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Comparing & Contrasting:

DRS vs. Liquid Alternatives

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One of the chal­lenges fac­ing today’s investors and finan­cial advi­sors has to do with under­stand­ing the role of alter­na­tive invest­ments with­in a port­fo­lio.

To address this chal­lenge, Swan Glob­al Invest­ments will provide a series of blog posts over the com­ing months to com­pare and ana­lyze var­i­ous types of alter­na­tive strate­gies and cat­e­gories. We seek to answer the most impor­tant ques­tions in each type of strat­e­gy, name­ly:

  1. What are the dri­vers of returns in each strat­e­gy?
  2. What are the risks in each strat­e­gy?
  3. What role does a given strat­e­gy play with­in a port­fo­lio?
  4. How does the given strat­e­gy com­pare to the Defined Risk Strat­e­gy?

Mak­ing Space for Ath­letes on the Team

Every win­ter, col­lege foot­ball fans around the nation eager­ly await Nation­al Sign­ing Day, when the nation’s top prospects announce their ini­tial com­mit­ment to a uni­ver­si­ty. I’m always intrigued by those kids who aren’t recruit­ed to play a speci­fic posi­tion, but are sim­ply list­ed as an “ath­lete.”

When it comes to judg­ing the poten­tial of a quar­ter­back or defen­sive end, the ana­lyt­i­cal met­rics used are pret­ty stan­dard­ized and straight­for­ward: speed, strength, body dimen­sions, etc. But with cer­tain prospects it’s hard to know just where they should fit on a team. Offense or defense? Every-down play­er or spe­cial­ty sit­u­a­tions? Every­one knows Chris­tian McCaf­frey or Jabrill Pep­pers will make a team bet­ter, but not every­one knows how to best uti­lize a mul­ti-dimen­sion­al tal­ent on a team.

The­se ath­letes are hard to clas­si­fy, just as liq­uid alter­na­tives are hard to clas­si­fy.

Since the Finan­cial Cri­sis of 2007-09 when most equi­ty man­agers lost mon­ey in lock-step with the broad mar­ket, there has been an explo­sion of strate­gies whose only com­mon thread or sim­i­lar­i­ty is that they are “doing some­thing dif­fer­ent.”

Liquid Alternative Morningstar Category Performance Before and After FInancial Crises- Swan Blog

 

The loose def­i­n­i­tion of alter­na­tive or liq­uid alt makes under­stand­ing or ana­lyz­ing them very tricky. The­se strate­gies are unique and wide-rang­ing. In 2016, Morn­ingstar expand­ed their liq­uid alter­na­tive frame­work by adding sev­er­al new cat­e­gories and cre­at­ing an alter­na­tive style box to com­ple­ment their work in tra­di­tion­al invest­ments.

MStar Style Box - Swan DRS vs. Liquid Alternatives - Swan Blog                                                         Source: Morn­ingstar Direct, as of 7/31/2016

Dri­vers of Returns for Liq­uid Alts

The “val­ue propo­si­tion” of alter­na­tives varies great­ly.

For exam­ple, some strate­gies try to short under­per­form­ing stocks as well as own out­per­form­ing stocks. The dri­vers of return in long/short strate­gies are pri­mar­i­ly at the indi­vid­u­al stock lev­el.

Oth­er strate­gies make top-down deci­sions and real­lo­cate their port­fo­lios based upon the antic­i­pat­ed rel­a­tive per­for­mance of asset class­es.

  • The fate of tac­ti­cal asset allo­ca­tors or mar­ket tim­ing strate­gies is dri­ven by sys­tem­at­ic, mar­ket fac­tors. We cov­er this in more detail in a recent blog post.
  • Mar­ket neu­tral strate­gies might try to have very low expo­sure to mar­ket move­ments.
  • Option-based strate­gies are influ­enced by “the Greeks” of option pric­ing mod­els — i.e., Delta, Gam­ma, Theta, Vega, and Rho.
  • The mul­ti-alter­na­tive cat­e­go­ry tries to repli­cate the “fund of funds” struc­ture employed by hedge funds by rolling many of the above strate­gies togeth­er in one pack­age.

