As featured in Investment Advisor magazine’s January/February issue
Calling all due diligence wonks. Get your coffee, your spreadsheets, your performance databases and dig in. Your role has never been more important. Investment manager due diligence has always been a critical, if not underappreciated, value add in the advisor-client partnership. The advisors evaluating strategies are the sole guardians between millions of clients and thousands of managers marketing to them. It’s never been an easy task, but it’s absolutely critical in the 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, performance dispersion in 2020 has been considerably wider than any of the previous five calendar years. (For the purpose of this research, we measured performance dispersion as the performance difference between strategies in the fifth and 95th percentile of Morningstar’s category for long/short equity and managed futures funds.)
Looking further back, dispersion for the long/short equity category in 2020 was 47.7%, compared to an average of 27.8% since the financial crisis through 2019. For managed futures, dispersion was 27.3% in 2020, compared to an average of 17.4% for the full period since the crisis through 2019.
Wider performance dispersion means a similarly wider range of outcomes. Poor outcomes in the alternatives space are troublesome, because the ramifications are usually larger than if a client is invested in an 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. The asset allocation remains the same, however. But pick a poor-performing alternatives fund and a client might completely retrench from strategies they already are less familiar with in the first place.
Whatever objective the advisor hoped to achieve with alternatives, whether it’s outperformance or diversification, is now lost, and inevitably, the client’s switch away from alternatives probably will come at the wrong time.
How can advisors avoid this outcome? Fund performance is never a guarantee, but as manager selection becomes more important in alternative categories, there are a few due diligence questions that can help, including some new ones for the current environment.
First, address the manager’s investment philosophy: What inefficiencies does the manager believe exist? Why do those inefficiencies exist, and why should they reasonably persist? Finally, what is the manager’s definable edge in exploiting those inefficiencies?
Second, advisors must identify the portfolio’s key sources of risk. Through returns-based and holdings-based analysis, one can identify: exposure to the equity risk premium; 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 to deliver alpha. With alternatives, however, if the strategy uses shorting, one should ensure the strategy delivers alpha on both the short and long book. From what we’ve seen, this is rare, but does exist.
When conducting due diligence, ask managers to provide you the numbers that show the performance of the short book. Make sure that you examine the full historical numbers, not just the three-year or five-year (or whatever time frame is on the fact sheet).
Finally, 2020 has added an opportunity for advisors to add another item to the due diligence checklist: How did they manage a crisis?
Market upheaval in the spring provided a rare window to see how a team navigated it. Did they panic and make wholesale changes to the process? Did they learn from it and make changes at the margins? Or maybe their process held up and they made no changes at all. Then again, maybe the process failed and they are too stubborn to adjust.
Whatever the response was, advisors should 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 more important to get due diligence right.
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