The Role of Alternative Asset Classes

in Diversified Portfolios
June 2010

Bill McKay, CFA, CAIA

Traditional vs. Alternative Strategies

Traditional Strategies

• Long-only equity and fixed income strategies

• Majority of returns derived from market participation

(beta) with some coming from manager skill (alpha)

• Transparency and liquidity generally good

• Cost is an important criterion (beta is cheap)

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Traditional vs. Alternative Strategies

Alternative Strategies

• Long/short equity and market neutral/low volatility hedge

funds

• Private equity, real estate, commodities

• Majority of returns derived from manager skill (alpha)

with some coming from market participation (beta)

• Transparency and liquidity generally not as good as

Traditional strategies

• Detailed due diligence process required to identify and

select appropriate managers

• Costs are higher

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Complementing Traditional Equity with Equity Long/Short

Rationale

• Most active form of equity management

• Returns are correlated with equity markets

• Net exposure is generally positive, but has large variation

• Asymmetric return profile

• Most value is added in down markets (when its most needed)

• Fees are higher, but justified by after fee performance

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Complementing Traditional Equity with Equity Long/Short

Advantages
• Risk measured in absolute terms, not tracking error to an index

• Short exposure can be used to manage risk or as a source of alpha

• Managers can hold cash and take a more market neutral position,
or even go net short

• Dynamic exposures

• Volatility substantially lower than traditional equities

Disadvantages
• Liquidity, transparency, cost

• Idiosyncratic risk

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Complementing Traditional Equity with Equity Long/Short

Performance Profile

Down Up
Performance In:
Months Months

MSCI World -3.9% 3.1%

HFR Equity
-1.6% 2.1%
Hedge

Capture Ratio 41.1% 67.2%

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Complementing Fixed Income with Low Volatility Hedge Funds

Rationale

• Similar volatility profile as fixed income

• Returns are uncorrelated with bonds

• Performance not as sensitive to interest rates as bonds

• Provides the ability to tilt portfolio away from fixed

income without increasing equity exposure

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Complementing Fixed Income with Low Volatility Hedge Funds

Advantages
• Not dependent on equity market direction for returns

• Non-directional, relative value strategies

• After crisis in 2008/2009, spreads on underlying

strategies have widened

• Tax effective (for taxable investors)

• Low correlation to fixed income

Disadvantages
• Liquidity, transparency, cost

• Idiosyncratic risk

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Complementing Fixed Income with Low Volatility Hedge Funds

Performance Profile

• Correlation to bond markets: 0.01

Fund of 50/50
Bonds
Funds Mix

Annualized Returns 6.7% 3.8% 5.3%

Risk 4.0% 5.7% 3.5%

Sharpe Ratio (RF=2%) 1.19 0.31 0.96

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 Traditional Portfolios

Typical Balanced Portfolio Allocation Typical Balanced Portfolio Performance

• Even split between traditional equities and

bonds/cash
• Half of portfolio exposed to equity market • Bond allocation has provided good buffer to
direction equity market volatility
• Half of portfolio exposed to interest rate • Secular trend in interest rates has been down,
direction supporting bonds

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 Adding in Alternatives

Diversified Balanced Portfolio Allocation Diversified Balanced Portfolio Performance

• Equity long/short used as a complement to

traditional equity
• Low volatility hedge funds used as a
complement to fixed income
• Traditional equity utilizing fundamental
indexing
• Different, more diverse sources of alpha

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Performance in Bear Markets

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Analyzing the Performance

• You can put together a better

portfolio without taking a lot of
risk

• It will perform better in most

market environments

• BUT – during a liquidity crisis, MSCI 50/50 Diversified

you will lose money no matter World Balanced Balanced

what your portfolio looks like Annualized

-0.4% 3.7% 5.1%
Returns

• Crises happen periodically: Risk 16.7% 6.5% 7.3%

Don’t Panic
Sharpe Ratio
-0.15 0.26 0.43
(RF=2%)

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