How do multi-asset alternative funds work?

My fund employs a rules-based methodology designed to avoid risk and produce positive returns regardless of the condition of the financial markets. It’s a strategic asset allocation fund, but it tactically shifts its allocations to reduce its correlation to the broad market during periods of volatility. Its multiple asset class approach uses futures and exchange-traded funds (ETF) to build a multi-asset alternative portfolio. This approach is similar to the one used by university endowment funds at Yale and Vanderbilt. Our fund has attracted substantial inflows from investors who want a fund that provides both growth and a safe haven.

Our methodology is not designed to hit home runs. Instead, it aims to lose as little as possible during down periods, while producing gains during up periods. This leads to a more consistent performance, which preserves capital regardless of market turmoil.

What’s your outlook for the markets?

The current volatility will continue for several years. The biggest reason for this continued volatility is that the structural problems that became apparent in 2008 haven’t been solved; they were just passed off to the government. Global investors are very concerned about how developed nations’ governments are handling the situation. Policymakers in both the US and Europe have yet to address these problems in a credible manner. Meanwhile, we may be sliding into another recession. It all boils down to uncertainty. Investors want to see the government reduce spending. But it will take policymakers years to reduce spending in a meaningful way, and there will be a lot of political bickering before the 2012 US election. Until our politicians propose such structural reforms, investors are unlikely to have the confidence necessary to turn the market around.

What are your thoughts on the situation in Europe?

A default in Greece is almost inevitable. The European debt situation is actually worse than that of the US, so it’s going to take some time to resolve it. That debt has to be reset somehow, either through a default or a eurobond solution [jointly issued bonds that would share the debt burden among EU nations]. Unfortunately, the US could soon find itself in the same situation. The US will probably experience slower growth for quite a while, simply because our debt burden is absorbing so much capital.

How is your fund currently positioned?

We cover almost every asset class but traditional individual US and international stocks and US bonds. Three months ago, we were long all 12 of the largest and most liquid stock markets in the world; today we are short each of them. That tactical shift has saved our performance during the most recent turmoil. We follow trends because they reflect the cost of what’s actually happening in the markets. Our fund went short in early August and it’s been that way ever since.

We have exposure to seven of the most liquid currencies, four of which are long and three of which are short versus the dollar. The three that are short the dollar are the euro, the Canadian dollar and the British pound. For the last two years, all of our currencies have been long versus the dollar because the dollar was weak. But the flight to quality is changing the dynamics of the currency markets due to a strengthening greenback.

A stronger dollar has also affected our commodity portfolio. For the last two years, we were long most commodities until late July or early August. Now 13 of our positions are short and seven are long. Gold and silver are obviously helping pad returns, as are agricultural commodities such as sugar, corn and soy beans. We’re currently short on the energy complex because of the downside risk in the economy that’s implied by the trends.

Our global bond positions, which cover eight of the most liquid bond markets in the world, are mostly long and doing well. When yields start climbing in a few years, we have the ability to hedge the downside risk of a declining bond price.

It appears your fund has adopted a bearish posture.

It has nothing to do with our opinion; it has everything to do with what’s happening on the ground. I’ve always been an optimistic investor, but the trends are pushing us into protection mode. So if the markets continue to fall, we’ll make money, just like we’ve made money the past several years on the upside in the markets. If the time comes when sentiment improves and trends begin to change, we will shift into bullish mode.

Are traditional long-only investors setting themselves up to fail in this market?

Buy-and-hold investors have certainly suffered during the last 10 years. It’s been a difficult environment for people to reach their investment goals, such as saving for retirement. To break that trend, you have to do what Yale, Vanderbilt and other successful institutions have done for years. They use alternatives as their core investment to protect assets. To many investors solely use stocks for the growth component of their portfolios without realizing there are other asset classes that can achieve that end. Of course, you can’t rely on long commodity positions as your only diversifier either. In times of economic duress, commodities can also decline because consumers stop spending. Investors need exposure to non-correlated asset classes that can zig when the markets zag.

How do you define a trend?

We use seven different time frames, ranging from a short-term 90-day trend to a 360-day trend on the long-term side. We survey the trends over these time frames in aggregate to avoid getting whipsawed or falling behind the trend. As long as the majority of the timeframes we monitor show a sustained trend on the upside or the downside, we’re comfortable going long or short on that basis.

We also don’t follow fundamentals because they can be misleading. You could watch a stock that reported a nice quarter or has a solid balance sheet, but the stock still declines because the entire market is falling.

What’s your best piece of advice for investors?

Investors should focus on adding alternatives that can help protect their portfolios from downside risk. Buy a mutual fund that employs multiple alternative strategies. I would also suggest that they avoid market-neutral mutual funds; because they’re neutral they generally don’t produce significant returns. They protect your downside, but they have very little upside. Investors who want to have growth, but also want to hedge risk should choose a multi-asset, multi-strategy portfolio.

How does one choose an alternative strategies fund?

If you don’t have a financial adviser, I would suggest researching the multi-asset alternative category (there are about 160 mutual funds available) and find the funds that give the smoothest return. In particular, look at their performance in 2008. That calendar year gives investors a good idea of how a fund performed under the worst-case scenario. A single multi-asset fund should be sufficient because it gives investors a core portfolio, with everything they need.

Also, when you look at a fund, make sure the fund invests in very liquid assets. Some funds get into trouble because they don’t focus on liquidity. These funds often sell their assets at a steep discount in weak markets to pay out investors who are redeeming their shares. So liquidity is crucial.

The best strategies are the ones that are designed to profit when the market rises or falls. If investors only buy a short fund, they’ll lose money two-thirds of the time. Long-term investors need a fund with the ability to go both long and short. I favor funds or strategies that follow a trend versus the ones that follow fundamentals. The funds that followed a trend performed better in 2008 and continue to outperform funds that follow fundamentals.   

How much should investors allocate to alternative strategies?

At the end of 2010, the average endowment of more than $1 billion held more than 60 percent of its assets in alternatives. In other words, alternatives were their core holdings. The average investor with a moderate tolerance for risk should allocate one-third of their assets to stocks, a third to bonds, and a third to alternative strategies. Investors shouldn’t expect alternative strategies to smooth out their returns the portfolio’s allocation to these strategies is great enough to meaningfully influence total returns