Alternative Manager Selection - What to look for?

The case for and use of alternatives is well established and allocations are rising.  Many factors are contributing to the growth of alternative assets most notably, the access companies have to capital from private equity and debt providers, changes to the banking system and growth in institutional allocations.  The aforementioned factors are partially responsible for the number of publicly listed companies in the U.S. falling annually over the last 2 decades. Today there is less than half the number of public companies in the U.S. relative to 1996. Alternative investing has been led by institutional investors but can help individuals who work with advisors that have the resources to assess available options.  For those considering increasing their allocation to alternatives, several key areas should be considered, including people, strategy, track record and regulatory environment. 

The quality and experience of a portfolio manager seems like an obvious and important part of any investment selection process, but is it any more important within alternatives versus traditional investments? It is. Alternative managers need to navigate a greater breadth of strategies, the use of leverage, illiquidity, and complexity. All these factors can enhance risk adjusted returns but can also impact results negatively. 

As a result, the dispersion of returns within traditional strategies is far less than within alternatives.  The opportunity for enhancing returns and risk has been established, but manager selection is critical.

Recommendation: Look globally as well as domestically for the right team to partner with.  The breadth of AUM, strategies and manager experience is greatest in Europe and the U.S. Both markets have benefited from a two-decade head start versus Canada due to earlier regulatory adoption. 

Alternatives are often viewed with a binary outcome: investors are either open to them or not, with limited middle ground.  This is generally a result of the perception of alternatives being too risky or not.  Alternatives can substantially reduce risk or increase it, depending on the strategy the manager employs. The dramatic failures of most alternative strategies are the result of one main factor, leverage. Leverage can come through outright borrowing (financial leverage) or the use of derivatives (exposure leverage). Strategies that employ significant leverage should be accompanied by enhanced risk management modelling that can adjust quickly to changing market dynamics.  It is important to point out that not all alternative strategies use leverage, and some use it in a measured and reasonable way. Special situation investing can offer significant upside without the use of leverage, but generally require experienced teams to find and execute on opportunities.  To achieve consistent results, a flexible approach is required.  Dislocations do not stay in the same place forever and a team need to be large enough, with a diverse set of skills to be able to invest confidently where the best opportunities exist.

Recommendation: Choosing an appropriate strategy based on your risk tolerance is almost as important as the manager you select. The effort required to find unique opportunities calls for a team of appropriate scale, with a reasonably sized fund to allow for a flexible approach. 

Results mater, especially the longer they can be observed and the greater the number of environments they have experienced.  Performance can help narrow your due diligence to a manageable number of firms to research. Most alternative investors are looking to achieve non-correlated results to enhance existing portfolio outcomes. The data will show whether a manager has achieved differentiated results or market directionality.  The later would limit the benefits of adding the strategy to existing portfolios. Ensure managers provide ample data and transparency to allow you to do the necessary due diligence and attribution, no short cuts. The data for private strategies where the securities in the portfolio are not publicly traded require additional care, as the risk metrics may not fully reflect the volatility that are inherent in the strategy.

Recommendation:  Get the data required to make an informed decision. Ensure the strategy has a track record of delivering the outcomes you require from your alternative’s allocation. More complex strategies need enhanced risk monitoring. Pitfalls can be glossed over by the manager only to appear when you can least afford them.

A final and less discussed topic within alternative investing is the regulatory environment the manager operates in.  While most regions have robust public market regulatory environments, the same can not be said for alternatives.  Europe and the U.S. have the most extensive regulatory frameworks resulting in greater transparency that can protect investors. Europe introduced the Alternative Investment Fund Managers Directive (AIFMD) in 2013 which requires, among other things, that managers’ report on liquidity, valuing of illiquid securities and mandates that remuneration policies be structured in a way that does not encourage excessive risk-taking.

Recommendation: Managers who operate in markets with greater regulatory oversight should be looked at favourably. 

Alternatives are well established among institutional investors and can be a helpful tool within private investor portfolios with adequate research. When building a portfolio, all risks can not be avoided, but they should be managed. When considering alternatives’, manager experience, strategy, track record and legal domicile can help assess the benefits of a strategy in delivering enhanced risk adjusted returns within client portfolios.