I could go on, but the point is that broad def­i­n­i­tion of “liq­uid alter­na­tives” encap­su­lates many dif­fer­ent strate­gies and try­ing to under­stand all the fac­tors at play becomes very dif­fi­cult to man­age.

Sources of Risk for Liq­uid Alts

Any expe­ri­enced finan­cial pro­fes­sion­al will tell you return is close­ly relat­ed to risk.  The risks will be direct­ly linked to how they gen­er­ate returns.

If a long-short strat­e­gy has a val­ue-bias, what hap­pens when growth is in favor? 

What hap­pens when a tac­ti­cal asset allocator’s pre­dic­tive mod­el breaks down? 

What hap­pens to an option strat­e­gy when a short posi­tion goes in-the-mon­ey?

The­se are the kinds of things that will be explored in a case-by-case analy­sis.

The Role of Liq­uid Alter­na­tives With­in a Port­fo­lio

As with return and risk, the role of an alter­na­tive with­in a port­fo­lio will vary depend­ing upon the broad type of strat­e­gy and the unique char­ac­ter­is­tics of an indi­vid­u­al strat­e­gy. Broad­ly speak­ing, most pro­fes­sion­als view alter­na­tives as either beta-reduc­ers or alpha-drivers…defense or offense, to return to our foot­ball anal­o­gy.

How­ev­er, the biggest prob­lem is that alter­na­tive invest­ments typ­i­cal­ly don’t make up a large enough allo­ca­tion to have a sig­nif­i­cant impact on the end results of a port­fo­lio.

If alter­na­tives are used, they tend to be in the 10%-20% range of an over­all port­fo­lio. More­over, many prac­ti­tion­ers divvy up their alter­na­tive allo­ca­tion amongst sev­er­al or many man­agers, dilut­ing the impact any one man­ager can have on a port­fo­lio.

How Do Liquid Alternatives Relate to the Defined Risk Strategy? 

When Swan first devel­oped the Defined Risk Strat­e­gy, the orig­i­nal intent was that it would be a total port­fo­lio solu­tion. The­se days, we most fre­quent­ly posi­tion the DRS as a core equi­ty posi­tion — one with large cap char­ac­ter­is­tics, down­side pro­tec­tion, and a sig­nif­i­cant weight­ing in a port­fo­lio.

That said, the use of options and the fact that the DRS return pat­terns don’t close­ly track the S&P 500 when using met­rics like beta, R-Squared, and cor­re­la­tion leads some to clas­si­fy the DRS as a liq­uid alter­na­tive. The­se themes are explored in-depth in Swan’s recent white paper, “Where Does Hedged Equi­ty Fit?”

Given the lack of under­stand­ing of alter­na­tives and the chal­lenges described pre­vi­ous­ly, per­haps it is no sur­prise that many investors have been reluc­tant to ded­i­cate a sig­nif­i­cant allo­ca­tion to strate­gies that are “dif­fer­ent.”

To return to our orig­i­nal anal­o­gy, Stan­ford or Michi­gan wouldn’t have won as many games had they kept McCaf­frey or Pep­pers on the bench. Those kinds of play­ers were game-chang­ers only when they were in the game.

The objec­tive of this Strat­e­gy Com­par­ison blog series is to help investors, and advi­sors, bet­ter under­stand the­se non-tra­di­tion­al strate­gies and how they com­pare and con­trast to the DRS when mak­ing port­fo­lio deci­sions.  See our pre­vi­ous posts on:

Feel free to review more infor­ma­tion on the Defined Risk Strat­e­gy per­for­mance, or its com­po­nents, call 970.382.8901.

 

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

 

Impor­tant Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non­qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains.  This analy­sis is not a guar­an­tee or indi­ca­tion of future per­for­mance. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970.382.8901 or vis­it swanglobalinvestments.com. 061-SGI-030317