[00:00:00] Pierre Daillie: Hello and welcome to another episode of Insight is Capital, I’m Pierre Daillie, Managing Editor at AdvisorAnalyst.com. If you’re at all curious about the effectiveness of liquid alternative strategies, stay tuned. I’m joined by Robert Wilson, Head of Picton Mahoney’s Portfolio Construction Consultation Service, and Pawan Vatvani, Director of Portfolio Construction, to talk about the results of research undertaken by their team on how effective Canadian liquid alternative strategies have been on delivering on the outcomes that advisors and investors are seeking.
Since the Canadian Securities Administrators democratized access to alternative assets and strategies for Canadian retail investors three years ago, financial advisors have rapidly adopted liquid alternatives in portfolios to the tune of over $25 billion Canadian*. And according to research conducted by Environics on behalf of Picton Mahoney, the two main reasons advisors allocate to liquid alternatives is to reduce portfolio risk, and improve [00:01:00] diversification.
[00:01:02] Announcement / Disclaimer: This is the Insight is Capital Podcast.
The views and opinions expressed in this broadcast are those of the individual guests, and do not necessarily reflect the official policy or position of advisoranalyst.com or of our guests. This broadcast is meant to be for informational purposes only. Nothing discussed in this broadcast is intended to be considered as advice.
[00:01:21] Pierre Daillie: Robert, Pawan, welcome to the show, it’s great to have you.
Great to see you, Pierre.
Thanks for having us, Pierre.
Let’s jump in. Robert, talk to us about the research that your team completed on liquid alternatives in Canada. What questions were you setting out to answer?
[00:01:36] Robert Wilson: Yeah, Pierre, a big focus for us at Picton Mahoney, it’s all about helping investors achieve outcomes with greater certainty. An- and a key to that is having alignment between your goals, and then the decisions that you’re making in the portfolio. We’ve previously done some work around how you could think about that from an asset allocation perspective, and here we wanted to extend that to the topic of manager selection and liquid alternatives.
So what we [00:02:00] did was we sought to answer three questions. First is, why are Canadian advisors using alternatives? What role are they seeking for those alternatives to play in the portfolio? Secondly, where are the flows actually going? What strategies are investors allocating to, and are those strategies aligned with those goals? And then third, overall, how have liquid alts done in terms of delivering on the outcomes that investors are looking for?
And, I’m happy to report that overall over the past three years, liquid alternatives have done a great job at delivering against that diversification, and that risk reduction goal that you were talking about in your opening comments.
[00:02:33] Pierre Daillie: What were the key findings from your research, Robert?
[00:02:36] Robert Wilson: There’s a few key takeaways, I think, that are really important to keep in mind. The first is that, it was interesting to see the difference between the stated- stated objectives for allocating to alts, and then where the flows are going. And what I mean by that is that when we looked at the the research from Environics, what we found is that over half of advisors placed an important score of 9 or [00:03:00] 10 out of 10 on risk mitigation and diversification. Those were the key reasons for allocating to alts.
And yet, when we created custom scorecards to evaluate strategies quantitatively, based on their efficacy at delivering those results, what we found was the categories that had attracted the largest flows, which were alternative credit and alternative equity, were actually the categories that, on average, had the lowest scores on those objectives.
So we dug a little deeper. And th- the key thing there is that there’s a very wide dispersion within each category. And that’s why manager selection is so key when it comes to alternatives, is that the bucket a fund sits within does not necessarily describe the objective it’s seeking to achieve, or the role it’s meant to play in the portfolio. And so having done detailed research at the initial fund level, there were some key insights there in terms of there being excellent strategies across all the alternative categories that played a good role at delivering that.
And th- the final thing would just be [00:04:00] importance of being intentional about what you’re measuring. Once you decide what your goal is, you really need to think about what kind of metrics could you use to assess a strategy at delivering on that goal? And a lot of the traditional metrics that we typically use in the industry don’t necessarily line up well against the reason why people are buying alts.
So there’s a need to be a little bit creative in building out those scorecards.
[00:04:21] Pierre Daillie: You mentioned a a goal-based framework. Can you talk more about this?
[00:04:26] Pawan Vatvani: Sure I’ll take this one, Pierre. Goals-based investing is a more client-centric way of investing. And the focus is constructing a financial plan and investment portfolio that is designed to achieve specific life goals, like saving for retirement, or saving for higher education. Now, in contrast as you can see from this slide traditional portfolio construction is typically focused on maximizing returns, given certain constraints, like the target risk level, for example.
