MASTERCLASS: Liquid Alternatives - October 2018

Liquid Alternatives and their investment vehicle structures have provided investors with access and exposure to new opportunities around the world. How should investors be thinking about them? And where can they find value and opportunity? Andrew Weisman, Kimberly Flynn and Cleo Chang join together to discuss the challenges Alternative Investment Managers are facing in the current environment and how their strategies fit into a larger portfolio.

  • Cleo Chang - Head of Investment Solutions, SVP and Portfolio Manager at American Century

  • Andrew Weisman - Managing Partner, Co-CIO Liquid Alternatives at Windham Capital Management

  • Kimberly Flynn - Managing Director, Alternative Investments at XA Investments
For Financial Professional Use Only / Not for distribution to the public

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  • 01 hr 05 mins 10 secs

Sarah Makuta:  Liquid Alternatives and their investment vehicle structures have provided investors with access and exposure to new opportunities around the world.  How should investors be thinking about them?  And where can they find value and opportunity?  Today I am joined by a panel of experts to discuss the challenges, Alternative Investment Managers are facing in the current environment and how their strategies fit into a larger portfolio.  Welcome to the Liquid Alternative Masterclass.  Ladies and gentleman, thank you so much for being here today?  Definitely, we’re excited about this topic for sure.  Let’s start with this question, what are the asset inflows into Liquid Alternatives, Kim, I’ll take that to you first.

Kimberly Flynn:  Sure.  Liquid Alternative inflows have been mixed, if you … depending on the time period you’re looking at.  I think that we are optimistic about future flows just given where equity valuations are today.  In the recent years, because equity performance has been so strong, I don’t think that the inflows have been as strong as we might have thought that they would have been.  Liquid Alternatives provide diversification and a lot of benefits for portfolios.  So that’s why we think on a going forward basis we’re going to see those inflows pick up.

Sarah Makuta: Excellent.  Andrew, do you want to add to that?

Andrew Weisman:  The inflows as my understanding, have been really critically dependent on which asset class you’re talking about.  So the futures strategies apparently have not done particularly well, those managers that are focused more on directional trading strategies, managers in other areas have done quite well.  In our case it’s been very strong.

Sarah Makuta:   Excellent.

Cleo Chang:  Yeah, you know, we think, you know, that the trend following and global macro has been a difficult space, you know, asset market goes, you know, one direction type of environment, it’s hard for this strategy sometimes to keep up.  However, I do think that equity long short or equity hedge and in the Liquid Alternative space, I think particularly the multi alternative, which sort of can serve that all in one type of option in investors’ portfolios has continued to see traction in this space.

Sarah Makuta:  Andrew, how would you characterize the current investment environment and what key challenges does it present?  I know you’ve brought along an interesting chart that we’ve pulled up here.

Andrew Weisman: Right.  So maybe we’ll take a look at this graphic.  This graphic, I apologize, is a little bit of a head hurter, but it’s worth taking a minute or two to kind of get a handle on.  Each one of those little data points represents two things, one, a two year rolling correlation of stocks versus bonds.  And in this case it’s actually the price of stocks versus the yield on a 10 year note.  And on the X axis it’s basically where the yield on the 10 year note happened to have been.  And what we notice first of all is that the low interest rate environment is everything basically to the left of that red line, that’s everything where the yield on the 10 year note has been below about 4-4½% and much of the mass is in the upper left.  And what that indicates is that in low interest rate environments, the correlation between the price of a stock and yield in the 10 year note is quite positively correlated.  In other words the price of stocks and bonds in low interest rate environments tends to be quite negative.  So stocks and bonds in a low interest rate environment tend to be a nice, effectively diversifying combination, however, what you also note is most of the data points are to the right of that.  Most of the data points in this graphic are actually below the 01 for correlation.  Since 19, the early 1950s which is essentially the date to almost present that this covers, most of the time stocks and bonds have actually been positively correlated in terms of price.

If you get the yield on the 10 year note much above the 4½-5% range there has literally never been a two year rolling window where stocks and bonds have not been positively correlated.  So it is virtually a revealed axiomatic truth that if we see a significant back up in yield at the long end of the curve that stocks and bonds are not going to be served as a diversifying mix to form a balanced portfolio.  But rather they are probably going to go down together, and that’s sort of a fundamental challenge, and beyond that there are a couple of issues that we all have to be cognizant of.  In the last several years the Federal Reserve has created … taken their system open market account, which is really their balance sheet from about 800 billion to essentially 4/4½ trillion, so there’s been over 3 trillion of basically high powered money.  We have engaged in significant fiscal stimulus at a time where the unemployment rate has reached frictional levels of unemployment.  And so there is a good argument to be made that yields are heading higher.  And I think that’s the fundamental challenge.  We have a market that’s indicating we’re going to move higher in yield and stocks and bonds are not going to be great and a correlated combination to provide stability for investors.

Sarah Makuta:    Excellent.  And what role should alternative investment managers play in meeting those challenges?

Andrew Weisman: Well, I think my colleagues can jump in on this, but I think critically what alternative investment managers should be doing are providing complementary risk factor exposures that are not critically dependent on the stock market going up.

Sarah Makuta: Are you going to add to that, yeah?

Cleo Chang:  I would agree, I think historically many investors have relied on stocks in their portfolio as their growth driver and relied on traditional bond, core bond holdings as the safety net that generated a reasonable level of yield for them.  As we’re climbing out of this zero rate environment, I think what investors have to understand is we have seen this year with core bond, many of them have yielded negative return, right.  And as we think yield rates are likely going to continue to creep up some more and given how tight spreads are, especially for the investment grade segment, I think it’s forcing a lot of investors to rethink about what other components can be added to their portfolio to serve as that additional diversifier.  And alternatives over the years have proven to be an invaluable component to that portfolio construction exercise.  So I think when evaluating an alternative strategy in one’s portfolio, to look at how it correlates with your bond holdings, in addition to how much equity protection it gives you, or uncorrelatedness to your equities are two easy questions that every investors should ask themselves.  And then from there to really seek out what additional attribute you are looking for, right.  Are you looking for income or are you looking for just uncorrelated return to other asset classes you may have?  So I think those additional attributes comes secondary, but first you should look at the correlation to equities and bonds in your portfolio.

