Maryland's Elizabeth Burton Says Still Possible to Find Alpha
November 9, 2017
Hoda Imam: Welcome to Asset TV. I am Hoda Imam. Liquid Alternatives have become a mainstay in the marketplace. But are investors up to speed? Today a panel of experts joins Asset TV to discuss the common questions and misconceptions around Liquid Alts and how their strategies fit into a larger portfolio. Welcome to the Liquid Alternatives Masterclass. Thank you guys so much for joining in today. We’re just going to jump right in. I would love to get a brief introduction to your firm and strategy. Anyone can go. Steve: So let me start, Miles Capital is a boutique asset manager. We manage assets for a wide variety of clients, from insurance companies, endowments, foundations, public entities as well as individuals. And we do that across the three major asset categories, fixed income, equities and alternatives. And specifically what we’ve done in the Liquid Alts space, since we manage direct hedge funds for clients, we have taken that, that knowledge and those processes and brought it to a multi alternative approach to Liquid Alternatives. Hoda Imam: Okay. John Fujiwara: Hi. My name is John Fujiwara. I am the Portfolio Manager for Janus Henderson Advisors. We are a $360 billion dollar asset management complex that very similarly manages strategies across equities, fixed income and alternatives. I am the Portfolio Manager for the Diversified Alternatives Fund, whose objectives are absolute return, low correlation to the traditional asset classes and a managed drawdown profile. Hoda Imam: Okay. Kevin. Kevin: Mosaic Financial Partners is an independent registered advisor wealth management firm. So unlike the supply side, we’re on the buy side. And employ alternatives widely in client portfolios. Hoda Imam: How do you broadly define Liquid Alternatives? Steve: Well, when we think about alternatives, just alternatives in general there’s really three categories that comprise the vast majority. That’s private equity, hedge funds and real estate. Now, private equity and real estate really don’t lend themselves well to the liquid space. So when we think about Liquid Alternatives it’s really bringing direct hedge fund strategies to the mutual fund space. Hoda Imam: Okay. John Fujiwara: So I have a slightly functional view on Liquid Alternatives. You know, alternatives are strategies that are meant to be diversifiers or to be diversified to the traditional asset classes. Liquid for me really just imposes kind of another requirement of daily liquidity. So generally for me when I think about Liquid Alternatives I’m thinking about diversifying strategies that have daily liquidities, likely packaged in a mutual fund or ETF format. Kevin: And the only comment I would add. And I think both those explanations, definitions are useful is that the term alternatives in and of itself is this umbrella term. It really describes a whole host of strategies. So ranging from a multi strat managed futures, along with certain types of investment categories such as real estate or private equity. So it really is this umbrella term that can be quite different in terms of what the experience of the investor is based on the type of underlying investment that you’re dealing. Hoda Imam: Do you see an uptake an asset flows? Kevin: Well, I mean again, recognize that what we’re doing is we are a buying entity. So we look at these firms as potential providers of investment management in the alts space. And so for our client portfolios, our client portfolios hold a relatively constant allocation to alternatives across the whole client base. Steve: Yeah. And I could add to that, I’d say we are generally seeing an increased interest. If you go back to say 2016, that was a real tough year for Liquid Alternatives. I think on average they were out about $7 billion of net outflows. But we’re starting to see that turn. We’re seeing more interest in what we’re doing from a multi alternative standpoint. And keep in mind we are multi alternatives, we’re talking to a lot of different managers out there, like John. And so what they are telling us, at least many of them are telling us is they’re starting to see an increase in interest in their strategy as well and we’re starting to see flows come back in. Hoda Imam: Okay. John Fujiwara: And I think that the challenge when we started five years ago was this education process around alternatives and getting investors comfortable with understanding what was going on. I think that as more and more people and more and more asset managers have come into this space, I think there has been more participation on the education side. So what I have actually noticed is that in the last couple of years I get more and more people at conferences asking me about, you know, to learn a little bit more about what we’re doing. So I do see an uptake in interest. I think that’s basically been a result of better education around the subject. And as far as specifically, I think flows are slow, but they’re starting to increase for us also. Hoda Imam: Do you see an uptake in asset flows and are investors increasingly up to speed in terms of education when it comes to the 40 Act space? Kevin: I think interestingly enough for us, the 40 Act space has been a slightly easier education process than the institutional space. Hoda Imam: Why? Kevin: Because I believe that the 40 Act space, the people in the 40 Act space are more objective oriented as opposed to what are all the individual little pieces. So what I find is that in the institutional space, people want to understand all the little details, whereas in the 40 Act space, they’re just asking for results, meaning can you maintain a low correlation? Or are you stably uncorrelated? And then what’s your return profile? So I think the answer is a little bit clearer for them in some regard. So I think the 40 Act space, we’ve been seeing actually a little bit of an easier education process. Steve: Yeah, I would jump in. I think one of the challenges and somewhat in counterpoint to John, one of the challenges in introducing the idea of this term, alternatives and what they are is the explanation of helping to educate clients around the underlying strategies. And you know, once you move away from a long only investment methodology, which is pretty straightforward and people understand, and you introduce variability to it, whether it may be leverage or more likely long short etc. You encounter, at least we encounter clients, “Okay, tell me about that”, with some confusion in the alternatives. And particularly the last couple of years which have been more difficult in a general term, more questions around that, “Well, why is this in our portfolio?” Or, Remind me again why I want to do this.” So those kinds of … and again it’s an ongoing education process that you have to go through with individual investors who are going to be holding alternatives in their portfolios. Hoda Imam: Right, yeah. Kevin: Yeah. And I agree with that too. I think we’re still fighting a battle of just a lack of understanding what these strategies provide. You know, last week I saw another article talking about hedge funds in general. And last year, they had a good year but it