The Building Blocks of Your Portfolio

There is a tendency in our industry to look at alternative investments as separate and distinct from traditional strategies. But at the most basic level, both alternative and traditional strategies invest in the same assets: equities, bonds, commodities and currencies. Delving a bit deeper, we find that all strategies invest in factors (knowingly or not). Factors are the basic building blocks of return streams. Whether you attribute the payoff to various factors to risk, or to market inefficiencies, value, size, momentum, quality, volatility and carry, among others, they explain a great deal about investment returns.

The failure to understand the factor exposures in a portfolio can quite easily lead to unwarranted disappointment. Take the performance of Long/Short Equity funds in 2015, for example. Many of the worst performing funds in the category were those that employed a value-based strategy. In fact, sorting funds based on Morningstar’s Value-Growth Score, value funds were down 7.3% on average in 2015, while growth funds gained 2.5%. Value, as a factor, experienced a difficult period in 2015, and as a result, viewing the long/short category monolithically could easily lead you to believe that those funds did a poor job. But many of those same funds rebounded nicely in 2016, in part due to the resurgence of the value factor. According to The Leuthold Group, through November, “…Value has been the only factor that has provided positive performance.” Their work shows that the value spread – quintile 1 less quintile 5 – for the 3000 largest companies in the U.S., has been about +13% year-to-date, while Momentum, Size, Growth, Volatility, Sentiment and Profitability have all posted negative return spreads.

On the heels of a troubled 2015, investors in those value funds withdrew close to $300 million during the first six months of this year, just before the value factor started to swing into favor. And through November, those value funds were up about 10.7%, while growth funds were off slightly, with an average return of -0.8%. Short-term underperformance = outflows = missed opportunities when performance reverts. A typical pattern that seems to repeat endlessly.

While these observations may not be all that eye opening, they do serve as a reminder that the way in which alternative mutual funds are viewed is years behind traditional, long-only fare. Morningstar, Lipper and others provide investors with short cuts to understanding performance through the way they classify funds. Size and valuation are the primary factors on which long-only funds are sliced and diced, and while there are many more factors to consider, that basic classification goes a long way toward explaining performance. Alternative mutual funds are thus far not grouped in the same way. The basic categories in use give the appearance that, for example, Long/Short Equity funds are somewhat homogeneous, when nothing could be farther from the truth. Utilizing both holdings-based and returns-based analyses, in addition to interviewing the manager, as part of a thorough diligence process, can triangulate the factor exposures in a portfolio, which will go a long way to setting appropriate expectations and reducing unnecessary manager turnover.