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Tail Risk Events and Alternative Investments

The distribution of possible events looks like a bell curve, with many everyday events in the middle and far fewer events in the tails. While these tail events occur infrequently, they can have a great impact on the overall financial system — both negative or positive. The negative (left) tail tends to be much larger and more visible than the positive (right) tail, and thus gets most of the attention and focus since it relates to money management and is often referred to as a “tail risk event.” On everyone’s mind is the most recent tail risk event (2008-2009), which Alan Greenspan describes in his most recent book, The Map and the Territory, as “downright obese.”

According to an Economist study conducted in 2012, 71% of institutional investors believe it is likely or highly likely that a significant tail risk event will occur in the next 12 months. When measured against the yardstick of historical market volatility there is little question about the fact that tail risk events are on the rise in terms of both frequency and intensity. Managers, concerned about the impact of the next tail risk event, essentially have three broad choices: make the portfolios more conservative, ride out the market cycles or develop defensive strategies through the use of investment alternatives.

“The Quest for Performance” is a recent study that focuses on “the institutional investment patterns to understand how investors are coping [post 2008-2009] with the challenges of portfolio construction and strategic allocation amidst low returns.” While the study focuses on a number of interesting topics, it is instructive to see how institutional money managers are responding to the recent crisis as it relates to the usage of alternatives.

The authors of the study summarized their findings regarding the use of alternatives:

• Globally, institutional investors have long embraced asset allocation strategies that include alternative investments.
• The financial crisis, rather then causing a reconsideration of such strategies, instead reinforced the commitment of institutional managers to strategic asset allocation strategies weighted to alternatives.
• Since 2008, institutional managers have expanded their use of alternatives and have expressed a clear intent to continue.

There are pros and cons for an advisor to evaluate when considering the usage of alternatives as part of an overall asset allocation strategy. The biggest benefit of alternative investments — which by definition do not have a direct equity or fixed income claim on the assets of an issuing entity — is to provide diversifying exposure away from stocks and bond performance.

Secondly, although alternatives may be considered risky on a standalone basis, when alternatives are combined in a portfolio they can produce higher risk-adjusted performance. This is due to the fact that when alternatives are added to a portfolio, they can increase returns and only slightly increase the risk of the portfolio because of the low correlation with the overall portfolio.

The biggest downside is that since many alternatives have a high degree of market risk, they often provide poor protection in mitigating the impact of major tail risk events. This was demonstrated when hedge funds’ overall performance proved to be poor during the recent crisis. As reported in the Economist study, after the 2008-2009 period investors began to reduce their hedge fund exposure while increasing exposure to other alternatives such as commodities, infrastructure, managed volatility equity strategies and managed futures — alternatives that are generally less correlated with the equity markets. Another concern with alternatives revolves around the issue of liquidity, which can be limited and costly during periods of market dislocations — the fatter the tail event, the more likely liquidity will create a downside.

While the use of alternatives within DC asset allocation funds such as target-date funds (TDFs) has been lacking, this will surely change over time as the “DB-ization” and the “institutionalization” of DC plan investing continue to progress. Nonetheless, certain TDF providers are allocating monies to alternatives. For example, Russell Investments has allocated as much as 11% to alternative investment funds within their LifePoints® Funds Target Date Series. Also, as more TDFs and other asset allocation strategies are constructed utilizing ETFs as the underlying investment vehicles, expect to see even greater use of alternatives. A 2012 Cogent Alternative Investment Trends report predicted that alternative ETFs will grow at twice the rate of alternative mutual funds in 2013 and 2014. This growth is mainly due to cost, liquidity, increased transparency and a greater array of alternatives available within the ETF universe.

In summary, investment alternatives will likely play a progressively larger role in asset allocation funds offered through DC plans as a way to improve returns and keep a lid on volatility. Increasingly, plan advisors will be called upon to express their views about alternatives and, thus, be should be in the position to discuss their pros and cons.

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