wasn’t good enough because they didn’t keep up with equities. And that type of thought process is exactly the challenge that we’re up against. You know, hedge fund strategies, whether it’s direct or in a mutual fund wrapper are not designed to keep up with equities. And so we have to keep educating on that and get people to understand that, you know, we’re trying to provide a stable return profile, a reasonable return profile, but as John alluded to earlier, that downside protection that isn’t there if you’re just in long only assets. Hoda Imam: And if you’re saying that there’s no sort of … there is a little bit of confusion on your end, then you can even imagine when it comes to an investor, right? Kevin: Absolutely. And that’s why it’s incumbent upon us to continue to provide that education, because the last thing we want is an investor making an uninformed decision. Hoda Imam And how would you say on a grand scale, how could that impact your strategy – overall strategy? Kevin: Well, I don’t think the education impacts our overall strategy, it just impacts the flows that we were just talking about and getting people to understand why would you use these. We’re still going to provide the same type of product. It’s going to be this multi alternative, widely diversified that has those characteristics that we just talked about. So it’s really more about getting them to understand and why it makes sense for these to be in a portfolio as opposed to infecting what we specifically do. Hoda Imam: Okay. Let’s move on a little bit. We’re going to come back to the 40 Act space. But where are you positioned right now? John, we can start with you, when it comes to managed futures, can you look back and give me a story on perhaps a theme that was successful? John Fujiwara: Well, sure. So first of all I want to, you know, reiterate that in our strategy, we’re a quant based and systematic based. So all the positions, our biases are generated through our models. So I can talk about what the models are doing. And actually they’re, right now the positions are quite consistent with the synchronized global growth story, which I think is playing out fairly easily right now in the marketplace. So to be very, very current we are short US dollars against the euro currency and yen. So that’s one of our positions. We are actually short or negative, have a negative bias on the fixed income markets in both the US and Europe, so bunds and 10 year notes. And we recently turned more constructive on the commodity markets, specifically oil and the industrial metals. So these are themes that have kind of evolved over the last, I’m going to say one and a half to two months. They are consistent with the synchronized global growth theme. And have so far been fairly successful. Hoda Imam: Okay. Did you want to add anything? Kevin: No. Hoda Imam: And so when it comes to the multi manager model, what strategies do you like? Steve: So there’s a number of them right now which is good. We’re talking about managed futures. That’s one we like right now. John and I were talking before this. And the one persistent trend we’ve seen over the last couple of years or actually more than that is equities. So there’s been a trend they’ve been able to take advantage of, but not in much else. But now as he said, we’re starting to see trends in commodities and currencies and rates. And so that’s one of the strategies we like right now. We also like long short equity. We talk about global synchronized growth, strong corporate earnings. Monetary policy, they’re taking some of that away, but it’s still pretty accommodative. And of course now we’ve got Tax Reform which is a boon to corporations, so all that leads us to be very positive on equities in general. There’s a couple of other things that I’d point to in long short equity that really drive the ideal environment. First and foremost is equity dispersion, what you don’t want is all equities moving up and down together. Long short equity managers, just like active long only managers are stock pickers. So if everything’s moving together it’s hard for them to add value. The way you measure that is through individual equity correlation. And what I can tell you about that is right now we’re sitting at multi year lows in correlation. So the environment is right. The other thing that really leads to the ideal environment is an upward trending market. These managers tend to be anywhere from 20 to 60% net long. So with the upward trending market they’re able to capture that beta portion of the return, if you will. And so we really like that strategy right now. I could go into a number of other strategies. I don’t want to hog the time, but… Hoda Imam: But this is all current because we’re in a bullish market. Steve: It is. It is, absolutely. Hoda Imam: And if the scenario was to change it all changes. Steve: It will change. And I can tell you a strategy we don’t like right now are the credit oriented strategies. You know, we’ve got interest rates that are low but they are rising, which is bad for bonds. We’ve got credit spreads at the tightest levels they have been since before the financial crisis. Could they tighten a little bit more? Sure. But they’re more likely to go the other direction. So that’s a strategy where we’re actually underweight because we don’t like it as much. Hoda Imam: Okay. Kevin, I saw you nodding your head, did you want to add anything? Kevin: No, no. Hoda Imam: Okay. Alright, so I said that we were going to come back to the 40 Act structure. What would you say are some advantages and limitations? You did touch on this John, but if you wanted to elaborate a little bit more on any limitations specifically. John Fujiwara: So, you know, with any regulated vehicle, you’re going to have a greater deal of oversight and certain limitations that you have to meet. In other words, you know, within the 40 Act structure you’re going to have some limitations around leverage and certain types of instruments that you can’t trade. But for our strategy our implementation hasn’t really been, you know, impacted by that. We’re doing everything that we want to do. On the operational side though, I do agree that there is more layers of compliance and whatnot that you have to follow. I have to believe that that’s all just part of being in a registered vehicle, because all those rules were set up for the safety of the client. So while there are some operational challenges, I think right now, I think most of the 40 Act funds are not being limited by the regulation on what they can do. So I’m pretty bullish on what people are doing still. Kevin: Yeah. And I would talk to the advantages, because as a buyer of these strategies, what do we look at? And you know, there’s a few things that are really critical. I mean first off when you look in the private placement world, the one that comes off the top right away is simply the price. So the traditional, although it’s changing, but the traditional 2 and 20 model, 2% on a management fee along with 20% of profits is a very lucrative model for the manager, not so much for the client. And that’s a high hurdle. And there’s a number of things put in place there. But that to us is tremendously significant. The other