The proliferation of alternative strategy mutual funds has generally been a positive for retail investors, who are otherwise consigned to portfolios consisting of long positions in stocks and bonds. Differentiated, or non-correlated, cash flows are the key to diversification from an asset allocation standpoint. However, the investment options that pool together many of these strategies under one umbrella (oftentimes with a fee for that umbrella) are an easy but ultimately unwise selection.
The term multi-strategy, in reference to hedge funds, has a wide array of meanings. In their best form, multi-strategy funds combine several positive alpha, non-correlated strategies and leverage them against each other, allowing for higher returns per unit of risk and per dollar invested. Leverage is often bemoaned as purely additional risk, but in the context of a multi-strategy fund it represents the opportunity to de-risk the portfolio by adding more non-correlated cash flows.
Take a look at some of the most well-known hedge funds in the world, with extremely successful track records, and you will see multi-strategy as their category. You will also find these funds at the top of the “regulatory capital” tables, despite having less AUM than many firms. That seeming disparity is achieved with the successful implementation of leverage.
So if positive alpha, non-correlated cash flows are good things in multi-strategy hedge funds, shouldn’t those benefits translate to the new liquid-alts models in mutual fund formats? Sadly, they do not.
Mutual Funds that are employing several hedged strategies under one umbrella are not allowed access to the kind of leverage that make their less liquid Hedge Fund brethren superior investments. Rather, multi-strategy mutual funds are often restricted on their exposures to little more than 100% of the assets in the portfolio. With such limitations, it is nearly impossible to generate meaningful alpha using hedged strategies. While the result may very well be a much smoother ride than equities, the watered down returns and additional fee drag make them much less appealing than individual hedged strategies in a 1940 Act format.
Further, the benefits that can be gained by allocating to multiple non-correlated return streams are eliminated in the mutual fund format, because investors aren’t able to decide when to add to out-of-favor strategies, or take profits from well-performing strategies. Investors would be much better off allocating to the individual strategies on their own, and rebalancing them actively to benefit from the non-correlation. Leaving them under one umbrella eliminates those significant marginal returns, and usually does so for an extra cost.
Alternative strategy mutual funds may be the best thing to happen to retail investors since the reduction of the cap gains rate. However, running portfolios of individual strategies allows advisors to extract the benefits of their non-correlation, where multi-strategy mutual funds do not. We believe the best portfolios have a high number of positive alpha, non-correlated investments in a setting where advisors are able to capitalize on that non-correlation, rather than letting it go to waste under a shell with another layer of fees.
Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes. www.Strategic-Alpha.com