The Alternative Within Alternatives: Blending Growth with Liquidity

Bart Zitnitsky, Portfolio Manager, First Republic Investment Management

May 27, 2014

For a portfolio manager who is charged with the task of protecting and growing your money, honing in on your goals and objectives is the first step in determining the investment strategy that leads to the all-important asset allocation decision. Asset allocation is the main determinant for investment performance, but protection of assets and management of risk also are essential for a successful long-term investment plan.

Traditionally, asset allocation and risk management were as simple as looking at a balance between stocks and bonds. But as portfolio managers continued to look for ways to improve returns and reduce risk, it led to venturing out and exploring other investment solutions, or “alternatives.” Fast-forward to today, and alternatives include private equity, hedge funds, diversified multi-asset strategies, managed futures, and real assets—such as real estate and Master Limited Partnerships in the energy infrastructure area, other investment real estate and commodities.

There are two aims to incorporating these asset classes into portfolios: 1) improve overall portfolio returns and 2) reduce overall risk through assets that are not directly correlated to stocks and bonds. The table below reflects the historic correlations of various asset classes. When compared to traditional stocks and bonds, many of these alternatives do not correlate—and therefore are very good portfolio diversifiers.

Less than 10 years ago, many of these investments were deemed off-limits to the average investor and best left to the big institutions that have megabillion-dollar endowments and could afford to place a segment of their portfolios in these unregulated asset classes. But as these portfolios reflected outsized performance compared to their peer groups, more attention was given to this area, and these strategies became very popular and were marketed to the individual, high-net-worth investor.

Clients were touting their hedge fund managers, as they compared their (again) outsized returns to their diversified portfolio of stocks, bonds and cash. As long as these above-average returns were produced, it didn’t matter that their money was tied up—without the ability to redeem for three, six or 12 months. The monthly statements were coming in and portfolio returns were increasing at dramatic rates. Then came 2008!

During the financial crisis, liquidity dried up and people began to get concerned—some even panicked. It was a very uncomfortable time for most investors, no matter what markets you were involved in. We speak about correlation and the power of diversified portfolios, but in 2008 and early 2009, the majority of assets went in one direction—down! At least if you were in stocks and investment-grade bonds, you could sell them if you wanted to. But the many investors who had been enjoying the fruits of hedge fund returns in prior years were suddenly concerned about getting their hands on their funds that were tied up in these illiquid investments. It was truly a wake-up call for these investors once they were able to finally redeem their funds—some at 50 to 75 cents on the dollar. They were willing to take a loss just to get out of the investment. Some who hung in there for the long term are beginning to see normalcy return to this market.

Source: Morning Star

The financial crisis was a game changer in many respects, as liquidity became paramount to investors. As a portfolio manager, I have always placed a premium on liquidity, since my personal philosophy is based on maintaining my clients’ ability to tap their money at a moment’s notice.

Today, these asset classes continue to be an important part of a diversified portfolio but are now in different structures. An important, positive outcome of this crisis period was the restructuring of many of these alternative strategies into mutual funds, which does provide liquidity to investors for these kind of strategies and allows investors who were once considered too small to invest in these funds to round out their portfolios.

Circling back to our original premise of searching for ways to increase return while reducing risk in an increasingly diversified portfolio, asset allocation using these non-correlated assets in mutual funds now provide a mainstream avenue and the much-needed liquidity for these alternative investments.

Lastly, when reviewing your holistic investment portfolio as it relates to alternatives, asset “location” must be considered. Because many of these investments are tax-inefficient, depending on your tax situation you should be considering alternatives as good investments for the tax-deferred segment (IRA or pension) of your diversified portfolio in order to minimize the tax impact to you each year.

Alternative or “alt” mutual funds are publicly offered, SEC-registered funds that use investment strategies that differ from the buy-and-hold strategy typical in the mutual fund industry. Compared to a traditional mutual fund, an alternative fund typically holds more non-traditional investments and employs more complex trading strategies. Investors considering alternative mutual funds should be aware of their unique characteristics and risks.

First Republic Private Wealth Management encompasses First Republic Investment Management (“FRIM”), First Republic Trust Company (“FRTC”), First Republic Trust Company of Delaware LLC (“FRTC-DE”), and First Republic Securities Company, LLC (“FRSC”), Member FINRA/SIPC. FRIM is a SEC Registered Investment Advisor. This document is for information purposes only and is not intended as an offer or solicitation, or as the basis for any contract to purchase or sell any security, or other instrument, or to enter into or arrange any type of transaction as a consequence of any information contained herein. All analyses and projections depicted herein are for illustration only, and are not intended to be representations of performance or expected results. The results achieved by individual clients will vary and will depend on a number of factors including prevailing dividend yields, market liquidity, interest rate levels, market volatilities, and the client’s expressed return and risk parameters at the time the service is initiated and during the term. Past performance is not a guarantee of future results. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not be relied upon as such. This document may not be reproduced or circulated without our written authority. The investment services and products mentioned in this document may often have tax consequences; therefore, it is important to bear in mind that FRIM and FRSC do not provide tax advice. The levels and bases of taxation can change. Investors’ tax affairs are their own responsibility and investors should consult their own attorneys or other tax advisors in order to understand the tax consequences of any products and services mentioned in this document. Accordingly, you and your attorneys and accountants are ultimately responsible for determining the legal, tax and accounting consequences of any suggestions offered herein. Furthermore, all decisions regarding financial, tax and estate planning will ultimately rest with you and your legal, tax and accounting advisors. Any description pertaining to federal taxation contained herein is not intended or written to be used and cannot be used by you or any other person, for purposes of avoiding any penalties that may be imposed by the Internal Revenue Code. This disclosure is made in accordance with the rules of the Treasury Department Circular 230 governing standards of practice before the Internal Revenue Service. Products and/or services offered by First Republic Securities Company, LLC, and First Republic Investment Management are not deposits or obligations of, or insured, guaranteed or endorsed by any bank, Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other agency, entity or person. The purchase of securities involves investment risks including the possible loss of principal. The opinions expressed herein are solely and exclusively the opinions of the Investment Adviser Representative of the Adviser or Trust Officers of First Republic Trust Company or First Republic Trust Company of Delaware LLC, as the case may be, and are not associated with the Broker-Dealer (First Republic Securities Company, LLC). First Republic Securities Co., LLC does not offer investment advice or market commentary.