question is, do you get something more from a traditional private placement hedge fund in relation to what you would get from an equivalent Liquid Alternative fund in that space? And there was some research done by a guy named David McCarthy who’s been in the alts space for a long time, teaches at Fordham. So he had a lot of graduate students who could actually dig into the data. He used the Morningstar database. And essentially what he did is he took out four strategies. He said, “Okay, we’re going to look at managed futures, over managed futures long short, a couple of other, [inaudible], multi strat.” And essentially what he said was, “Do you get the same profile, risk return profile, market exposure correlation with these in a liquid form as you do in a private?” And the exception was multi strat and I’ll come back to that. The exception was, yes, you do, managed futures, if you look at those characteristics, they’re very comparable. If you look at market neutral, very comparable. The multi strat was, you know, the variation there is that there isn’t a set, here’s the exposure to each of these management styles. And so there’s enough variability that to try and compare was a challenge. And it wasn’t necessarily that you don’t, but it was difficult to measure. And the point of all of that is simply that if I can buy, you know, an effective solution in the alternative space for, you know, 140/160 basis points versus 2 and 20, I don’t have to think very hard or very long as to the desirability of that. And the lower the cost structure the more appealing that becomes within reason. Steve: And I would just lean on the multi alternative front as well. I think the returns are a little more challenged versus the LP there, because there are certain strategies that you just can’t access. Things like distressed, is illiquid so it doesn’t lend itself well to a mutual fund wrapper. So because of that, if you look at Liquid Alternatives versus direct hedge funds over long periods of time they tend to slightly underperform. But that would be expected because of that. In terms of some other limitations, I would say from the multi alternative space one of the things that we are faced with is that we’re not investing in other liquid vehicles. And so the mutual fund regulations put a restriction on how much of that vehicle we can own. So it potentially is a capacity issue. Now, we’re nowhere near capacity now with what we’re doing. But that’s something that we have to monitor that. You wouldn’t have to in the direct hedge fund space. Hoda Imam: Would that ever be a concern? Steve: Well, I mean we’re not going to be a $2 billion firm but I’d love to have that problem to worry about. Hoda Imam: And how do you benchmark or contextualize the performance of your funds? Steve: Well, I’ll start. I mean the one where we don’t benchmark is versus the S&P 500 for reasons I talked about earlier, we just don’t think it’s the right and appropriate way to think of these things. There are a few ways that we can do it from the multi alterative space. First of all there’s the Morningstar category and there is for every strategy. I caution people though on the multi alternative category because it’s not very homogenous. There are a lot of managers in there, in fact the majority of managers in there allocate to long only strategies, fixed income or equities. There are managers in there that are focused on a single strategy like event driven or macro. And so we’re cognizant of the fact that we’re going to get compared to that. But we don’t think is the best comparison. So what we’ve done is we’ve constructed a peer group of that, that there’s a peer group that’s comprised of funds that are pure plays and alternatives, they only use those strategies and they’re diversified. And so it’s about 15-20 that we look at there. And the other way, even though we know we’re going to underperform is hedge fund indexes. So we are trying to deliver as I said, earlier on, that institutional experience we got on the direct hedge fund side into the liquid space. And so it’s an appropriate comparison to make with the understanding that we’re not going to consistently beat that benchmark, but we should track it in terms of the risk profile. Hoda Imam: Okay. John Fujiwara: You know, I’d like to contextualize. Is that the word I’m looking for? Hoda Imam: Yeah. John Fujiwara: So just kind of to give you a little bit of an idea of how we thought of building the strategy and what we kind of wanted out of it. So our strategy is diversified different returns drivers, across geographical region, across asset classes. When you have a portfolio that’s that diversified, it’s not going to be home run hitter. So one, diversifying for our strategy, we’re not a home run hitter. The other side of that argument though is that we’re also very, very unlikely to experience any kind of drawdown, like what you saw the stock market do in 08. So really the theory is that we’re built around a … try to deliver an advantageous risk reward profile. So let’s think about that risk reward profile in the context of a sharp ratio. So I’m saying that generally alternatives that are diversified alternatives are kind of in that space, .7 to a 1 sharp. And based on what kind of volatility they’re targeting, that puts a lot of them, including ourselves in this kind of 4 to 8 to 10% expected return kind of, you know, range with kind of a similar risk or volatility profile. So we’re happy to, because of our mandate for absolute return, we’re happy to be looked at against an absolute return benchmark, maybe Libor plus 300 or something. It’s tough because Libor never loses money and 300 never loses money. But that’s kind of how I like to frame investors’ expectation for return. Kevin: Yeah. And let me weigh in, and again coming from a different perspective as the buyer of strategies. But it speaks to the comments that both Steve and John have made, which is fundamentally what we look for in adding alternatives is a diversifier, our diversifier, so our investments that have a lower correlation to the market. What we’ve seen, and we employ managed futures, we have long short market. So there’s a number of the strategies. And the research that we have done and what we’ve observed is in point in fact, and let’s take the 07-09 downturn, the reality is most of those strategies lost money. None of them lost money on a par with what the S&P experience was. And in fact the recovery, if you look from trough to point of recovery, was substantially better than the S&P because the downturns were less. And during that time, managed futures actually was producing a positive return. If we go back to the 2000-20002 downturns, most of the alternative strategies that we tracked were in fact producing positive returns at a point when the equity markets were going south. That’s what we do look for. And in setting client expectations, just as an aside, what we talk about is our expectation is a return profile somewhere between fixed income and equity overdrive. You know, it’s not about hitting home runs. It is about moderating the volatility of equity when we most want it. Hoda Imam: So you would say you are market neutral, is that correct? John Fujiwara