a lot of frankly institutional investors like pensions and endowments, people with a lot of experience and a lot of resources, as alternatives move more to the mainstream, what are the key things you think retail investors should really consider while they are evaluating these alternative strategies?

Hill: Well, the alternative strategies are quite different to evaluate compared with a typical, let's say, active strategy in equities, where you might look at what the performance drivers are relative to some benchmark. Most alternatives strategies don't have a benchmark. So, it comes down to having a dialog with the manager, whether it's a private equity manger or a hedge fund manager, and finding out what drives their return process and making sure that they deliver what they say they deliver. So, in the periods when the returns should be in their favor, they should be having good returns, and in other periods they should be having maybe poorer returns.

Burns: During the past few years, we've definitely seen a transition in alternatives as they move more mainstream. We've also seen them move into more liquid vehicles, and it seems like the demand for that liquidity is happening. These are things that aren't necessarily in private equity or hedge fund type structures, but more in 40 Act vehicles, whether mutual funds or ETFs. Why do you think that's going on, and do you really expect that trend to continue?

Hill: Well, I think that the trend will definitely continue. I think that hedge funds have delivered some surprises in the last few years. There is individual manager risk. Some of those funds have closed so that you couldn't put in more money; others have put restrictions on taking money out. So, whether you are talking about an individual investor or an endowment or pension investor, people are looking for more liquid access, and they're also looking for a little bit more transparency into the investment process and the types of securities that the hedge fund manager is using to deliver those returns.

Burns: Right. Do you think 40 Act-type liquid hedge fund strategies will overtake hedge funds? Do you think that we are looking at the swan song of the hedge fund structure right now?

Hill: No. I find that pretty hard to believe because if you look at the asset growth within the hedge fund industry, it continues. I think, we are over $2 trillion in hedge funds now. So, I think what will probably change is that there will be mutual funds that will now offer access to hedge funds via a mutual fund wrapper, much more so than they have in the past. But it will probably still be a fairly small part of the hedge fund industry compared with pension-endowment investing in hedge funds and high net worth.

Burns: Well, Joanne, thanks for your insights on alternatives. I'm Scott Burns with Morningstar. For this and other ETF information, please check out Morningstar.com's ETF center and Morningstar's ETF investor newsletter.