Alternative investments have delivered over the long term, but individual strategies can be as different as the day is long. We have some ideas on how to cut through the clutter.

Alternative investment strategies typically access a wider investment universe—and have more flexibility—than do traditional strategies. Market movements, or beta, tend to have less influence on alternative returns than on traditional equity or bond returns.

Different alternative strategies perform in dissimilar ways in times of stress, and there’s quite a bit of dispersion among manager returns—even within the same strategy category (Display). There is no typical performance, and this makes understanding each manager’s approach essential. If you don’t choose the right strategies and managers, your alternative allocation could help your portfolio a lot less than you think—and might even work against you.

Alternative Managers

The first thing to do is understand the categories you’re looking at, whether you’re looking for a single strategy or building a diversified allocation. There are many categories, with common ones including long/short equity, event driven, relative value and global macro.

[drizzle]It makes sense to get to know all the categories so you can decide what’s best for your portfolio. But that’s just the beginning. It’s important to narrow down the choices to the strategy or strategies that work best for your alternative allocation. Over the years, we’ve found these six principles to be effective.

  1. Design—and maintain—an effective mix. A diversified alternatives allocation may provide a powerful benefit to an overall portfolio. But thorough and ongoing research is critical to designing the right mix. This involves analyzing how strategies behave over time and under different conditions. It also means understanding how the strategies interact with and complement each other to achieve investors’ objectives.
  2. Find managers who’ve been around the block. Since a manager’s skill is often honed over time, there’s no substitute for experience. Look for specific skill sets that drive returns. If you want a long/short equity strategy, make sure the manager has proven skill in shorting. Track records are important, too—especially returns both during and after market crises.
  3. Watch for strategies that change their stripes. It’s important to get comfortable with a manager’s level of investment conviction and discipline. A good manager will stick to his or her guns in terms of research approach and investment process. When a strategy is missing performance goals, managers may be tempted to deviate from the stated philosophy. That’s a problem if you’re designing your alternative allocation based on expected behavior.
  4. Don’t cut bait quickly—but if you do, know why. Once you’re invested, we think it’s best to stay with the manager you’ve chosen. But you should always be on the lookout for negative signs. When you do decide to get out of an alternative strategy, do it for specific reasons: a process becoming unclear, a manager who doesn’t stay true to a discipline or changes to the portfolio team. The most important thing? Don’t chase performance—take a strategic view.
  5. “It’s the fundamentals!” Emphasize managers and strategies with a long-term investment plan and a fundamental bias. When you’re investing in alternative strategies that play out slowly, consider adopting a longer time horizon than with more traditional asset classes. And fundamentals are the source of most returns: look for managers who believe in research-driven investing. This involves looking closely at revenues, expenses, assets and liabilities to gain insight into future investment returns.
  6. Be cautious of the “black box.” This phrase describes investment processes that aren’t transparent to the outside world. You want to understand exactly how a fund generates its returns, so you can determine whether its investment process makes sense and is repeatable.

Watch out for roadblocks that make it hard to learn how managers make investment decisions and design portfolios. You may miss some opportunities—some managers won’t share what they see as proprietary information. But in the end, knowledge is power and transparent processes should stay that way. Once you’re invested, get out if the strategy becomes cloudy—even if performance is good.

Creating an effective alternative allocation requires doing extensive homework day in and day out. The goal is to ensure that alternative investments provide the maximum possible enhancement to your overall portfolio. Applying these principles is a good foundation.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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