SHANA ORCZYK, INVESTMENT ANALYST

November 20th, 2008
In today’s turbulent markets more and more financial professionals are beginning to look to alternative funds for investment options. As a result more and more investment managers are beginning to create alternative funds, and many hedge funds are registering their products under the 40 Act making them more accessible to investors. As the interest in alternatives grows so is the confusion. At many of the industry conferences I’ve attended lately, I hear many Investment Advisors ask, “but where does it fit?” A review of the endowment model may shed some light on the issue.

In 1952, Harry Markowitz introduced the world to modern portfolio theory. Originally modern portfolio theory focused on having a diversified basket of stocks to help spread out the risk in a portfolio. In 1958, John Tobin suggested introducing a risk-free asset into the portfolio mix to create a more attractive risk reward profile. Five years later William Sharpe introduced the Sharpe ratio and the efficient frontier. The idea was simply that with the right mix of stocks, bonds, and cash you could create the optimal risk-reward profile for your portfolio. Over the next few decades these ideas became even more refined, first suggesting diversification across market caps, then across countries, and finally additional asset classes with the advent of REITs as investment vehicles in 1986. As you can see the theory of portfolio diversification is constantly evolving in an effort to create the best risk-reward profile for investors.

As the media becomes more and more influential in our daily lives, we, as investors, are beginning to recognize the fantastic returns generated by the large university endowments like Harvard and Yale. The consistency of the endowments’ outpaced returns, even during difficult markets, has peaked the curiosity of many investors, and led to increased research into their methods. As a result, investors are beginning to realize that these portfolios contain significant exposure to alternative investments, in the form of hedge funds, private equity, and real assets. The average endowment allocates between 60-80% of its portfolio to these investments.

So the question remains, how do we as smaller investment managers or retail investors use alternatives to enhance the risk-reward profile in our portfolios? Clearly it is not feasible to allocate 60-80% of our portfolios to alternatives, simply because the liquidity needs and time horizon of the average individual investor are very different from an endowment. In my research I’ve run a number of different models to find the best mix for our clients, regardless of risk tolerance; that “optimal” allocation seems to be 20%. In my research 20% is provides enough excess return to provide meaningful performance upside without substantially changing the risk profile of the portfolio.

Your next question is probably: “Great, where does this 20% come from?” At Peak we use a variation of the Core/Satellite strategy to implement our alternative strategies. If we have a $1,000,000 to invest, we take 80% (or $800,000) and put it in the appropriate core allocation for the client’s risk tolerance and time horizon. We view that $800,000 as one portfolio, and manage that portfolio using traditional diversification guidelines. We then take the remaining 20% (or $200,000) and put it in a portfolio we call simply “Alpha”. The Alpha portfolio is managed separately from the core, and this portfolio is where we make our investments in alternatives. So in essence we just take 20% off the top, and don’t try to figure out whether we should take it from large cap value, international developed, high yield, etc. This allows us to take advantage of the low market correlations demonstrated by alternatives while still adding excess return to the portfolio in a manner that has very little effect on the portfolio’s risk composition.

In my next blog I will attempt to help investors differentiate amongst the many types of alternative funds available to them, and help explain the fundamental differences between the large number of funds that Morningstar categorizes as “Long/Short”.