Sarah Makuta:  Excellent.  Kim, what types of alternative investments make sense in the rising interest rate environments?

Kimberly Flynn:  Well, I mean I think to your point, alternatives should be part of the core.  And so what we’re observing is advisors replacing fixed income allocations with alternatives.  They’re also replacing equity allocation with alternative equity.  And so we see alternatives as part of that core.  And so in a rising rate environment we like alternatives that are floating rate in nature, in today’s market senior loans, collateralized loan obligations, CLO debt, CLO equity, these types of alternatives are used by banks, pension funds, institutions, because they provide not only attractive total return, but floating rate income.  So we think a lot of individual investors should be open minded to thinking about alternatives, replacing part of their core fixed income for something alternative that might be shorter duration and have more floating rate characteristics.

Sarah Makuta:  Excellent.  Let’s talk about the return of volatility in alternative performance, Cleo; I’ll come back to you for that one.

Cleo Chang:  Yeah.  I think this has been an interesting year, I think this environment where normalized volatility is something that many market participants has been anticipating.  We saw a little bit of this coming back at the end of 2017 and we have seen a lot more of it this year.  You can attribute this to the trade war discussion, you can talk about this as terrorists and we can see emerging markets going through a difficult stretch since the second quarter of this year.  And that could very well lead to other events in the marketplace that we have yet to see play out, so all those have contributed to volatility.  The fixed income rate market’s been more stable but we have seen spreads moving around.  So for example, the way we think about managing an alternative income product, we have been choosing where to overweight and underweight between high yield and loans, right, depending on where we are in the spreads.  The spread over the last two years moved somewhere between 300 and 450 basis points.  So it’s been a meaningful range where managers who have an outlook on the market can position their portfolio to take advantage of the wider spread and ride that spread down in a high yield market and as high yield spreads are tight like they are today, we can likely overweigh loans or other CLO type of instruments, which tend to be higher quality and right, so the spreads back up.  So I think that type of active management is just one of the ways that alternative managers like ourselves are trying to provide important risk diversification as well as bring return to the investors’ portfolios as we see volatility coming back.

Sarah Makuta:   Excellent.  Do you want to add anything about volatility, Kim?

Kimberly Flynn:  Well, I mean I think that, I don’t try to predict volatility but I think that if you can build a portfolio that’s going to perform in low volatility and rising volatility environments, you’re going to be better off.  And so some of the alternatives that we’ve talked about today give you that sort of hedge from, what we’re really talking about is equity volatility.  So many of the alternatives that we’ll talk about today, give you that ability in the portfolio context to reduce overall risk, so what we want are better returns for clients with less risk.  And I think that’s what alternatives are really seeking to do.  It may not be a higher return but it might be a higher risk adjusted return.  So when you’re thinking about volatility, I think it’s always helpful to put it back into what’s the goal for the portfolio and what is it can help in terms of driving the portfolio level risk.

Sarah Makuta: Excellent.

Andrew Weisman:  Actually I’m making a couple of extra comments here, but this resurgent volatility really coincided with a couple of inflation prints which actually technically put both core and headline CPIs slightly above The Fed’s target.  And really what investors are concerned about is that may force the hand of The Fed at this point where they simultaneously now have to be responsive to resurgent inflation.  And that to a certain extent relieves the Powell, formerly known as Yellen, formerly known as Bernanke put in the market.  And it’s really, you know, you can see it to the day when that inflation, or rather, volatility began to pick up.  So that’s going to be a big challenge.  I think in addition to that The Fed has been pretty clear about the path of rates, they’re going to move higher.  And I think that that’s something that is barring a major systemic risk event, something you can rely on.  If you think about the last time The Fed raised rates, that sort of 05/07 period, they raised rates at the short end, 25 basis points, every six weeks, 17 times in a row as part of an unannounced social welfare program known as no trader left behind.  And, you know, it really provided an interesting opportunity for people who were attempting to capture those sorts of effects.  But bottom line is, I think that, you know, given some of the factors we’ve cited earlier, I think we’re in a more volatile environment.  And I think it’s something that you can reasonably expect to persist.

Sarah Makuta:   Definitely.  Cleo, let’s talk about global growth, is it still synchronized?

Cleo Chang:  Yeah.  I think definitely we’ve seen, as I mentioned earlier, we see emerging market decoupling from developed markets.  We’ve seen other divergence, I think from Central Bank policy where the US is one of the first to start tightening, while the rest of Central Banks are still sort of in a different type of environment.  We’ve seen growth in value, so a divergence between the two playing out for some time now, developed versus emerging.  And we also see in the fixed income market, if you have looked at the spreads for investment grade versus spreads for high yield, those two spreads have moved apart as well.  So unlike, I think markets sort of prior to second half 2017 where it’s very easy to find asset classes literally tracking each other for some time, definitely in the last 12 months and more.  So this year we’ve been able to identify some very clear divergence, whether issuing the right policy, by the macroeconomic backdrop or events that’s playing out in the marketplace, that we definitely think this is a much more interesting environment for active managers in general.  And given the flexibility that comes with many alternative strategies, we do think this is a very conducive environment for alternative managers because not only can we profit from our long ideas, we tend to have the ability to profit from our short ideas.  So I think this type of divergence does create a much more conducive environment for alternatives.

Sarah Makuta:   Kim, you wanted to follow up to that.

Kimberly Flynn:  Sure.  As Cleo noted, I think it’s the right time for advisors to be talking with their clients about alternatives because of the opportunities that present themselves.  The last few years have been a great environment for passive beta exposures.  But when you’re seeing the decoupling, when you’re not seeing things move in lockstep you really want to have a conversation around where your allocations are today.  And so I think it’s really a timely point to bring that up in terms of having those client conversations.  So we see that as an opportunity for advisors and their clients.

