Asset Allocator’s Soapbox: Coombs on alternatives

Rathbones’ head of multi-asset investments David Coombs on why it may be time to review your alternatives exposure.

The alternatives space provides the most important cornerstone of our ethos of non-correlated returns.

Many of the successful equity long/short funds preserved capital well during the bear market of 2001 and 2002, as well as the credit crisis of 2008. Post-2008, however, most have struggled to generate good returns.

Allocating to long-short is potentially tricky because it’s not an asset class, and the variability of outcomes is extremely high. However, it’s the poor performance of these strategies in 2011 that has spurred our review of the area.

In a nutshell, long/short equity strategies involve buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value. Generally speaking, the strategies fall into two categories – ‘directional’ and ‘market-neutral’. Directional strategies take net long or short positions in the market, whereas market-neutral strategies try to achieve minimal market risk by balancing long and short positions. Both try to make money under all conditions.

Return is also an important part of the equation – an obvious but important point – and returns from this strategy have been impacted by a number of factors. Macro-driven markets have led to a lack of stock dispersion, where the prices of good and bad companies move in synch. This makes it very difficult for stock-pickers to add value.

Volumes and liquidity have been lower, and lower interest rates have also led to more muted returns, as the proceeds from short sales earn lower returns. As a result, managers are showing less conviction through lower gross exposures.

In light of these headwinds, it is important to consider the opportunity cost to investing in equity long/short strategies, and to closely examine whether these funds represent expensive lower risk (beta) strategies or whether they can genuinely add to return (alpha) and provide sufficient portfolio diversification.

Strategies that could provide a similar risk/return profile to equity long/short funds include buying portfolio protection to offset long only positions; using option-writing overlay strategies; buying equity-linked structured products, equity income funds or convertible bonds.

Long convertible bonds and equity income products are an interesting and more easily accessible way of adding value in this respect. Long convertible bonds are hybrid securities, which should be defensive in falling markets and display equity-like characteristics in rising markets. Clearly, they carry credit, interest rate and liquidity risk, but could still be considered as a viable alternative – we currently have no exposure.

Finally, we have equity income funds. Manager selection is key, but some funds, such as the Troy Trojan Income fund, which we do own, held up well earlier this year, although the sector as a whole fared less well.