Empirical evidence shows that only focusing on building the best possible portfolio, without considering or tying it back to end-client life goals can [00:05:00] oftentimes cause clients to deviate from their financial plans at the most inopportune times. De-risking, and going to cash, for example, after big market draw-downs. And when markets eventually bounce back, this impulsive decision to de-risk can compromise well-thought-out financial plans, and reduce the probability that designed goals can be achieved.
Goal-based investing really seeks to put the client goals front and center, and makes saving and investing an asset. The thought process here is that this will increase the likelihood at which clients will stick to their financial plans, and therefore maximize the certainty which their goals are going to be achieved. And we think it’s a more humanistic approach to investing, and a natural evolution of wealth management.
[00:05:41] Pierre Daillie: Absolutely. I think the more that you can systematize this process of having a long-term perspective and having a goal in mind, rather than just trying to make money right now, is really critical.
Robert, let’s get into the details, how did you evaluate the funds?
[00:05:58] Robert Wilson: What we did, Pierre, is [00:06:00] we set up three scorecards based on the reasons why an investor would want to allocate to alternatives. And within each scorecard, we set up sub goals to use to measure the efficacy of the strategy. The first reason was risk mitigation, right? And with risk mitigation, we wanted to look at three things.
First of all, what was the standalone risk of the strategies? How volatile were they? What kind of max draw-downs did they experience during the three-year period? That sort of thing. The second thing we wanted to look at our risk mitigation is the idea of stressed risk control. So what we’re talking about there is, how did the strategies perform when risk assets are selling off? What were the average returns in months where high-yield spreads were widening and credit was losing money, or in months where global equities were declining, because those were the months where you need risk mitigation the most, and where, unfortunately, some strategies have failed to held, hold up historically.
And then finally, what’s the contribution to the overall portfolio? If we were to add a 10% allocation of that strategy into a balanced portfolio, [00:07:00] how much would that help to mitigate the portfolio’s overall risk? And looking at those three things, we lined up specific quantitative metrics to assess the efficacy, and come up with an overall risk mitigation score for each strategy, and for the alternative categories overall.
The second scorecard we set up was based on the goal of diversification. And so there were three areas again. First, we were looking at fixed income diversification, so how correlated and how sensitive are you to fixing of markets? Then equity diversification, so the exact same thing on the equity side. And then finally, how much of your historical risk could be explained by a global risk factor model?
And so what we mean there is if we sent a model, and we’ve got a great multifactor model here at Picton Mahoney we use, it typically will explain about 90% of the risk in the portfolio. And it’s all about understanding, how sensitive are you to changes in the levels of different markets? So how much of a strategy’s risk could be explained by that global macro [00:08:00] model?
And that’s important because if your risk can be explained by the same underlying factors as the traditional strategies that are already in your portfolio, it’s likely that your diversification benefits could be lower. So again, we combine those three up, fixed income, equity, and explainable risk from the factor model, to come up with a diversification score.
And then finally we look at quality of return. And this is such an important topic, because there’s no use adding a strategy that’s going to stabilize the portfolio, and provide diversification, if it can’t also generate attractive return. And a really interesting fact about investments, this is whether you’re looking at traditional assets or alternatives, is sometimes the strategies that have the highest diversification benefits actually have relatively low quality of return.
So we stand that on traditional assets, the asset classes that provide very high diversification benefit against equity risk tend not to have the greatest quality of return, or return per unit risk. And we found the same thing in our liquid alternative research. So there’s actually probably a sweet spot for investors where you could focus in on strategies that have a [00:09:00] low correlation, but slightly positive to traditional assets, but still generate a solid quality of return.
And so when we assess that, what we’re looking at for quality of return is two things. What is your standalone quality of return, so in isolation, how attractive are the returns you generate relative to the risks you’re taking? And then what’s the contribution of your strategy to a portfolio’s overall quality of return?
And so there again like risk mitigation, we allocated 10% allocation to a fund into a balanced portfolio, to see how that improves the overall portfolio’s quality of return. And then combining those three scorecards of risk mitigation, diversification, and quality of return we come up with an overall score for each strategy.
I think it’s a great approach, it’s something that advisors could use when selecting strategies, or when monitoring managers that are already within a portfolio. Now, perhaps your specific goals might differ from the goals in our research, in which case you would find different metrics to assess the strategies. But the actual framework itself is a great framework, nice way to save yourself time.