Sarah Makuta:  Andrew, what key attributes are important in the selection of managers and strategies?

Andrew Weisman:  So, I think the primary responsibility of an alternative asset manager is to provide essentially complementary risk factor exposures.  So these are sources of return that by and large are not critically dependent on the stock and bond market going up or down.  These risk factors should be, as I mentioned before, to use this $10 word, relatively orthogonal or statistically independent of these traditional benchmarks, they should be scalable and investable.  And finally, you know, you shouldn’t be seeking from an investment, an alternative investment manager that which you can get for 7 basis points from the folks at Vanguard, which are traditional equity exposures.  There should be a good intuition with respect to why you deserve to be compensated for every one of these risks that you’re taking.  And there should be a fair amount of information, both the academic and practitioner literature that support the idea that these things tend to pay off over time.

Sarah Makuta:   Excellent.  Do you guys want to add anything to that strategy selection?

Cleo Chang:   I would say since 2008, unbeknownst to many individual investors, the make up of our fixed income capital market actually looks very different today than pre 2008.  And over the last 10 years we have observed fixed income market really start to favor those managers who specialize in certain segments of the fixed income market.  So previously I think you can find managers who were very broad and be able to find enough relative value trades to really generate alpha on a persistent and consistent basis.  I think the market has evolved to a point where we really think those specialty managers who have a particular insight on a subset of the fixed income market will come out to benefit from the new environment.  And that’s been the approach that we’ve taken in constructing the alternative income portfolio.  And what you find is they tend to bring very uncorrelated and very complementary return patterns to each other.  So that, I think going forward that seems like a strategy for investors to consider if they are thinking about alternative credit type of investing.

Sarah Makuta:   Great.  Add to that, yeah.

Kimberly Flynn:  ] Sure.  We evaluate alternative credit managers; we’re looking for time tested processes.  We’re looking for cycle tested teams.  So I like to see a deep bench, when you’re talking about active management it’s really important to have people who have worked together in prior credit cycles and really have from the top down the training of the analysts, the associates, all the way up to the investment committee.  So that’s really important in terms of picking the right alternative credit manager.  And, you know, from there you get the performance that you want to see.  You get better risk adjusted returns and a focus on capital preservation is really important.  And that comes through when we analyze risk management, what is the team doing to protect the portfolio and are they doing it in a consistent way.  So that’s how we tend to evaluate our alternative credit managers.

Sarah Makuta:  Excellent.  Cleo, did you want to add anything, anyone talk about the flattening treasury yield curve, investor sentiment and performance?

Cleo Chang: So I think one of the things that’s sort of come through on the headlines a bit over the last year or so has been this flattening yield curve.  And I think this is not something that’s alerting but I think it is something worth watching, because we’ve seen that the flattening or in the inversion of the yield curve, sometimes serves as a leading indicator to recessionary environments.  I think what’s unique about today’s environment and the flattening of the yield curve is historically the flattening or inversion of the yield curve tend to happen when rates are somewhere above 4½-5%.  Today we’re actually observing the flattening and potential inversing yield curve at roughly the 3% range.  So, as that sets a very different and unique backdrop I think that adds another layer of complexity to what the flattening yield curve means to investors.  And I think we’re lucky that today I think there are more alternative fixed income instruments out there, or funds or vehicles out there for investors who are concerned about what a flattening potential inversion yield curve can mean to their traditional fixed income portfolio or the broader economy so that they have more choices.  And I can identify whether capital preservation is now a primary objective versus capital appreciation, income generation over capital growth.  So I think the market today offers many more thoughtfully constructed strategies, whether it’s illiquid alternatives or something less liquid that provides a higher yield premium for investors to choose from.

Sarah Makuta:   Excellent.

Andrew Weisman:    I’d like to add a couple of things to that.  I have a more sanguine view of the shape of the yield curve simply because … and I think you were kind of alluding to this, but the short end of the curve is basically domestically determined by Fed policy, the long end of the curve is determined more globally.  So we still have the European Central Bank heavily involved in buying the long end of the curve.  So, to me it’s not particularly surprising that you’re seeing a flattening of the yield curve.  I think the thing to be concerned about is what’s more going on in the credit sector.  There have been some particular buildups of potential crisis, so I’ve read and seen it characterized as a situation where there’s a fair amount of tinder and dry brush in the bottom of the forest, which would really represent the necessary conditions for maybe a systemic risk event, but not sufficient conditions, or rather.  You know, so as an example, since 2008 we’ve seen the Triple B segment go from, you know, about 800 billion to about 3 trillion, it now represents fully half of the investment grade credit.  You’ve seen a growth of about a trillion in the last 18 months, so there’s this big blob at Triple B which is essentially that sector which can very quickly, if the economy slows down, result in a big collection of fallen angels and forced selling.

You know, you see 2007 the average sort of debt coverage ratios as measured by the amount of debt outstanding relative to forward earnings, or relative to EBITDA, rather, be about 2.1, and that was considered high at the time.  We’re now at 3.2; with 37% of the Triple B sector that ratio is above 5.  So it’s, you know, we’re arguably highly levered and with the potential for a situation where if we start pricing in perfect and go slightly below perfect or perfection that you could have some significant disruptions in that market.  So I think it’s a difficult sector, I think that, you know, having a manager that can potentially be responsive to that reality, I think could be very helpful, at the very least, someone who has the ability not to adhere rigidly to a benchmark where they have to stay long and just enjoy the ride down.

Sarah Makuta:   Sticking with credit markets, Cleo, where can investors find opportunities?