We’re market neutral. I was going to touch on that a little bit later in one of the other questions but that’s… Hoda Imam: Well, let’s come back to this because I want you, the next question for you is … and I’m going to take a deep breath before I ask it. I really would like for you to break down risk premia investing. We talked about risk just a couple of minutes ago. But if you could just break it down and then I want to know sort of your thoughts on it. John Fujiwara: Sure. So at the very highest level, risk premia strategies are systematic quantitative strategies that look to take advantage or to profit from certain observed market behaviors or behavioral biases in the marketplace. I think that one of the defining characteristics of risk premia is that they’ve been studied widely and documented in academic literature. At least that’s the way we started. Hoda Imam: With formulas? John Fujiwara: Formulas and research – empirical research, proof in a sense, or empirical proof that this excess return exists. And these quantitative models and algorithms can be developed to harvest that return over time. And like I said, it really is important because, to point out the fact that they are very well documented by some of the smartest guys in the world. The other thing is that they do occur in every single asset class. You can find these phenomena, I guess, you can call it or behaviors or models in equities, in fixed income, in commodities, in currencies. So if you can imagine there are literally hundreds, maybe thousands of documents and reports and whitepapers that have been produced across this wide, wide array of approaches, strategies, behaviors. So for us, when we finally put it into the portfolio it has to have a couple of things that are pretty general in nature. I really feel strongly that to put something into the portfolio I have to feel that there is a fundamental economic underpinning to why that return exists, because it’s coming from a quantitative model. So I need to form some intuition around why I believe that it can produce positive return in the future. So I am very far away from black box. I am kind of more quantitative, systematic harvesting of something that I understand. And secondly, because of our mandate for diversification, the risk premia strategies that I pick are all long short. They are market mutual. You know, lastly, from an operational standpoint of view, you know, they have to have institutional liquidity and capacity, so those are kind of how I look at what my universe of possibilities are and then how I finally get it down to the portfolio. Hoda Imam: Okay. And I mean I guess it’s very obvious to say that if assessing risk was so simple then you guys might not be here. And you guys might not have a job, you know, and that’s a big part of it, right, just the reason why there’s so much research and equations is just because they’re trying to break down risk and which is very complicated. John Fujiwara: Well, first of all you have to be quantitatively very rigorous, that you’re not data mining, right. Data mining is an issue. So you have to be very quantitatively rigorous about what you’re doing. And you know you have to have a high degree of confidence that it’s statistically significant that this exists. The other characteristic are that once you create these strategies they all have their own unique return distribution characteristics. So to your point about risk, yes, you have to understand what the distributional characteristics are. If they’re left tail skew, right tail skew, and you know, have those characteristics, bimodal. But in any case that’s all part of the assessment of the risk return profile. Hoda Imam: Okay. Did you guys want to add anything? Kevin: You know, to the point of data mining and it is a very real risk. There are at this point, somebody, I think I heard to the effect of researching up to 150 different risk premia. And I’m sorry, if I can add. But there are in fact well recognized premium, we value is one as an example or size. And what you look for is that, okay, you’re in sample study, great. What does out of sample look like? What does it look like across, okay, if we observed this in the US, does it exist overseas? Those kinds of persistence and examples, and so, yeah, it is the search for that silver bullet that nobody has yet found. Hoda Imam: Steve, how do you perform due diligence on your managers? Steve: There’s a couple of different kind of broad themes around due diligence. It’s quantitative and qualitative. So the quantitative is relatively easy. We’re just looking at return based information, you know, whether it’s absolute returns, risk adjusted returns, performance during difficult periods, metas, sharps, all those types of characteristics as well as factor exposures. We want to understand where we’re taking risk, where our managers are taking risk. And so we do that, we identify track records, if you will, that fit with what we’re trying to do within our portfolios. So that’s pretty easy, as I said. And you might go from a set of 50 that you’re looking at and narrow it down to 5 or 6 that you really think fit what you’re trying to accomplish. Then you move into the qualitative, and that’s much more important. It’s where you identify was that track record luck, or is it repeatable? And you know, there’s some common themes amongst all the strategies. We’re of course looking at the people and their pedigree and their experience and their capabilities. But then there’s some individual things based on strategy. So we’ve talked about managed futures, you know, there’s a couple of key things that we want to make sure we understand our managed futures. One, how do they create the models? How do they think about the models, test them, incubate them. How long does it take before they put them into practice? And then how do they think about the terms? So managed future players will typically have short term models, medium terms models, and long terms models. And that can mean something a little bit different to each fund. So we want to understand how they think about it, and how they allocate across it. If you have a heavy allocation in short term models you’re more likely to underperform in periods where we have a lot of asset class reversals. Consequently if you have a lot of allocation in long term models you’re going to underperform when the asset trend turns because you’re going to be slower to pick it up. So we want to understand how they’re allocated those and where they’re getting their return sources. And the other big thing on managed futures is data, managed futures is the model driven approach and it’s only as good as the inputs. So one thing we want to understand is where do they source their data? How do they source it? How do they scrub it to make sure it’s good? So those are a couple of key things that we look in managed futures. Hoda Imam: But then how much data is enough data, right? I mean that’s going back to data mining. Steve: Well, and again this doesn’t get at data mining, it’s just making sure that it’s quality. So that the stream of data you’re analyzing, trying to determine the trend, there’s nothing bad in there, there’s no faulty data in there. So