Investors have had mixed experiences with alternative investments lately, as the market landscape has made it hard for managers’ skills to shine. It’s time to ask some pointed questions to get the right fit.

2016 Hedge Fund Letters

Alternatives are designed to provide less market exposure and more emphasis on outperformance through security selection or other active investment decisions. Reducing market exposure offers some protection in difficult times—and alternatives were largely successful at this. But recent market downturns have tended to correct quickly, so the real stumbling block for alternatives has been that they didn’t reap as much upside as investors expected when markets rallied over the past six years.

We think investors need to adopt a new framework that will help them assess their specific needs in terms of alternatives—and help them choose a manager that’s more likely to deliver.

Defining Expectations: It Doesn’t Help to Be General

To start with, investors need to be more specific about what they want in alternatives. Objectives such as capturing some of the market’s upside and getting some protection in down markets are good, but they’re too broad. How much of each? 70% of the market’s gain during a rally? Half the market’s loss in a downturn?

Defining these preferences more precisely can shine the spotlight on the exact up/down capture experience an investor is looking for. Investors can use these needs and expectations to build a framework designed to home in on the right alternative strategy or strategies (Display).

Beta Alternatives

Alternatives

To find the best fit in an alternative strategy, investors need to ask the following three questions:

Question One: Where Does Its Market Exposure Come From?

The market an alternative strategy invests in makes a big difference in defining its returns. A long/short equity strategy can invest in any combination of geography, market capitalization, style, and even sector and industry. Credit long/short strategies can invest in a combination of geography, fixed-income sector and credit quality. Whether we’re talking about US large-cap stocks or high-yield bonds, don’t overlook the type of market risk—also known as its source of beta—that an alternative strategy takes.

Question Two: How Much Market Exposure Does It Have?

The amount of market exposure is just as important as the type of market exposure. In other words, two managers can answer question one the same way, but they could have very different answers to question two.

A short example illustrates the point.

A long/short credit strategy might be relatively insensitive to the movements of the Bloomberg Barclays Global Aggregate Bond Index. Let’s assume that is moves half as much as the index, in this case. Its beta would be 0.5. If the market returned 10%, this strategy would expect to capture half of the Global Aggregate’s return, or 5%. Another strategy might be more beta-sensitive—let’s assume a second strategy has a beta of 1.5. If the market rose by 10%, this strategy would expect to capture one and a half times the market return, or 15%.

There’s a broad range of beta levels among alternatives—and managers can adjust their beta as market conditions evolve, which creates even more combinations of approaches to choose from.

Question Three: What’s the Balance of Alpha and Beta?

There’s one more piece to the alternatives puzzle—the contribution from security selection and other active decisions, known as alpha. With alternatives, alpha tends to be a bigger part of the return mix than with traditional strategies. The third question explores how alpha and beta fit together in a strategy’s return mix.

Even managers who seem alike in their types and amounts of market exposure can make diverse portfolio decisions that create very different alpha-beta mixes. Think about two long/short equity strategies, each with a steady beta of 0.5 to the MSCI World Index. Strategy A invests 50% of its portfolio in long stock positions and 50% in cash. So, strategy A has a beta of 0.5, and we’d expect its return to be about half the MSCI World’s return—plus some amount of alpha.

Strategy B is built very differently. It combines 250% in long equity exposure with 200% in short equity exposure. The net exposure of those positions is 50%, so strategy B has roughly the same 0.5 beta as strategy A. But B has many more individual stock exposures—both long and short. So, alpha will likely play a much bigger role in B’s returns than in A’s. The way a manager mixes these market and nonmarket risks is a major driver of an alternative strategy’s return patterns.

The Bottom Line

Market returns have been strong for years, but that won’t last forever. Indeed, for most of 2015 and 2016, markets saw much more modest gains.

We’re also likely to see higher volatility and dispersion among asset classes and securities. These trends will reshape the investing landscape—and will likely make alpha a bigger return driver than it’s been in the last six years.

If investors want to recalibrate their alternative allocations for this new environment, they need a deeper framework for finding strategies with the best fit. Using this approach could go a long way toward making alternative investments a more effective component of well-diversified portfolios over the long run.

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.

Article by Richard Brink, Christine Johnson – Alliance Bernstein