Cleo Chang:  Yeah, I think to echo Andy’s comment, this we find to be a particularly interesting marketplace for high yield, where we, without that passive approach to high yield investing can be more dangerous today than in previous years.  This is really where credit selection and having the expertise to look for a high yield name, to have the asymmetry in upside versus downside, hopefully more upside, less downside.  It’s really, really important and it goes to my earlier comment, you really are looking for specialty managers who, to Kim’s point, have gone through multiple cycles, the team has been through this before, so this is not the first time they are going through this.  And, you know, as we’re approaching closer towards the tail end of the credit cycle, these are things that you expect to play out.  So experiencing going through this is really important.  Additionally, we think asset backed securities [inaudible] a really interesting market.  We still see relatively strong fundamentals for companies, particularly in the investment grade space.  And, you know, I think that the debt to leverage ratio is higher but nowhere near, you know, what we are seeing in the high yield space.

So we think asset backed securities through careful security selection can also represent a really fruitful segment of the fixed income market.  And we think investors can be well rewarded for the risks they’re taking.  And the long space, right, so bank loans and CLOs that we think in this environment as rates are expected to continue to rise somewhat, I think will continue to provide that uncorrelated sort of rate adjusted return for investors going forward.  So I think some combination of those things could be very complementary to a traditional core bond portfolio.  We typically say 10-20% a core bond portfolio can be easily allocated to these other ideas that really is, if managed well can come in at a very modest volatility and very complementary to the core bond.

Sarah Makuta:  Excellent. Kim, do you want to add to that at all?

Kimberly Flynn:  Well, I was just going to mention that high yield is one of those asset classes that people may not realize does well in a rising rate environment, at least looking historically.  So it, too like loans or CLOs can be something that is a positive returning part of the portfolio in a rising rate environment, at least that’s what we’ve seen in past cycles.  There is a lot of interest in the marketplace today in less liquid credit investments, things like direct lending, middle market private debt.  We’ve seen a lot of interest in BDCs, partly because they’re a total return vehicle but they have attractive income and yield.  So, that too, away from more familiar types of credit investments, we’re seeing a lot of advisors that are interested in those types of alternative credit.

Sarah Makuta:  Excellent.  And when evaluating alternative credit opportunities what should the investors really be looking for, to both of you ladies?  Do you want to try to answer?

Kimberly Flynn:  Well, I mean I think that it depends; we talk with a lot of folks who think about their fixed income allocation differently.  So we’re hearing a lot more from clients, family offices that if it is a total return tool then they’ll consider it, even though it might also be a yield or an income oriented option.  So they’re using some of these alternative credit strategies differently.  They are using it to diversify their other sources of total return.  So I like that, I think that’s a refreshing way to think about alternative credit, usually people are just attracted to the stated yield.  But, you know, as we’ve been talking about, it’s more than just the stated yield, it’s what can it do for you in terms of total return and risk adjusted returns.  So I think there’s more conversation around what these types of alternative credit vehicles or investments can do for the overall return.

Sarah Makuta:   Definitely.  To Cleo.

Cleo Chang:  I would say as we believe we’re inching closer to sort of the later stages of the credit cycle, this is where sort of capture protection is becoming more important than say if we were in the earlier part of the credit cycle.  So as we look at our high yield exposure we are increasingly focused on the managers’ ability to sort of navigate through that type of environment.  We also think this is where we advocate for responsible yield, not all yield is the same.  So as we’re picking up yield in the current market environment, we don’t want to pick up nickels and dimes in front of a steamroller.  So, we are very judicious in finding yield and trying to sort of weigh the benefit of that yield versus total return, and making sure that the balance of the portfolio is optimized to accomplish the best risk adjusted return.  Because we think at the end of the day that’s what will achieve or help investors achieve their long term objective.  And I think that’s one very important metric for investors to think about when they are selecting alternative strategies is not just to look at the return or the risk on their own, but really look at their risk adjusted return, whether it’s measured by sharp ratio or sortino ratio which tend to be a downside focused risk adjusted metric.  So I think those are very helpful things to help an investor navigate during the selection process.

Sarah Makuta:   Andrew, do you want to add anything?

Andrew Weisman: ] Yeah.  I’ll be the Cassandra in this situation, so I think the big concern is if you do believe your lifecycle, the reality is that a lot of the high yield stuff or corporate debt in general when push comes to shove, it does trade like an equity.  So if you went and visited the folks at Moody’s [inaudible], one of their prime responsibilities is calculating default probabilities on corporate debt.  The way that stuff is typically modelled is something that looks like what’s known as a Merton Model which is essentially structured as a call option on the assets of the firm, with the notion that if it drops below a certain level, people tend to walk away.  So conceptually it’s actually modeled like being long the stock market and it’s something that performs very, very well right up to the point where it just stops performing altogether.  So it’s got this big left tail that’s not necessarily even going to show up in the in sample data.  And unfortunately life is not a sample, so that’s a big issue.  So on the one hand it gives the appearance of looking like it’s uncorrelated, in many cases it’s because you’re dealing with securities that have less liquidity, that tend to be priced very adaptively rather than, you know, mark to market and it’s sort of model marked in many cases.  And that tends to artificially reduce the correlation to traditional benchmarks.  But quite honestly, when push comes to shove, that stuff looks like an equity, talks like an equity, quacks like an equity, yeah.

Cleo Chang:  And that’s an interesting point, so I think it’s interesting, I think it’s not uncommon to find a lot of alternative managers, either like certain hedging strategies.  And sometimes equity hedges serve well against a high yield portfolio, especially when we look at how the futures market roll and the cause of these different hedges.  Those are things that we’re actively evaluating every single day and making sure that the portfolio has the appropriate protection, given the market conditions, and if it’s the high yield hedge that we think is appropriate, so be it.  But a lot of times for high yield exposures we can oftentimes utilize equity hedges to partially hedge out what you’re talking about, so it’s interesting to hear you say that.

Sarah Makuta:  Kim, let’s talk about alternatives for retirement and long term investments.  How much liquidity do you need in your retirement portfolio?

