Are Retail and Institutional Advisors on the Same Page?

Given the current long-running bull market, with equities up over 15% annually and lower than historical levels of volatility, many advisors who allocated to alternative strategies post financial crisis have been frustrated. They thought they were doing the right thing for their clients but have been left with headaches from investments and performance that hasn’t met expectations. After many failed to deliver what people wanted in 2018, we’ve noticed advisors abandoning the space altogether. Given common behavioral biases, we certainly understand that sentiment, but on the other hand, we see larger institutions maintaining or in some cases even increasing their exposure. For example, a new report by Preqin, noted that 26% of institutional investors said they expect to commit more capital to hedged strategies in the next 12 months. [1]

I can’t help but see this diversion of thought and wonder what is going on.

I have plenty of my own ideas but have heard three common themes in my recent conversations with advisors. I wouldn’t assume this is comprehensive of all the thoughts out there, but this is what keeps coming up. (If you have other insights, we would welcome the feedback.)

    1. 1. Time constraints. For most advisory practices, days are spent meeting with clients, trading portfolios, handling incoming requests, managing employees, as well as regulatory and compliance issues, not to mention paying the electric bill and hanging on the phone with the internet provider when there is an outage. This means less time to commit to deep due diligence efforts.
      • Contrast this to an institution: They have departments handling the logistics of the building, an HR department for managing employees, and teams of analysts conducting diligence.
    1. 2. This relates to the second reason…lack of resources. Most advisory firms have a handful of people; one or two advisors, an assistant/operations person and then maybe a trader/research/jack-of-all-trades person. It is not likely that a single person’s full-time job is to evaluate investments; and even if there is someone dedicated to the task, most time would likely be spent on the larger asset classes. Due diligence on alternatives is so much different, especially because of the dispersion in returns and approaches—there often aren’t resources available for the required level of analysis needed.
      • Contrast this to an institution: Not only do they have analyst teams, but they are broken out by specialty. They can have a handful of people just looking at alternatives. In addition to that, they have Bloomberg terminals, contacts at investment banks, networks in the hedge fund world, etc. All of these resource advantages make it more likely that an institution will have the extra resources needed to spend on alternative due diligence.
    1. 3. The last is working with individual clients. While you likely spend much of your time with clients explaining the construction of their portfolio and encourage them to stay invested over the long term, you may also have a handful who call when the market drops or who question you every quarterly review about why so and so fund did XYZ. The truth is, alternative strategies are designed to move differently than long-only stocks or bonds, but it is easier to explain why your stock holdings go down when the market does. It is not always easy to understand and explain why alternatives move the way they do (we call this ‘explanation risk’) and sometimes the reality for advisors is, the explanation risk is so high that any potential benefit from the investment over time is just not worth it.
      • Contrast this to an institution: They are often managing to different benchmarks than the S&P 500 Index, they have targeted portfolio returns and often the groups that make the investment decisions don’t sit with individual investors…and they certainly don’t have to take calls on the day the market drops. In addition, their time frames are often different so their perspective on any one-day move is much different than an individual who watches their account every single day.

So, what do you do?

You can’t add more time to the day, or hire a bunch of people, or stop taking client calls on tough days…so what are your options?

If you do want to commit to due diligence in the space, we have some suggestions.

    1. 1. Do not use the same method that you use for your long only managers. There are plenty of advisor resources out there that categorize and rate/rank funds. While these are effective for long-only asset classes, they are severely lacking for alternatives. With that, it’s important to know what you’re trying to solve for when conducting due diligence on an alternative investment. If you rank solely by three-year category numbers and look at a couple of risk measurements for instance, you are going to constantly be chasing returns and may underperform going forward. You will have to do a lot more work around betas, alphas, exposures, trading styles, market cap, geographic exposure etc., than you typically must do for other asset classes, where they are already categorized for you.
    1. 2. Set expectations with yourself and your clients. All strategies struggle at times, other times they will outperform what they ‘should’ return. Make sure you understand the thesis behind a strategy (and question if it makes sense and is viable going forward), as well as the drivers of that so you can communicate it. You’ll also need to allow for a bit of variability—an average of 50% down capture monthly doesn’t mean every month the market goes down 10%, you will only be down 5%. Things don’t happen linearly, but by assigning fair time horizons around your expectations, it can hopefully eliminate some of that explanation risk.
    1. 3. Make sure you work with a strong partner. For some firms, you need to be moving tens of millions of dollars for them to give you the time of day. If performance is struggling, you may never hear from your relationship person and will have to rely on yourself to figure it out and explain what is going on to your clients (more time you don’t have). By working with a responsive/proactive partner you can get answers when you need them—you won’t have to spend time figuring out what is going on with the investments because they will have done much of this work for you in preparation for potential client questions.

Institutions have certain advantages over individuals, but that doesn’t mean you can’t tap into some of their insight and do what you can to provide your clients institutional style money management on the individual level. Given the bull market and prospects going forward for many asset classes, it may be prudent to pay attention to this move (or continued exposure) to alternatives by many large asset managers. You can also provide that for your clients if you choose to commit a bit more time and a disciplined process around setting your allocation and selecting strategies to fill it.

Read more in The Wide Disparity Within Alts Categories >