it doesn’t get at data mining and trying to find this is what my thesis is so I’m going to find data that supports it. It’s just making sure the data itself is clean. Hoda Imam: But that’s what I’m saying, how much data, quality data is necessary? I mean is it just… Steve: Well, it depends, and of course the answer is it depends upon the terms of the models. So you’ve got those short, medium and long term models. So you need to have enough data and, you know, we like to see, you know, at least 10-20 years of data, so it gets data across an entire business cycle, entire market cycle. And if I translate that now into something like long short equity and some of the things that we specifically look for, again, it’s still the people, we want to understand that. That’s the most important component. But here we’re trying to look at, do they have some edge? Do they have an edge in their experience? Do they have some process they’ve developed where they know? We tested these 10 factors and these are the most important things for stock selection, they have a quantitative model. It’s understanding that and then very importantly, it’s making sure they’re disciplined about risk. For a model driven approach you don’t have to worry about it, because a model’s telling you what to do. But when a person or people are deciding it, you know the adage that it’s much easier to buy an investment than to sell, it holds true. People can become emotional about it. So that’s why you want to make sure they have a disciplined risk process. And if a risk factor is triggered, that they take the corresponding action. I’ve seen that happen before, I won’t name the fund. But back in 2016 we had an investment in a fund that we knew what the risk process was; we knew the exposures they had. And we knew that based on how the market moved, this exposure they had over here shouldn’t have stopped out, they should have liquidated it. They didn’t. So that was our time to exit. And that manager actually last year in 2017 had more than 10% negative return. And so it’s those things, they have to be very disciplined to try to remove that emotion from the investing equation. Hoda Imam: Going back to the 40 Act space. How does your 40 Act differ from an equivalent hedge fund strategy? Steve: Well, for us, you know, the strategy itself is the same as I said. We are trying to take this kind of, this multi approach, this diversified approach that we use in our direct hedge fund business to the liquid space as well. But there are some things that differ. And we talked about it earlier, the fee structure is different. So that’s more beneficial to the end investor. Another way it differs is, is the fact that there are these strategies, again we talked about that earlier, certain strategies you can’t access in the 40 Act space. And finally what I would say, in the direct hedge fund space there’s just a bigger opportunity set. You know, there’s upwards of 15,000 individual hedge funds. Now what I will tell you is that most of them aren’t worth their while, but at least 10% of them are. So you have a bigger opportunity set from which to construct portfolios in direct space than you do in the liquid space. Kevin: Although sorting the wheat from the chaff can be a challenge. I mean when you look at the numbers I mean there are, as Steve is talking about, roughly three times the number of hedge funds as there are mutual funds. Now, if you throw ETFs in there and whatnot, that maybe is twice as many, and the real question is are there that many managers that are that good to earn the kinds of fees that are associated with it? I will say one of the advantages of the private hedge fund typically is lockups. And I say that in that one of the challenges that you have when you are working with individual investors is managing behavior. And I will use the term self-destructive behavior in that those most likely to be damaged in a difficult market cycle are those who exit a strategy that makes sense and inevitably lose the recovery. They’ve experienced the pain [inaudible]. Lockups for some period of time or slowing the ability to exit can have an advantage in that regard, not sufficient to warrant the pricing. But it is something that does exist and has a value. And partly it’s because simply because of the nature of the investment set where you simply can’t liquidate holdings that you have, and so you’re going to restrict access to capital. Steve: That’s exactly right. And that’s why you want the liquidity that a hedge fund provides to match their strategy. The last thing you want to find an investor in the fund, if we’re both investors, John wants out and it’s an illiquid strategy I don’t want him to get out because it’s going to force the entire portfolio to be depressed. Hoda Imam: Let’s move on to portfolio positioning. How do you construct a portfolio? John Fujiwara: Again, I’m going to go back to this fact that we are a systematic trader. I guess the question we have to solve is that we have strong conviction that all of our strategies have a long term positive expected return. So [inaudible] now is 11 of these strategies in there. What I don’t know, what I don’t know is the path by which these strategies are going to take to get to that. So what we have decided on as far as constructing our portfolio is to spread our risks equally across all of our strategies. So, on a monthly basis we rebalance the allocation to each of our quantitative strategies so that the marginal contribution to risk of each is equal, meaning that each strategy contributes equally to the total risk of the portfolio. So you know, to be clear, all of the strategies trade daily, they do something daily, they, you know, shift positions or you know, recalculate positions daily. But on a monthly basis we reallocate to the individual strategies so that they are equally contributing to risk based on the most recent calculation of the covariance matrix. So what that means is that, and what I’m trying to avoid is a single theme, a single position, a single market performance dominating the entire performance of my portfolio. So that’s what I’m going for because I don’t know the path. Hoda Imam: And this is safer for you? John Fujiwara: For me, I think, we continue to want to … we continue to test and look for abilities to time. But there hasn’t been enough strong … I haven’t gotten enough strong conviction on any timing mechanism that I’m willing to use it and kind of move away from, like you said, the more of the risk controlled approach. So I’m not saying that we don’t look for it. It is the Holy Grail. If I could time the portfolio correctly, but you know, realizing that this is one question that we can’t solve yet, the path, we take an equal risk methodology to allocating and constructing the portfolio from our strategies. Kevin: I like the yet, so just slip that in there, you know. Steve: And I would say we have a lot of similarities to what John was just talking about. And we think it’s very important to take a diversified approach to the multi alternative segment. And we’re diversifying in a couple of different ways, one across strategies and if I were to analogize that to an equity portfolio, you’re not going to take an