Kimberly Flynn:  I think this is one of the risks that we don’t talk enough, like post credit crisis portfolios have become almost all liquid.  And so if you’re investing for a long term goal like retirement or to buy a home, I just question how much of the portfolio really needs to be in daily liquid investments.  So I would challenge advisors and clients to think about that mix.  Every person’s going to be a little bit different.  But if you think about alternatives there is a wide spectrum of alternatives that you can’t package in a daily liquid mutual fund or exchange traded fund.  And so if you’re looking to get access to some of these institutional alternatives there’s a way to do that.  But you do have to acknowledge that there is this liquidity risk.  And also the liquidity risk will drive additional return, which we call liquidity premiums.  And so that’s why we think that particularly for people saving for retirement, they really stand to benefit by moving part of their portfolio into less liquid alternative investments.  Pension funds, endowments, they know the value of investing in less liquid investments and they have a time horizon that matches.  So we would argue that retirees should really think about this liquidity mismatch, meaning they have too much liquidity in a long term retirement portfolio.  And what the risk is, is you’re leaving return on the table.

So, I like, many people in the industry think that the ETF industry is going to continue growing.  And we know why, because it’s such a cost effective way to get the exposures advisors want for their clients.  But I do think that there’s room for multi asset class solutions, there’s room for advisors to talk with their clients about alternatives, because in reality, how do we add value?  We add value by helping our clients understand some of these new types of risks, helping them get comfortable.  And that’s why I think that so much of what gets talked about today in alternatives is the Liquid Alternatives.  And there are a lot of good ones but I think that there are opportunities, and we can talk about some of the structures that allow access to less liquid or illiquid alternatives.  And it’s not going to be appropriate for every client, but an allocation for a retirement portfolio is worth considering if you’re looking for diversifying sources of return.

Sarah Makuta:  Cleo, long term investing retirement, to what Kim said?

Cleo Chang: I agree with what Kim said.  I think, liquidity is one of those things, when you ask people, “Do you want it,” they always say yes.  When you ask them, “Do you need it,” the answer tends to be much more thoughtful.  I think the challenge for investors oftentimes is they seek liquidity when liquidity tend to hurt them the most.  I think that’s the challenge and I think that’s why having well thought out, well-constructed actively managed alternative strategy, whether in the daily liquid,  or something else is so important because the investors needs that assurance to know that someone’s actively managing it.  And it helps investors make fewer knee jerk reactions to marketplace because we oftentimes see in the data, those knee jerks reactions is often the most painful trade for investors, and they never get back in, in time to make up for the losses.  So I think, you know, that’s definitely a topic worth discussing, and a lot more education is needed to help us further along that dialog.

Andrew Weisman: And there’s a well-known concept in the field of behavioral finance, that to a certain extent attempts to explain why people don’t achieve their long term investment goals, and it’s something known as a disposition effect, where you essentially are much more sensitive to upside gains than losses.  And people have this sort of tendency to trade out of stuff that has gone up a little and kind of closed their eyes when things go down whole hog.  And so there’s a lot of these kind of effects that I know to a certain extent constraining people from allowing their base or impulses to sort of subvert their portfolio goals over time, they can be helpful.  The only real issue is I think the sort of the proper pricing and understanding of the dynamics of liquidity and the effect, and the real cost of it.  And so that’s one of the positives, but there is also a lot of good research that’s been done on actually pricing the liquidity as simply not having it, what’s it really worth in basis points?  There was a good paper published in the Journal of Portfolio Management that was awarded the … what’s it called, the Roger F. Murray Prize, which sought to actually price that effect.  And I say that tongue in cheek because I wrote the paper.  But in my opinion it’s not something that’s … well, I co-wrote the paper, I had a co-author on that.  But, you know, lacking liquidity with an investment can be a surprisingly expensive effect and it’s something you should really understand in addition to, you know, just what the good stuff is and there’s a bit of both.

Kimberly Flynn:   So we looked at quantifying liquidity premiums.  The Harvard Management Company that runs the endowment put liquidity premiums on average at 3%.  It depends on the asset class.  There are liquidity premiums that exist within equity markets within the treasuries, so you see differences in pricing based on how liquid the security is.  And so I think the behavioral finance component is really important in terms of how investors think.  And it’s also why financial advisors serve as a reminder; they help in terms of the commitment device.  I think that investors need to be thinking about allocations and not in that moment where liquidity dries up.  You know, and I think that’s the concern in terms of having these highly liquid portfolios, because in times of crisis those too, liquidity will dry up and people don’t think they have the liquidity that they want or need.  And so in some ways, active managers who have pools of capital in that period of time, our firm develops registered closed end funds.  So a closed end fund is an example of a closed vehicle that can take advantage of some of those market dips and they’re a buyer when others are sellers.  We see a lot of innovations in the marketplace today, advisors and their clients want registered types of vehicles and partly it’s because that’s what they’re accustomed to with mutual funds and ETFs.

A different type of registered fund is a closed end fund, closed end funds can invest up to a 100% of their assets in illiquid alternatives, and so we’re seeing a lot of innovation and growth in terms of different types of funds, they could be listed, they could be non-listed.  And we’re seeing new alternative managers come to the marketplace, so it really presents an opportunity to get access to alternative managers that otherwise you couldn’t, unless you bought one of their limited partnerships.  So we’re seeing a lot of growth in that part of the market, it’s still a small part of the market.  But it is, the structure, the closed end fund structure is a much better fit with a limited partnership structure.  So it allows alternative managers the same degrees of freedom that they have in managing their private funds.

Sarah Makuta:  Moving to investment philosophy and portfolio construction.  How do you construct a portfolio?

