Increase the Valuation of your Advisory Business

Adding alternatives with lower correlations and absolute return mandates may help reduce clients’ overall portfolio volatility, which can increase the valuation of your advisory business in the long term.

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March 2, 2020

Bring Stability to Your Business

Volatility diminishes the rate at which investments grow over the long term, has a negative impact on portfolio returns, and can also adversely affect the value of your advisory business.

Reduced Portfolio & AuM Volatility

Adding alternatives with lower correlations and absolute return mandates help reduce clients’ overall portfolio volatility, which to many advisors, means it helps dampen the volatility of your AuM. Extreme market fluctuations are driven by human emotions. During a financial crisis, investors notice substantial declines in many of their holdings. Scared that there is no bottom in sight, many investors panic and sell – usually at the worst possible time. A portfolio that exhibits lower volatility can help mitigate these dangerous swings in investor sentiment.¹

Reduced Volatility in Client Portfolios may Increase the Value of your RIA Business

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Source: This analysis is for illustrative purposes and not meant to show actual performance.
These volatilities are approximations. Actual volatility is 5.27%, 15.81%, and 26.35%, respectively.
*The actual volatility for the S&P 500 is 12.70% from January 2010 – February 2020.

After 10 years, the investment with 5% volatility resulted in nearly $200 million more in AuM and a higher annual advisory fee, when compared to the investment with 25% volatility. The simple average annual return for all investments was the same at 5%.

Private Assets are Not Priced Daily

Because many private equity transactions are non-public in nature, industry pricing usually occurs on a monthly or quarterly basis versus a daily basis. Their values are likely to remain more stable over time, since their pricing is not updated, or “marked to market,” on a regular basis like publicly traded securities.

Private investments mitigate risks related to the behavioral biases associated with public market investing, and as a result bring stability to your assets under management.²

Alternative Investment Strategies Have Historically Demonstrated the Ability to Reduce Risk

Hedge Fund Strategies

Relative Value

Relative Value funds do not take directional market risk insulating their investors from volatile market moves. Relative Value funds are focused on capturing spreads between highly correlated securities. When the spread widens between related securities, these funds put on trades that can benefit from spread tightening.

Distressed

Distressed funds buy and trade bonds and other instruments that have typically sold off before the Funds became involved and are thus less sensitive to overall market moves. Funds also drive performance through active involvement in bankruptcy/restructuring processes.

Macro/ Managed Futures

Macro & managed futures funds buy and sell a wide array of instruments that are uncorrelated to broader equity markets such as foreign currencies and commodities. They have the ability to capture downward moves in equity markets via shorting.

Private Equity Fund Strategies

Private Credit

Private credit has been one of the safest corners to invest in over the past 30 years, and is expected to do well even if the broader market environment turns for the worse.³ Private Credit funds target the ownership of higher yielding corporate, physical (excluding Real Estate), or financial assets. Credit exposure can be either corporate, with repayment coming from an operating company’s cash flows, or asset based, with repayment coming from cash flows generated by a physical or esoteric asset. Private Credit strategies include mezzanine and senior debt funds, distressed credit and credit opportunities funds.

Buyout

Small and mid-market buyouts have historically been outperformers on a risk-adjusted basis.³ The Leveraged Buyout (LBO), or Buyout, strategy looks to borrow a significant amount of capital from loans and debt to acquire a company, business unit or business assets from the current shareholders. Firms focus on buyout investments when they believe they can extract value by holding and managing a company for a period and exiting the company after significant value has been created. The goal of the Buyout strategy is to generate returns on the acquisition that will outweigh the interest paid on the debt.


Minimize Risk & Preserve Capital by Bringing these Actively Managed Alternative Investment Strategies to your Clients’ Portfolios


Alternatives Have a Long Track Record of Reducing Volatility and Adding Yield

Hedge Funds

  • Diversification
  • Low Correlation to Other Asset Classes
  • High-Risk Adjusted Returns
Alternative Investment Strategies Graph Hedge Funds Value

Hedge Funds are Volatility Dampeners

Hedge fund volatility has been consistently lower over trailing three-year periods for more than a decade.

Research has been conducted into how public markets and the buyouts corner of the private market had fared during various periods of volatility. As the chart below shows, returns from stocks in excess of the risk-free rate have buckled in the most volatile environments, as one would expect. Returns from buyouts, however, have maintained their premium over stocks across volatility regimes.

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Source: Business Insider June, 2019

What the Experts are Saying

OCIOs Expect More Money to Flood into Alternatives

Consulting firm Cerulli Associates’ survey⁴ found clients of outsourced chief investment officers are planning to trim their exposure to stocks in favor of alternative assets, amid fears of a coming downturn.

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Investors are paying close attention to portfolio diversification and the low correlation of many alternative asset classes to public investments, particularly equities.

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Persistent single-digit equity returns and relatively low interest rates make it challenging for investors to reach target returns using only public investment opportunities.

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While public and private pensions number among the industry’s largest investors, representing close to 40 percent of total hedge fund capital in 2017, other client types are gaining in importance. For example, private wealth clients, including wealth managers and family offices, are among the fastest-growing sources of hedge fund capital, according to the consulting firm.

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Shifting market conditions, including rising volatility, drive demand for varied strategies. Investor interest in global macro and multi-strategy credit could indicate greater interest in volatility dampening strategies.

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- Laura Levesque, Senior Analyst at Cerulli

The Need for Active Management

In times of volatility, a more hands-on approach to investing often leads to better returns. According to Deutsche Bank, an active investing strategy for stocks can outperform the overall market by taking advantage of short-term price fluctuations. Passive investors, on the other hand, are in it for the long term and limit the amount of buying and selling within their portfolios. Passive investors usually allocate to assets that mirror the composition of major stock or bond indices. There are many alternative investment strategies designed to capitalize on exactly those opportunities volatility creates and passive investors ignore.

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I think in this environment, it would be prudent to raise cash, but also secondly, try to reduce passive investment strategies, (exchange-traded funds), and also go into investments that are active, where you have some ability to also raise cash, also have the ability to look into non-index stocks.

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Our portfolio construction has shifted into more flexible mandates, unconstrained strategies that potentially can benefit from higher volatility. Because I think whatever everyone seems to agree upon is that ... volatility is rising.

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- Rainer Michael Preiss, Executive Director at Taurus Wealth Advisors⁵

Volatility is Here to Stay

Over the last decade central banks have repeatedly used monetary policy during times of stress in attempts to reduce market volatility. This has resulted in trillions of dollars of negative yielding debt globally. Unfortunately these monetary policies don’t address the underlying risks in the economy and merely kick the can further down the road. While central bank policies may temper volatility for certain periods of time risk inevitably shows up. When it does, it happens fast and all at once.

Sources:

  1. Crowd Matrix
  2. UNIVA Capital, 2017
  3. Business Insider June, 2019.
  4. Institutional Investor June 3rd, 2019
  5. CNBC August, 2018

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