Harnessing Alternative Investments for Goals-based Portfolio Construction

September 5, 2019

We explore the role that alternative investment strategies can serve in a goals-based approach to portfolio construction.

Alternative investments have historically been cordoned off into a separate allocation, combining private equity, hedge funds and real estate strategies into one catch-all bucket despite their very distinct characteristics.

However, when we build portfolios based on their objectives — blending asset classes to optimize for each underlying goal — we believe we can improve on the traditional asset-class bucket approach to portfolio construction. 

Jim Smigiel, Chief Investment Officer of Non-Traditional Strategies, discusses how integrating alternative strategies directly into goals-based allocations can represent a more effective way to build portfolios.

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Transcript

Hello, I’m Jim Smigiel, Chief Investment Officer of SEI’s Non-Traditional Strategies. 

Today I will be exploring the role that alternative investment strategies can serve in a goals-based approach to portfolio construction. 

The objectives that underlie an investment strategy typically include a combination of return enhancement, risk reduction and inflation hedging. These goals can often be met in a traditional portfolio with investments like equity and credit, fixed income and cash, as well as inflation-sensitive assets. 

Alternative investments have historically been cordoned off into a separate allocation, combining private equity, hedge funds and real estate strategies into one catch-all bucket despite their very distinct characteristics.

We believe integrating alternative strategies directly into goals-based allocations represents a more effective way to build portfolios. 

When we do build portfolios based on their objectives — blending asset classes to optimize for each underlying goal — we believe we can improve on the traditional asset-class bucket approach to portfolio construction. For example, under the asset-class-bucketing method, high-yield bond strategies might reside in a fixed-income allocation despite the fact that they have equity-like characteristics, causing the fixed-income allocation’s performance to diverge from investor expectations. 

The same problem can occur in alternatives allocations, even if the rest of the portfolio follows a goals-based approach. Individual alternative strategies have different correlations to the equity market and introducing an alternatives allocation with a high equity-market correlation to a portfolio that already has an exposure to equities will just over-concentrate the portfolio in this one particular type of risk premium. 

We can deploy alternatives more effectively by fitting each underlying strategy where it will best support a given goal and ensure the most diversified blend. 

Combining traditional and alternative strategies satisfies the basic principles of efficient portfolio construction by broadening diversification and, ideally, improving risk-adjusted returns. 

According to Modern Portfolio Theory, expanding the variety of risk assets in a portfolio can reduce overall volatility while maintaining high expected returns, or can increase expected returns with comparable volatility.
Digging into the strategies themselves, we believe our multi-manager approach to goals-based portfolio construction is particularly well-suited to alternatives. 

The performance differential between top- and bottom-quartile managers has been relatively restrained in traditional asset classes over the last several years. Alternative strategies, on the other hand, have shown wide differences. 

Our manager selection process seeks to avoid the common mistake of being overly reliant on past performance — which is not a dependable guide for the future — and which often causes investors to chase performance at the wrong time. 

We take a forward-looking view by selecting managers whose investment approach, we believe, enables them to capitalize on sustainable competitive advantages. 

We can then monitor for any signs of change or diminished advantage and, if necessary, part ways with the manager earlier rather than waiting for poor performance to materialize. 

In closing, by broadening the diversity of the overall portfolio with alternative strategies, and aligning them with the goals they’re best suited to achieve, we believe investors can build more efficient portfolios and improve their risk-adjusted returns. Thank you for listening.

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Glossary of Financial Terms:

Correlation: Correlation measures how closely related the movements of two variables are. A value of one (negative one) implies perfect (perfect negative) correlation, while a value of zero indicates no correlation. 

Global Bonds: Global bond strategies invest in fixed income securities from countries domiciled in developed countries throughout the world. 

Global Equities: Global equity strategies invest in companies domiciled in developed countries throughout the world. 

Global Macro: Global macro strategies involve investments in a wide variety of strategies and instruments, which often have a directional stance based on the manager’s global macroeconomic views. 

Equity Long Bias: Equity long bias strategies are a type of long/short equity strategy. These strategies involve long and/or short positions in equity securities deemed to be under- or overvalued, respectfully. Exposures to sectors, geographies, and market capitalizations are often flexible and will change over time. 

Non-Core Real Estate: Non-core real estate strategies focus on value-added and opportunistic investment opportunities, which emphasize capital appreciation over income and exhibit higher operating risk. 

Private Equity: Private equity strategies invest equity capital in private companies through a negotiated process. 

Relative Value: Relative value strategies involve the simultaneous purchase and sale of similar securities to exploit pricing differentials. Strategies in this sector offer potential to generate consistent returns while minimizing directional risk.

Venture Capital: Venture capital strategies are a specialized form of private equity, characterized chiefly by high‐risk investment in new or young companies following a growth path in technology and other value‐added sectors.

Legal Note

Disclosure:
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only.

There are risks involved with investing, including loss of principal. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Bonds and bond funds will decrease in value as interest rates rise. High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments.

Alternative investments are subject to a complete loss of capital and are only appropriate for parties who can bear that risk and the illiquid nature of such investments.

Alternative investments:
• often engage in leveraging and other speculative investment practices that may increase the risk of investment loss
• can be highly illiquid
• are not required to provide periodic pricing or valuation information to investors.
• involve complex tax structures and delays in distributing important tax information
• are not subject to the same regulatory requirements as mutual funds; and
• often charge high fees.

Index returns are for illustrative purposes only and do not represent actual fund performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company. Neither SEI nor its subsidiaries is affiliated with your financial advisor.