Cleo Chang:   Well, I think, you know, it’s really important, you know, we make the crude assumption that most investors have some kind of stock and bond allocation in their portfolio.  So when we think about adding anything to further complicate the portfolio it has to be additive, right.  And some of the easy metrics to measure when an investment would be additive to the portfolio is to look at the correlation, is to look at its risk adjusted return, right.  And then furthermore, is to look at the sources of return where we’re capturing it from to make sure that there’s limited overlap with what’s already in the portfolio.  So that’s usually sort of the basic premise.  And as we construct portfolios we always want to bring those additive attributes to a stock swamped portfolio.  For example, the alternative income strategy, we tend to avoid sort of treasuries in investment grade credit because we do feel like those are the core components investors probably already have through their traditional bond holdings.  So we try to navigate into niche segments of the fixed income market where we see attractive relative value.  And it’s also important for our clients to understand, more alternative strategies on the market today are constructed thoughtfully around a risk budget type of framework.  So I know some investors still associate the word ‘alternative’ with very high risk type of strategies.

But if you look at sort of the Morningstar Multi Alternative category and if you look at using the three year risk sort of measurement they have, you will find many of them have very comparable risk return to what investors typically associate with a bond portfolio, somewhere between 3-6% annualized risk is very common for the multi alternative category.  So I think that’s another thing that we want to continue to help investors understand is adding alternatives to your portfolio can sometimes lower the overall risk to the portfolio rather than adding to it.  And you’re benefitting from the uncorrelated source of return, which therefore improves your long term risk adjusted return.  So, from a portfolio construction perspective, that’s what we think.  I often get the question, you know, as an asset allocator for a long time is, “Well, what should be the right alternatives allocation within my portfolio?”  You know, I think if we start to look at some of the most sophisticated institutional investors in the endowments and foundations segment, they are more than 50% alternatives.  And that’s not what we’re advocating for individual investors.  But we also think adding 3%/5% to your portfolio is not going to have enough impact on the bottom line of the portfolio.  So when we think about it we would say for investors who are new to alternatives, who are still trying to learn the different strategies, a 10% allocation combining some different strategies, you know, maybe an equity long short with a more credit oriented at 10% in aggregate would be a good place to start.  But we do think more optimally speaking somewhere between 10-20% will really deliver that improvement in risk adjusted return over the long end.  And we think investors will … are seeking for.

Sarah Makuta:  Excellent.

Andrew Weisman:  So my experience in this area, it involves actually working, consulting to 70 or so major institutional portfolios and doing very rigorous kind of factor analytical studies of where the money’s been made and lost.  And in a typical pension fund endowment it’s probably got 50% of their portfolio in equities, roughly 30% in fixed income and typically about 20% in terms of alternatives.  But the reality is, when you ask a much more rigorous fundamental question, how many truly independent sources of variance are there in their data?  You know, how many truly independent things are going along that explain their outcomes month to month?  It’s typically well in excess of 90% of their outcome in any given month is determined by a single factor.  So they have highly concentrated risk factors and it generally tends to be, answer the following question, did the stock market go up or down?  And that’s going to determine the outcome.  So, you know, from a starting point, that whole notion of doing these studies, they are typically referred to as principal component analysis.  That has become increasingly [inaudible] amongst guys and girls who are doing factor modeling and portfolio analytics.

You know, my preference is to have as little as possible explained by that first principal component, by that first source of risk, but just try and get things spread out as much as possible.  And there’s a few ways of doing that, number one, you want to use independent sources of risk as much as possible, don’t simply rely on the stock market going up.  You want to combine these in such a way that the marginal contribution that each one of these risk factors are making is essentially equivalent across the portfolio.  So if you add a dollar to anything in your portfolio it’s essentially going to have the same overall contribution to risk.  So in other words don’t allow any single risk factor to dominate the outcomes.  That is like critical to getting better risk adjusted returns over time.  And finally, in terms of how you think about all of this stuff, you should be using at the very least, as an overlay, some sort of statistical methodology that takes into account more recent data, more heavily than older data.  So to the extent that you’re estimating the volatilities and the independent structure in the portfolio, you should be using more recent data, more so than older data.  And the reason for that is it’s a well-known feature in financial markets that volatility tends to cluster.  So high periods of volatility tend to precede additional periods of heightened volatility, so there’s a lot of value associated with playing a more active rigorous role in terms of managing the risk and the building blocks you’re using in a portfolio.

Sarah Makuta:   Did you want to add anything?

Kimberly Flynn:  No, I agree, I think that we just challenge advisors to think about alternatives, despite the newness and complexity of them.  I think that there is a misconception that alternatives are risky or riskier.  But if you take a hard look at equity volatility, you have to acknowledge that many of the alternatives that are out there present an attractive risk return or maybe even a lower volatility.  So don’t confuse complexity with volatility.  We all understand the equity markets, we follow the equity markets.  But I would encourage people to start following some of these alternative asset classes.  And it reduces the level of newness and complexity and as advisors become more familiar with alternatives I think they’ll see them for what they are, which is diversifiers.

Sarah Makuta: Andrew, what is Wyndham’s core investment philosophy?

Andrew Weisman:  So it’s sort of consistent with a few building blocks.  Number one, we don’t believe that anyone, including ourselves can forecast performance with any useful degree of accuracy.  There’s a lot of good evidence to that.  In fact I actually got a hold of a really interesting dataset; it was some 6500 forecasts by 68 of the world’s most [inaudible] names in the world of market forecasting.  And as it turns out, the degree of, you know, the variability in terms of … and the mean of that distribution of getting it right, and I’m not talking about point forecasts with confidence bounce, how about you said it was going to go up and either it did or it didn’t.  The degree of variability in that group of forecasters is completely consistent with the whole hypothesis that none of them were any better than a coin tossed.  In fact there was a small amount of evidence that they were slightly worse than monkeys.  And these include a lot of famous people, which I’m not going to mention just because I don’t feel like getting sued.

