Morningstar’s Nadia Papagiannis Demystifies Alternatives:

The highlight of last week’s Alternative Investments Conference for us was definitely Morningstar’s Nadia Papagiannis’ presentation  titled, “Demystifying Alternatives: The ABCs of Alternative Assets, Strategies and Vehicles.

To be a speaker at these conferences, you essentially have to be an expert in the business and we have to hand it to Mrs. Papagiannis, she really knows her stuff. She not only understands the complexities of managed futures, but a vast array of alternative strategies and assets, making her an ideal speaker. 

1. “Alternative in name, doesn’t mean Alternative in practice.”

The overall theme of her talk was simply, “know what you’re investing in.” It seems like an elementary statement, but many investors see the name “Alternative” and think it’s the answer to a diversified portfolio.  Putting it more bluntly – you need to know what’s under the hood before investing, not just what’s on the label. Papagiannis astutely points out that “Alternatives” term has increasingly been thrown around since the 2008 crisis and that if you don’t understand what the return drivers are, you shouldn’t be allocating your money into that investment in the first place (that’s Investing 101). On the most basic level, she defines Alternative investing as:

“1. An Alternative Strategy (the way you’re investing)

2. Alternative Investments (what you’re investing in)”

More specifically, she provides a definition of a “good alternative investment.”

“…is one that produces positive risk-adjusted returns (over a reasonable time frame) and exhibits a lower correlation to traditional investments.”

2. Perceptions of Alternatives

We think she hit the nail on the head there, and with her next point – which was that the term “hedge fund” or “mutual fund” refers only to the legal structure of the investment.  A hedge fund doesn’t necessarily have an “alternative trading strategy” or trade “alternative investments” as defined above.  A hedge fund can even be registered with the SEC the same as a mutual fund is. What’s more – a hedge fund doesn’t necessarily take more risk than a mutual fund, and doesn’t necessarily have better performance than a mutual fund.  These terms are MERELY the vehicle by which an investor can access an investment strategy.

Next, Ms. Papagiannis asked institutions and advisors what’s driving people towards Alternatives, and we were happy to see both groups answered “Diversification/Low Correlation” as the number one reason for alternative investing (78% of institutions, 75% of advisors).

Top Drivers of Alternative Investments

Table Courtesy: Morningstar & Nadia Papagiannis

3. Allocation of Alternative Investments

But enough about perceptions and definitions… where are retail investors and advisors putting their money?

Flows in Liquid Alternatives

Chart Courtesy: Morningstar & Nadia Papagiannis

Looks like… for all the talk about liquid alternatives really taking off – it is really all about the non-traditional bonds category (especially this year) Why… a person in the audience asked? Her response:

N: “Income seems to be the name of the game these days.”

I guess all that Quantitative Easing and yields close to zero is helping someone out – the people running these bond funds seeking higher yield.

Q&A

Part of what makes these conferences so unique and interesting is not just the presentations, but the questions from audience members that drive the discussion. While there were multiple Q and A’s during Papagiannis’s presentation, we thought one in particular was important enough to note:

“Why is there such a disparity between Managed Futures Mutual Funds, and Limited Partnerships [accessing essentially the same managers]?

Papagiannis’s succinct answer was:

“…possibly because of fees.”

A more involved answer would be – the mutual fund structure can bring additional layers of fees not seen in privately offered funds accessing managed futures. It is a tradeoff between access and cost, similar to a wholesale/retail type pricing.  To get the mutual fund past the rules prohibiting investing in derivatives (paying for swaps), to register with the SEC as a fund company, to get selling agreements in place with the Schwabs and Fidelitys of the world costs money, money which a privately offered fund doesn’t have to spend – thus doesn’t have to pass on to investors.

It’s not fair to say the Mutual funds are purposefully trying to rip you off with more fees (although some are definitely charging more than they need to), it is just that the only legal way for the funds to access managed futures function is by using these complicated structures involving multiple players and layers.

The Managed Futures takeaway:

Our takeaway from this conference is that managed futures has definitely established itself as one of the choices for those seeking so called alternatives exposure.  It’s no longer a matter of if managed futures should be an asset class in your portfolio, but how much, who, and when (which we see as a big victory). The when is a bit of a question right now, however, with managed futures looking at their 4th losing year out of the past 5.

One conference attendee hit this on the head:

Q: “Why allocate in managed futures if it’s in a bad performance period?”

Papagiannis: “Managed Futures is non-correlated to other asset classes, and has lead to a better risk adjusted return.”

But it gets even better. She was then asked her recommendation for asset allocation… her answer?

“3 Alternatives = Long Short Equity, Managed Futures, and Market Neutral.”

And what about that how much question?  How much should you allocate to alternatives? Papagiannis says the majority of alternative investors allocate anywhere in between 5-20%, but what is the appropriate allocation? Several speakers throughout the conference indicated that you might be wasting your time if you don’t allocate at least 15-20% to alternatives. For our recommendation of managed futures allocation, see our newsletter here.

So there you have it…. have managed futures be part of your alternatives allocation, and make that allocation at least 20%. Couldn’t have said it better ourselves…

 

 

 

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