Calling all due diligence wonks. Get your coffee, your spread- sheets, your performance data-bases and dig in. Your role has neverbeen more important.
Investment manager due diligence hasalways been a critical, if not underap-preciated, value add in the advisor-cli-ent partnership. The advisors evaluatingstrategies are the sole guardians betweenmillions of clients and thousands of managers marketing to them. It’s never beenan easy task, but it’s absolutely critical inthe current market environment, especially for alternative strategies. The reason:Performance dispersion in the alternatives category has widened considerably.
For both long/short equity and managed futures funds, two of the more common alternatives strategies, performancedispersion in 2020 has been considerablywider than any of the previous five calendar years. (For the purpose of this research,we measured performance dispersionas the performance difference betweenstrategies in the fifth and 95th percentileof Morningstar’s category for long/shortequity and managed futures funds.)
Looking further back, dispersion for thelong/short equity category in 2020 was47.7%, compared to an average of 27.8%since the financial crisis through 2019. Formanaged futures, dispersion was 27.3% in2020, compared to an average of 17.4% forthe full period since the crisis through 2019.
Wider performance dispersion meansa similarly wider range of outcomes. Pooroutcomes in the alternatives space aretroublesome, because the ramifications areusually larger than if a client is invested inan under-performing stock or bond fund.
Pick a poor stock fund, for example,and the advisor and client will eventually switch to a different stock fund. Theasset allocation remains the same, however. But pick a poor-performing alternatives fund and a client might completelyretrench from strategies they already areless familiar with in the first place.
Whatever objective the advisor hopedto achieve with alternatives, whetherit’s outperformance or diversification,is now lost, and inevitably, the client’sswitch away from alternatives probablywill come at the wrong time.
How can advisors avoid this outcome?Fund performance is never a guarantee,but as manager selection becomes moreimportant in alternative categories,there are a few due diligence questionsthat can help, including some new onesfor the current environment.
First, address the manager’s investment philosophy: What inefficienciesdoes the manager believe exist? Whydo those inefficiencies exist, and whyshould they reasonably persist? Finally,what is the manager’s definable edge inexploiting those inefficiencies?
Second, advisors must identify the port-
folio’s key sources of risk. Through returns-
based and holdings-based analysis, one can
identify: exposure to the equity risk premi-
um; exposure to other risk premia such as
size, value or momentum; and exposure to
sector and/or geographic concentrations.
As with any strategy, it’s also important to measure the manager’s ability todeliver alpha. With alternatives, however,if the strategy uses shorting, one shouldensure the strategy delivers alpha onboth the short and long book. From whatwe’ve seen, this is rare, but does exist.
When conducting due diligence, askmanagers to provide you the numbersthat show the performance of the shortbook. Make sure that you examine thefull historical numbers, not just thethree-year or five-year (or whatevertime frame is on the fact sheet).
Finally, 2020 has added an opportunity for advisors to add another itemto the due diligence checklist: How didthey manage a crisis?
Market upheaval in the spring provided a rare window to see how a teamnavigated it. Did they panic and makewholesale changes to the process? Didthey learn from it and make changes atthe margins? Or maybe their processheld up and they made no changes atall. Then again, maybe the process failedand they are too stubborn to adjust.
Whatever the response was, advisorsshould ask, and make sure they are comfortable with the answers. It’s an additional piece of the due diligence puzzle.And for alternatives, it’s never been moreimportant to get due diligence right.
Josh Vail, CAIA, is president of 361 Capital.
ALTERNATIVE INVESTMENTS
By Josh Vail
Performance Dispersion Ups the Ante for
Alternatives Due Diligence
Advisors need to look inside the numbers to see where success, failure and
risk exist.
wanwei/Shutterstock