So number one, you can’t forecast.  And if you think about why that’s the case, from a purely statistical standpoint, equity vol typically at the one year time horizon runs at about 15%.  So 95% confidence bounce around a one year estimate are basically plus or minus 25%.  So anything within about a 50% range from a statistical standpoint is essentially the same number.  So how good am I?  Not that good nor is anyone else.  The thing that you can do with a better than useful degree of randomness is essentially forecast the volatility independent structure within a portfolio.  So we do that, and we like to get a handle without actually taking a view on what’s going to pay off.  And basically select well-known, well documented risk factors where there is, you know, good evidence in both the academic and practitioner literature that these things pay off over time, where they’re known to be relatively orthogonal, and then just to very closely manage the portfolio on a daily basis to just make sure that nothing is dominating and you’re staying at a specific targeted risk.  So that’s what we’re all about.

Sarah Makuta:   And in building a risk focused investment program how are the risks analyzed and selected?

Andrew Weisman:   So, once again they’re really analyzed and selected essentially where you really do have a good intuition with respect to why you’re getting compensated.  So, the classic risk factor that is composed is typically in excess of 90% of the risk of a typical investment portfolio.  And I’m going to tell you, it’s a secret hedge fund strategy and I will tell you, but you must share this with no one.  It turns out, stocks are more volatile than a T-Bill and therefore I have this expectation over time that I’m going to get compensated for being long the stock market.  That’s the equity risk premium, everyone loves and knows that and you’re getting compensated, at least from an expectational standpoint for being long stocks.  Now, as it turns out, there was an interesting study done from 1820 to 2014 and it showed that even at a 20 year time horizon there’s about a 15% chance that T-Bills will actually outperform the stock market.  So it’s not a premium, it’s a risk premium so it doesn’t always work out that way.  So, good intuition, orthogonality, scalability and that’s really essentially what we’re focused on.

Sarah Makuta:  Excellent.  Kim, what is next in the world of alternative products?

Kimberly Flynn:   Well, I think that clients are going to demand access.  So they want exposure to things that they don’t have in their portfolio today.  So it might be farmland or timberland, things that aren’t easily packaged into a mutual fund.  We see a lot of potential opportunities and innovations in terms of giving individual investors access.  I think that not only do clients potentially want those investments, I think it’s a real opportunity for advisors to distinguish themselves, not only can they provide tax planning or estate planning, they can provide alternative investment planning.  And it’s a way for them to distinguish themselves in the financial advice community.  And so I think that the market in terms of giving an investment advice has come a long way.  And I think this really is what’s next in terms of giving your clients the right kind of advice.

Sarah Makuta:  Excellent.  Cleo, same question to you, what’s next in alternative products?

Cleo Chang:  Well, I think we will likely see further advancement in letting alternative strategies become even more unconstrained.  We live in a very dynamic world, capital markets generally are out every single day.  I think as many alternative strategies, like the ones American Century offers and other firms offer continue to deliver a proof statement that these less constrained strategies can bring value to clients, rather than having these very asset class specific, benchmark specific type of strategies.  Investors will entrust us with more leeway to make active decisions in a portfolio.  And our job is to respond by making better than average decisions on where to go, and how to navigate.  Our objective is to always have a view on the market, and not that we’re right all the time.  But it’s hard to make active decisions if you don’t have a view on things.  And our goal is to go where the [inaudible] is going to be rather than where the [inaudible] is, and in that process make sure that the portfolios are well diversified, the portfolio is well constructed, the volatility is managed, that we damper it to the point where we don’t trigger the investor to make that knee jerk reaction at the worst time for them, and for us as the manager.  And if we can do that on an ongoing basis over the long term we think, you know, we will benefit, our clients will benefit and our industry will continue to make advancements.

Sarah Makuta:  And, Andrew, what distinguishes the Wyndham investment approach?

Andrew Weisman:  [0:54:03] It’s a little bit of repetition of some of the things that I’ve said already.  I think just a real focus on quantitative rigor I think is really important.  One of the other things that we do is there are some useful asset classes which I think generally represent a smaller proportion of alternative asset managers’ portfolios, and I think are very important, most notably in the commodity sector.  And the commodity sector is a particularly useful diversifying asset class in large part because you’re dealing with an asset class that has a very big right tail.  And it has that big right tail because you’re dealing with an asset class where there is essentially an inelastic demand and very few good substitutes in the short run.  So if it gets really cold, there’s a frost, a drought, pod boars are chewing through cocoa pods in the Ivory Coast, I will still selfishly insist on heating my home and feeding my family and eating chocolate.  And so you get these massive outside moves which are generally exogenous shocks in the marketplace.  And if you have something as an example, a commodity trading in an investment strategy that effectively replicates a straddled like payout and its peak periods of performance coincide with these exogenous shocks.  It’s an incredibly useful diversifier in the context of other things going on in your portfolio because these tend to be the primary periods where the rest of the portfolio is being disturbed, particularly on the long only side.

Sarah Makuta:   Kim, how do you overcome market expectations that hedge fund strategies are risker than they say, than say the more traditional asset class allocations?

Kimberly Flynn:   Yeah.  I think that that is a common misperception.  I think that there’s such a variety of hedge funds that I would encourage investors to consider what they’re looking for.  So if they’re looking for an income substitute, think about it in the context of that fixed income risk return expectation.  If you’re thinking about it in terms of an equity replacement then you might be willing to take more risk.  And so it really is going to be a function of what’s the purpose, what’s the goal for that alternative in the portfolio.  And that, I think if you break down, partly because there is such variety, you know, we talked about commodities a moment ago, we talked about managed futures to start, there is a huge spectrum.  And so we would encourage people to spend the time and break through some of those misconceptions.  And I think that part of that, the reason that those exist is because we’ve seen a long equity bull market run.  And people are more receptive to thinking about these alternatives in different times.  And so I think that what we encourage people to do is think about it now before you see, you know, any sort of equity market correction and be proactive in terms of sorting through what types of alternatives, what type of hedge funds might be of interest to you or to your investors.

Sarah Makuta:   Investors associate alternative investment as hedges against equity drawdowns, do they necessarily equate their diversification benefits to fixed income?