equity portfolio and put all your money in technology stocks, although you would have done really well last year. But there’s just too much risk and sectors take turns in being the best and worst sectors and it’s very similar with hedge fund strategies. There’s different environments that are better for different strategies. So we think it’s very important to be diversified across those strategies. The other way we diversify is across managers. What you will find within alternative space, whether it’s direct hedge funds or whether it’s liquid alts is that manager performance is much more widely dispersed than it is for long only asset classes. And so we want to make sure that, you know, when that good manager that we have in our portfolio, they just happen to have a bad month, a bad quarter, bad year, we want to make sure they’re not too big a part of the portfolio. So we generally hold 15-20 different managers in our portfolio and put a hard limit at 10% in any one manager to manage that risk of a good manager just having a tough period. Hoda Imam: And when you spread out the risk over say 15 managers, I mean the likelihood of one manager causing a ripple – a huge ripple is not very… Steve: Correct. And just you’re constructing the portfolio to have different factors. And as an example, I guess several long short equity managers that I’m using right now, and none of them are doing exactly the same thing. The last thing I want is two managers that have the exact same exposures in it. So we’re managing those exposures, and not just within long short equity, across all the strategies we use so they’re all doing a little bit different. If one of them has a bad go of it, it’s typically a result of individual security selection. So it doesn’t impact the other managers. Hoda Imam: Okay. Kevin. Kevin: Yeah. I mean just again we’re coming from a somewhat different place, but there’s a similar process in that… Hoda Imam: I think it’s nice to have your perspective, and then John and Steve’s perspective. Kevin: But in allocating to the alternatives, yes, we’ve identified some core strategies that we want to implement our objective. As has been discussed before in other comments is really about looking for low and in a perfect world, negative correlation, managed futures is probably the closest we get to that. And so how do we incorporate that? And the extent to which we have exposure to any of those strategies will vary based on the client return profile as we look at the portfolios that we design and how much equity versus fixed income versus alternatives. But it is, you know, I think there’s just a lot of parallel in terms of the process of looking at what are we trying to accomplish and how are we going to best get that done. We tend to hold ours more constant though. So probably less, I don’t know necessarily whether this is an accurate statement, but where there’s less shifting within the strategies themselves. So we’ll hold an exposure to managed futures, that’s a constant exposure in the portfolio, we’re market neutral etc. Hoda Imam: So, Steve, you touched on hedge funds, let’s go back to that a little bit. How do you overcome market expectations that hedge fund strategies are riskier than say the more traditional asset class allocations? Steve: Yeah, you’re right; we have talked about that a little bit. And it really goes back to this lack of understanding of what they’re there to provide. It’s this kind of reasonable return with a downside protection. And so when we talk about risk, the most common way of addressing risk is looking at volatility returns. So if we do that and place kind of the broad categories on a spectrum, we’ve got fixed income first, the lowest volatility, then hedge funds and then equities. And hedge funds are much closer to fixed income and volatility than they are equities. In fact they have about a little less than half the volatility of equities. So from that perspective equities are the most risky. And people don’t think of it in that term. The other way I would think about this is thinking about just the reason you use hedge funds and how they correlate to other asset classes. And specifically, we’ve talked about this earlier in terms of the difficult periods that you mentioned. And if you look at hedge funds as a group, and so a broadly diversified group and go back to that bear market that was created out of the dot-com bubble bursting. You know, you had equities, and we’ll use the S&P 500 as a proxy for equities, lost half its value, during that same period a diversified portfolio of hedge funds lost about 5 or 6%. So that’s what they bring to the table, that downside protection in a prolonged bear market that you don’t get in the long only asset classes. So when people talk about hedge funds being too risky, those are usually the two benchmarks that we talk about, the fact that the volatility’s a lot less in equities and they do a lot better, at least, historically have in down environments. Kevin: Yeah, and I would … go. Hoda Imam: Well, I was just going to say the downside protection; you don’t hear that as often, you know what I mean? It’s there but I guess that’s what, when it comes to the educating side, like that’s what you have to bring up on a regular basis. Steve: It is because they constantly get compared to the equity market and obviously we’ve had a very strong bull market for quite some time, in fact I think if we make it to August it’ll be the longest bull market on record. Kevin: Yeah, I was going to say, and it is an education issue. A lot of that is this question of perception of risk. And I think part of that is the lack of understanding because the investments themselves have a degree of complexity that isn’t in peoples’ normal experience. So the whole long short approach, although they can understand it when it’s explained, it isn’t something they are naturally knowledgeable about. And so if we don’t understand something it’s going to be perceived as having greater risk. And one qualifier or caveat I would add is yes, lower risk but not necessarily as we saw in the financial crisis, a different driver. We saw a lot of hedge funds go south and blow up. And that was really about their access to capital, when capital calls were being made. And so back to the importance of manager selection and the evaluation process, there were a lot of failures at that timeframe. And it wasn’t all the product of bad investment decisions; it was access to capital when calls were being made. Steve: Correct, correct. But even in that environment, the broadly diversified portfolio of hedge longs lost about 20%. So you still have the downside protection, but you’re absolutely right, there were certain players that got hurt by liquidity. John Fujiwara: I think conceptually at times, a lot of times my strategy gets compared or gets lumped in that kind of that category of, hedge fund like or, hedge fund replication or hedge fund beta. I don’t really have a great answer for all the questions. I find myself kind of focusing or my efforts on transparency. And so because I’m a mutual fund and my positions get published every quarter and you can see what I’m doing. I think that for me it’s easier to approach this issue