Traditional sources of diversification were viewed as the safest way to pursue greater returns with less risk. But when stocks, corporate bonds, emerging markets and real estate all went down together in 2008, so too did this traditional theory.
In 2010, a growing number of financial experts are looking to alternative strategies for answers to improving diversification, managing risk, and building durable portfolios.
Dr Andrew W. Lo, Professor of Behavioral Finance at MIT Sloan School of Management and founder of AlphaSimplex Group, believes one of the lessons learned from the recent crisis is that the whole notion of diversification may need a significant revision.
“What we thought was diversified became very highly correlated because of the global integration of the financial markets. Assets we thought were uncorrelated have moved together, so we have to be much more thoughtful about asset allocation,” Dr Lo said.
In fact, Dr Lo believes many investors suffer from a disease he calls “diversification deficit disorder.” “The issue is not that diversification failed. It’s that diversification was not implemented properly. The financial system has gotten a lot more complicated, and it’s more difficult to achieve diversification than it used to be. In the 1970s, you could be diversified by holding 100 NYSE stocks. Nowadays, you have to go farther and broader in terms of strategies and markets to be able to achieve proper diversification,” he said.
As a multi-boutique specialist, Natixis Global Associates is uniquely positioned for this new era of diversification. Many of its affiliates bring together a diverse range of alternatives expertise under one company – including AlphaSimplex Group, Aurora Investment Management, Gateway Investment Advisers, Westpeak Global Advisors, and a multi-strategy fund of hedge funds at Natixis Asset Management.
Alternatives as a core
Today’s economic scenario is ideally suited for alternatives, according to Dr Lo. “When you have such complex economic interactions, the traditional long-only 60/40 model of investing is simply not adequate, because it doesn’t take into account the dynamics of these economic cycles that are far shorter and more erratic than they were 50 years ago,” he said. Also, the sheer magnitude of today’s global financial system – including 6.5 billion people now living in the world and each of them engaged in financial transactions of one sort or another – means we can’t invest in the way that we used to. “More sophisticated technologies must be developed to deal with a more complex world,” Dr Lo added.
Alternative mutual funds, including absolute return funds, hedged equity funds, hedge fund beta replication funds, and funds of hedge funds, are now readily available for core components of portfolios. These non-traditional strategies offer ways to add non-correlated and absolute returns to client portfolios. They can also help investors diversify across more sources of risk, hedge to protect on the downside, and actively seek to limit volatility.
Three portfolio applications of alternative mutual funds wealth managers may want to consider are: a risk-managed component of a core portfolio; a satellite to the existing core for alpha generation; and a complement to alternative investments.
Looking beyond hedge funds
Although hedge funds, as a group, fared considerably better than long-only equity investments in 2008, they suffered steep losses as well. This poor performance changed many investors’ perspectives about what they think they’re getting out of hedge funds.
In response to investors’ concerns about their hedge funds’ portfolios, AlphaSimplex Group (ASG) launched a hedge fund beta replication strategy in a mutual fund to provide investors many of the benefits of exposure to hedge funds, but without many of the drawbacks. ASG, acquired by Natixis Global Asset Management in 2007, was founded in 1999 by Dr Lo, a world-renowned authority in the areas of risk management and quantitative and behavioral finance.
ASG LASER Strategy is a proprietary hedge fund beta replication strategy that seeks to deliver the broad market characteristics and correlation properties of the hedge fund universe. Lo uses highly liquid futures and forward contracts and other instruments to capture hedge fund beta exposures through long and short positions in world equity, bond, currency and commodity markets. But unlike many hedge funds, this beta replication product is cost-effective, liquid and transparent, and all positions are adjusted daily to pursue a target 8% annual volatility.
In terms of portfolio application, this beta replication strategy can help address three issues. It can provide a measured, risk-controlled option for entering alternative investing. It can also be seen as a liquid alternative or complement to hedge funds, or an absolute-return-oriented diversification choice for traditional long-only portfolios. The strategy is still subject to specific risks associated with its investments in derivatives, structured investments and international investing.