Cleo Chang:   I think this is where, to Kim’s and Andy’s earlier point, there’s really a large variety of different strategies.  I would say if investors are particularly concerned about equity drawdown, traditionally there was the fixed income that was always sort of the safe haven, now we have alternative credit strategies that can play a role.  But I will argue that any type of equity long short or equity hedge strategy should provide investors with partial protection against a full equity drawdown.  And interestingly, market neutral strategies, equity market neutral strategies which have zero betas can also give investors very interesting exposure within a portfolio.  And we failed to mention, in the earlier discussion you asked about what type of strategies tend to benefit in a rising rate environment.  And because market neutral tend to be a sort of Libor plus X type of strategies or as the short term cash return is creeping up in response to rising rates, market neutral strategy is a natural beneficiary of this rising rate environment.  So if you think that rates were at zero and equity market neutral tend to return say 2-4% on top of cash, once now cash is at 2½%, you’re still at that 2-4% of return premium.  So all of a sudden you’re looking at 4-6% return for zero market beta, zero equity market beta which, you know, I think is easy to make the argument that’s something that many investors could potentially benefit from, from having allocation in their portfolio.

Andrew Weisman:  And to sort of amplify that point and actually to your point earlier on about sort of the lookback period that you like to see in your managers.  A lot of the equity analysts that exist today, probably got their MBAs about eight/nine years ago and have gone through their entire careers without ever having to consider the time value of money, because interest rates have essentially been at zero.  So you can provide, put very high valuations on stocks in a world where money received 10,000 years from now is worth the same as money received tomorrow.  But there’s a very good argument to be made that as rates move higher there could be some very significant style rotation effects that take place, so where you have to once again think more seriously about discounting dividends and future cash flows in a much more time sensitive manner.  So, one of the classic Fama French risk factors is to be long baskets of stocks that are cheap relative to their accounting fundamentals and short those which are rich.  So this would be the other side of the FANG trade, and there’s a good argument to be made that as rates move higher you’re going to see some very significant style rotation effects in that relatively market neutral strategy.  So that’s another interesting risk factor that I think going forward could play a very interesting diversifying role in a portfolio.

Sarah Makuta:  And I’ll ask this to all of you, for the professional viewers who are looking to access these opportunities that we’ve talked about today, how should they be thinking about allocation?

Cleo Chang:  Well, I have said before I think for the investors who are just starting to learn about alternatives and are finding ways to allocate to alternatives, I think starting at a 5-10% should be an easy way to look into it.  Anything less than 5% at the end of the day is hard to make an impact on the bottom line performance of portfolios.  So we would say for the newcomers, try 5-10 as a way to start.  But we think that a 10-20% allocation really is what’s needed to deliver the enhancement that we expect investors to get over the long run.  And, you know, for investors who are venturing into more esoteric type of alternatives, you know, they could be looking at allocations above 20% in the aggregate portfolio.

Sarah Makuta:   Do you want to add to that?

Kimberly Flynn:  Well, commonly I think that I like to talk about income, looking at how much income you need and looking at alternative sources of income, only because that’s an easy place to start.  If you’re new to alternatives I think that for advisors it’s a good way to step into alternatives, partly because people, they love their equities.  And so I think alternative credit, alternative income, if you are talking about a 10-20% allocation, you can easily talk about what this income product or income strategy is going to do relative to something you might already own.  So I think that might be a good place for folks to think about adding.  And then for experienced alternative investors, you know, continue to encourage that they think about using alternatives as substitute to their core equity and bond holdings because you can get differential returns and lower risk if you’re thinking more than just a small piece of the pie being allocated to alternatives.  I think that really constrains how alternatives should be used in the portfolio.  So I think using them as substitutes gives more freedom and potentially higher allocations and it’s a thoughtful way to implement alternatives.

Sarah Makuta:  Excellent.  This has been incredibly informative guys, this has been a great conversation, thank you so much.  Let’s leave with some closing remarks.

Andrew Weisman:  I think the bottom line for me is that dealing with individual investors as a starting point and then extending the same set of comments to institutional investors, a typical individual is going to have roughly a 60/40 stock bond portfolio if they have money.  And they should be well aware of the fact that well in excess of 90% of the volatility that they’re going to see in that portfolio will be dominated by the stock market.  So the stock market goes down, with your 60/40 portfolio you’re going to lose money.  The second point is, as we move higher, if we move higher in terms of yield, that correlation between those two asset classes is going to become increasingly moving to one.  And so the bottom line is that the one free lunch you get in finance is diversification.  There are a collection of other well-known, well documented sources of return that are relatively independent of that and it would be well worth people’s time to go investigate and add those things to their portfolio.

Sarah Makuta:  Excellent.  Cleo, closing remarks.

Cleo Chang:  I will say we sitting here enter a really interesting and likely more complex market going forward.  To Andy’s earlier remark, there’s been trillions of liquidity injected into the capital markets over the last 10 years, which is a rising tide floats all boats.  And as we see equity valuation reaching the levels they’re at today, so that the spreads, the high yield and credit spreads where they are today.  I do think this is an environment where active management, whether it’s in the traditional asset classes or in alternative asset classes are going to become really a driver of not just total return, but you’re really going to see active managers shine in the coming years.  So those investors who have benefitted from investing passively at a lower cost might think now is a good time to rethink their thesis behind that.  And maybe think about starting to reincorporate or add to the actively managed portion of your portfolio because as markets shift, this is where active management really, really pays off and is worth every penny that investors are paying for.

Sarah Makuta:   Excellent, Kim, final thoughts.

Kimberly Flynn: At XA Investments we’re firm believers in active management.  Alternative managers, alternative strategies are worth consideration.  There’s a proliferation of ETFs and beta exposures.  And so we think that advisors and clients need to take the time to evaluate potential alternatives, and not just Liquid Alternatives, think about some of the less Liquid Alternatives too for that return potential.  And we think there’s a lot of opportunities coming to the marketplace, interesting structures that are readily accessible for individual investors which makes alternative investing easier.