by being as transparent as I can about my strategy, try not to overcomplicate my little individual strategies and try to make those as simplified as much as possible. And again, like I said, the willingness to show all my positions. And so I think that’s kind of my go to thing for trying to, you know, get people to be more comfortable. Hoda Imam: So you would say it’s too risky, hedge funds? John Fujiwara: No. I just think that the perception of being risky is because there’s not always the transparency. So people, they see the returns, we’re talking about the actual return characteristic, being clear, clearly less risky. But in their head they can’t get there because they don’t understand what’s going on. Hoda Imam: I see what you’re saying, okay. John Fujiwara: So the transparency issue for us is kind of key because it helps them get from like, well, you have this really controlled risk return profile, okay, I kind of get it now because I kind of know what you’re doing. You’re willing to tell me everything you’re doing; you’re willing to show me all your positions. So I think being transparent is kind of helpful in addressing that question. Hoda Imam: What would you say advisors should ask or rather know, when allocating to a Liquid Alt strategy? Steve: Well, I can say from the multi alternative standpoint, and I’ve heard about this earlier is make sure you get what you think you’re getting, because from a multi alternative viewpoint, so as I mentioned earlier there’s a lot of managers that allocate to long only strategies. So if as a financial advisor you’re coming up with an asset allocation between fixed equities and alts for one of your clients, makes it incredible difficult if your alts manager is also doing fixed and equities. So you want to make sure you have a pure play, and that’s one of the biggest things that I would caution advisors about. Make sure that you’re getting what you expect you’re getting, I would say from our perspective a diversified approach which, if you don’t have that parity, if you don’t have that diversification it’s very likely you could be disappointed in that period when you most want those strategies to help support you. Hoda Imam: Okay. John Fujiwara: So I’m going to give the article that I wrote and support his … I wrote an article exactly about that. And it’s not… Hoda Imam: Well, tell us about it. John Fujiwara: It’s not a unique article but the point being I can’t emphasize enough exactly that point, which is if you’re objective of a Liquid Alternative’s allocation, is liquid diversification then you have to do everything you can. The process to analyze stable non-correlation is possibly as important as the analysis that you do regarding your expected return. And I think that that’s what gets lost at times, because everyone’s worried about this return. But yet, they forget about really being rigorous about the diversification, the non-correlation. And we sometimes do very simple analysis; I call it coincident down day analysis. So take whatever you’re trying to diversify, pick all its down days, what did your alternative allocation do on those days? And figure it out, how likely it is that your allocation is going to either add to your woes or help you. So I think you can go through any number of analytical processes but I think what sometimes gets pushed to the back is really being rigorous about that correlation analysis. Hoda Imam: Okay. Kevin: There’s not a lot I could add to this. I mean I think the deep dive, understanding what you’re buying is absolutely essential, and understanding the correlation part of that is absolutely critical. When you look at some of the strategies that are out there, just fundamentally from a strategic standpoint, you’re going to see a closer correlation to the US market than maybe the perception of what that might otherwise be. So understanding the correlation, looking at doing a deep dive in terms of the strategies, the advantage of the Liquid Alts space is greater transparency. The disadvantage at this point is simply relatively short history in terms of the range of offerings, doesn’t make the managers bad managers, but it makes it more difficult to assess what are you getting. Hoda Imam: What do you mean, short history? Kevin: Well, so if you look back to, you know, Steve was saying we have 15,000 hedge funds today. If you look at the evolution of hedge funds it looks like a hockey stick where the number has just skyrocketed. Similar at a much lower level if we look at alternative mutual funds, Liquid Alts, those have burgeoned over the last few years. And so I don’t know the data directly, but my conjecture would be that if we looked over the last five years those numbers have probably tripled or more. And so you’ve got relatively short track records, if you will, history in terms of the managers in that space. Steve: Yeah. With hedge funds you’ve got track records that date back 20 years or more. So it’s much easier to make those analyses. John Fujiwara: So I live this, exactly what he’s talking about, which is we have a five year track record, and live track record, and that’s for a risk premia fund anyway, the mutual fund space, that’s considered really long. There was a study done by one of the banks that said in risk premia, just in risk premia, there are actually only, I think less than 10, probably something like 7 or 8 strategies that have been reporting returns for more than five years. And I know it was a very specific category of risk premia. But it speaks to the point that a lot of the entries into this space have come very, very recently. So you’re looking at trying to make an analysis on two, three, years of data, of [inaudible] sample data which is very difficult. Steve: And all it’s been is a bull market during that time. Hoda Imam: So where do alternatives fit into a larger portfolio? And what would you say is the sweet spot when it comes to the right size allocation? Kevin: And again from a client standpoint when we … and again, we began using, if we look at real estate, which is not necessarily the best of alternatives, if you’re in the REITs it means you’re trading in the exchanges you look a lot like a stock as much as real estate or more so. But beginning with real estate and building out the alternatives over time, we said, “Where do we take it from? Do we take it from equity? Do we take it from fixed income?” This is where art rather than science takes hold. And our bias was, let’s take a little out of each. And in part, again remember the premise that we start with in talking with clients. And I think we have, if we look at the strategies that we employ we do have an expectation, as John was talking about, a long term expectation of growth and positive return, and a profile that at the alternatives bucket, if you will, or its allocation, an aggregate return somewhere between fixed income and equity. And so the logic of removing it from both resonated with us. Steve: And we look at it the same way. The kind of the traditional approach to a balanced investor was the 60/40 split between fixed income and equities. And we think it’s gravitated more towards a 50/30/20, 50 fixed income, 30 equities, 20 alts. And they’ll vary by client