The problem with diversification is that once everyone begins to own an asset class, it loses much of its non-correlated power.
At one time, all an investor really had to do was cross the ocean — into developed market international stocks — to pick up the value benefits of diversification. However, as almost investors’ portfolios now includes exposure to international developed market stalwarts like consumer products firm Unilever (UL) or Japanese mega-bank Mitsubishi UFJ Financial (MTU), international firms’ share prices pretty much move in lock-step with the S&P 500.
Ownership of international stocks begets exposure to emerging markets. Emerging markets beget exposure to commodity futures and real estate investment trusts. All with the same effect — as they become more popular, correlations among asset classes are getting stronger and closer together.
For investors looking for “true” non-correlated assets, that means looking outside the box to really take advantage of diversification. Luckily, recent changes in legislation means more alternatives are coming to a portfolio near you.
A Fund Giant Stakes Its Claim
Following Blackstone’s (BX) and a few other fund managers’ leads, bond house Pacific Investment Management has decided to dive head-first into the retail investor alternative asset management business.
Liquid alternative funds, more commonly known as “alts”, use strategies not found in regular stock/bond index or actively managed mutual funds. These more exotic ways of producing a return can be as simple as shorting — or betting against — stocks to more complex such as using managed futures or merger/arbitrage.
The basic tenet of alternative funds is to create consistent risk-adjusted non-correlated returns. Keep in mind that beating the market isn’t the real objective, and such funds can beat or underperform the broad stock market in any given year. Essentially, alternative mutual funds give retail investors access to the world of hedge funds and private-equity funds minus the exclusivity and lock-up periods.
The positives of adding such funds to a portfolio can be great. Obviously, the non-correlated nature of something like a 130/30 fund can provide zig when the market zags. That can offer downside protection in a major market event. Many alts strategies still produced positive — although small — returns during the financial crisis.
That zig can mean the difference between retiring in style or eating Alpo in our golden years.
That zig can be seen with the Barclay CTA Index, which tracks an index of managed futures tactics. From 1993 to 2012, the index had a correlation of -0.9% to the broader S&P 500. During that time, even investment-grade bonds — as represented by the very very popular Barclays Capital U.S. Aggregate Index — showed a positive correlation to stocks. Overall, that means bonds didn’t adequately provide cushion when the market was in flux, while managed futures funds would have truly moved in a direction opposite the market.
Additionally, having a swath of alts in a portfolio can provide an extra boost to returns without adding too much additional risk. That can be an important tool for scared baby boomers nearing retirement who still need to make up for extra savings.
PIMCO and Its New Funds
Due to changes in regulation courtesy of the Jumpstart Our Business Startups Act, mutual fund companies are now able to pitch alternative investment products originally geared for institutional as well as wealthy individuals towards retail investors.
According to Morningstar, retail investors have been flocking to the changes by adding alts funds in spades. Through July of this year, the fund ratings agency reports that retail investors have plowed a little more than $59 billion new cash into mutual funds and ETFs that track these exotic strategies and asset classes. That compares to just a total of $25.6 million for all of 2012.
PIMCO certainly sees the writing on the wall and hopes to parlay its institutional alternatives business into a new retail investor one. The firm has nearly $110 billion in assets under management in liquid alternative funds, as well as about $27 billion in private-equity and hedge-fund strategies.
The preliminary prospectus for PIMCO’s new fund — dubbed the PIMCO Trends Managed Futures Strategy Fund — will invest in derivatives linked to interest rates, currencies, mortgages, credit and commodities. The fund will only have a minimum initial investment of $1,000. Subsequent investments will be a minimum $50. That’ll put the alts fund directly in line with the Californian-based asset managers other more traditional bond and stock offerings.
More importantly, that low starting investment should help Bill Gross and company compete with other popular alts funds like the IQ Hedge Multi-Strategy Tracker ETF (QAI) and ProShares 130/30 Fund (CSM).
All in all, with one of the largest and most popular asset managers now getting into the alternatives business, investors can expect to others follow suite. Look for more alts coming to an investment platform near you. Just don’t get carried away with your exposure, and they should provide more benefits than harm.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.