depending on the risk return tolerances. But we agree with you taking it from both sides. And if you think about the correlation of the diversifying benefits, it provides diversifying benefits to both fixed income and equities. One of the things we like to look at, we’ve talked about correlation, but that only tells you half the story. Correlation just tells the direction. But you need to look at magnitude. And so one of the things we do to look at magnitude is look at an up down capture. So if the market’s up 10% and a fund is up 5%, it has a 50% capture ratio. So you do the same thing on the downside. And of course what you want to see is you’re capturing more of the ups than the downs. And again, I’ll use hedge fund data since we have a lot longer data stream there. But over the last 20 years you’ll see that diversified hedge fund portfolios tend to capture about 50% of the upside and only a third of the downside, and of course too, much better in difficult environments. The story is even more compelling against fixed income. They capture about 85% of the upside and negative 85% of the downside. So they make money regardless of whether the fixed income is going up or down. And so we agree with you taking it from both places, we think that makes sense. John Fujiwara: So I’m kind of a quant guy so I like hard numbers a little bit. Kevin: There is the science speaking, okay, we got that. John Fujiwara: So our research has kind of showed that about 40% of advisors are now considering alternatives. And of the advisors that are considering alternatives, well, their average allocation is somewhere in the 10-12%. If you did a little bit more scenario testing against, you know, of adding in, it starts to get impactful around 20%. But I understand that that seems a very, very high number for advisors right now. So I think it makes sense to us, what we’re seeing in the marketplace. Steve: You know, it’s interesting, if you look at that 50/30/20 split I told you about instead … and comparing it to the 60/40 over the last 20 years you’d get about the same return for less risk. Kevin: Less risk, yeah. No, that’s exactly right. When we do our modeling, and that’s part of the starting point for where do we take it and how much do we take and whatnot, it really is. Now we’re using indices but we’re able to look at this and what we see is as we add alternatives to a traditionally fixed equity allocation, we see return profiles stay at or maybe modestly above but with less volatility. Hoda Imam: Okay. So what would you say is the so called sweet spot when it comes to the right size allocation, what percentage, could you… Steve: Well, you know, I threw that 50/30/20 out there. And that’s just a starting point. I mean each client is specific. And some clients will have, you know, a greater risk tolerance than others. Some clients may say, “All I want is equities.” And that’s okay. You know, the point that we try to bring out is we want to give you some education so you understand what these strategies are about. So if you don’t invest in our fund you invest in another fund or you don’t use alts at all. At least you’re making an informed decision. So it’s really hard to pinpoint a hard number down. You know, John talked about 10-12, I mentioned 20. I think it really depends upon the individual investor and you can’t consider that all investors are the same. So we just won’t treat them as though they... Hoda Imam: So there’s always going to be this range, right? Kevin: Well, and I think the other side to that is, that it also depends on the nature of the underlying investments you’re holding and what those exposures may be. And so you can model. You know, traditional hedge fund strategies, what I would refer to as strategies in the alternative space were probably somewhere around 15 plus. But we add some other categories that could fairly be argued are not alternatives, but we look at them, real estate would be an example. Emerging markets debt which is, you know, not for widows and orphans typically, we put in the alternatives bucket. And so our alternatives allocation is probably closer to 25%, but incorporating things like real estate, like EM, along with traditional, what would otherwise be referred to as hedge fund strategies in the Liquid Alts space. Hoda Imam: And for our last question I’d like to hear from each one of you about your thoughts on Liquid Alts. Obviously there are supporters and there are critics. What else could you add? Kevin: Well, from my bias, I think what I expect to see is a continued growth in the space, I think for very good reason. I think these are investments that can help client portfolios. It is an education process. So John was alluding to the fact that advisors are beginning to enter into this. I think from an advisor’s standpoint, you need to get educated. You need to know what you’re investing in. You need to be able to set expectations for clients realistically. But I think that this is, you know, Liquid Alts are with us to stay and I think will continue to grow. John Fujiwara: I can’t, I don’t think I can say it any better. I attended a conference and with a lot of smart people, but I thought that the most interesting thing was that someone said this is the next asset class. You know, it’s an actual asset class. Maybe risk premia Liquid Alternatives, but I think it has that potential. It has the potential to be disruptive in a good way, to the traditional model, so I think it’s here to stay. Hoda Imam: You do? John Fujiwara: Yeah. Hoda Imam: Okay. I didn’t think you were going to say that. Kevin: You know what, I agree with what they said. I think obviously you need to understand what you have. And people come up with acronyms to remember things. So let me give you an acronym of what we think is important. And the acronym is DEEP, so one, in the multi alternative space you want to be diversified, that’s important to be able to deliver the right return profile, E, experience, make sure who you’re investing with has the experience and the qualifications to be able to do this. For us the second E is execution, we do things, like I said, we utilize other liquid vehicles. So if we want to make a shift in our portfolio or if we find a manager that we just don’t have confidence anymore, we can make that change in a day’s time. Now, there are other approaches to the multi alternative space, that you might take several weeks or months to make those types of changes. So we think that is important, that nimbleness. And then finally, well, I’ve already mentioned several times today but I think it’s important to drive this home is make sure what you’re getting is a pure play in alternatives otherwise you’re liable to be disappointed in an environment where you’re looking for them to support your value. Hoda Imam: Okay, so DEEP or DEEPS? Steve: DEEP. Hoda Imam: There’s no S at the end? Steve: No S, unless you put my name at the end. Hoda Imam: We can, you know, have your copyright on it. Well, thank you so much for taking the time to share your insight with us. And thank you for tuning in. Please be sure to take the corresponding quiz on assettv.com for your Continuing Education Credits. From San Francisco, I’m Hoda Imam for Asset TV.