[00:10:00] Pierre Daillie: [00:10:00] Diversification seems to be by far the biggest nut to crack when it comes to constructing portfolios. And perhaps the most under, underestimated risk is the the behavioral risk, the way that, that, the way that advisors or investors will react to individual line items in their portfolio, from one period to the next.
And you really wanna take away if- if there’s a goal in mind, I think, besides the two sort of mechanical goals of portfolio construction, or the, the two functional goals, I think it’s to take away the feeling or the need to make changes when dramatic things happen to the market.
And just getting advisors and investors just to stick to th- the construction that they put in place in the first place is definitely by far one of the hardest things to, to [00:11:00] accomplish over the long-term. And I can see where quality of return being, being implemented in the strategy plays a significant role.
The number-one goal for advisors allocating to alts is to reduce portfolio risk. Within the goal-based framework, what are some of the ways to think about risk, and how can it be measured?
[00:11:26] Pawan Vatvani: This is a great question, Pierre, and just to double-down on some of the comments that you made earlier, and what we’ve found really empowers advisors in conversations with some of the tough client conversations that they need to have, particularly even when markets are really choppy, is projecting confidence that they have in very robust framework to analyze portfolio risk.
When we typically think of portfolio risk, we naturally gravitate to something like volatility or standard deviation of returns. But this might not be the first thing that comes to advisors’ [00:12:00] minds, or even end-clients’ minds when they’re thinking of risk. Oftentimes they define risk as the largest possible loss that their portfolio, or particular holding, has experienced.
In all of the work that we do we use multiple risk measures. We do use the typical kind of industry-wide risk measures like volatility, for example. But we also focus on the less widely understood and widely used metrics of tail risk, like skewness and kurtosis. Robert mentioned we use a risk factor model that seeks to only not just measure the amount of risk that you’re taking in your portfolio but identifying and quantifying the different drivers and behaviors that your portfolio can, display during specific market conditions like rising rates and widening credit spreads.
So we take, basically, y- it, arming advisors with a more precise understanding of portfolio risk, that really arms them to have more detailed [00:13:00] conversations that, that then allows those end-clients to stay invested and stick to the plan. The overall objective is again, like to maximize the certainty with which client goals are achieved and to minimize shortfall risk.
To be successful to do this, any portfolio needs to not only generate the sufficient return but also avoid what we call an unfavorable sequence of return risk. Let me demonstrate those two things with an example.
[00:13:27] Pierre Daillie: Sure.
[00:13:28] Pawan Vatvani: So if you consider a retiree that has a $1 million asset base, and needs $80,000 in retirement for the next 25 years here on this slide we kinda show you three portfolios that this advise, this particular investor can consider. Portfolio A generates the return of around 6%, and the client goal is achieved. Portfolio B experiences a shortfall of six years, because it generated an insufficient level of return of only 4%.
Portfolio C experiences a negative 30% return in year one, [00:14:00] a 30% recovery in year two and generates an annualized return of 7.5% per year thereafter. But even this portfolio fails because even though the average annualized return for the entire period was 70 basis points, or 6.7%, which is higher than Portfolio A, it fails because of larger draw-downs early in retirement. Right?
This is really a practical, then, example of sequence of return
[00:14:29] Pierre Daillie: Absolutely.
[00:14:30] Robert Wilson: And you really can’t overstate the importance of this, right? Five million Canadians are turning 65 this decade, right? So they’re in that critical period, those five years before, and five years after retirement. And if you have one of those large draw-downs during that window, that’s what’s going to cause your financial plan to fail, right?
How do you mitigate that, how do you manage a sequence of return risk? You really do need to understand, okay, what is the largest source of risk in my portfolio, how can I dial, that risk down, [00:15:00] but not dial it down in sitting cash or short-term bonds, you’re not going to make enough money, right? You need to dial it down. And I think about reallocating it to other sources of return that are not dependent on the same risk driver.
And if you’re able to do that in a thoughtful way, and this is where the liquid alternative strategies we evaluated really tended to shine you’re going to be manage that sequence of return risk, and get the client through that critical decade. And they can achieve their goals with very certainly, they can make sure the financial plan is able to hold up to the test of market volatility.
[00:15:28] Pierre Daillie: Yeah, it strikes me that we’re definitely in a period where it’s very easy to get derailed. And of course, the sequence of returns risk, with- without actually contemplating, what a recovery looks like from that the chances of making mistakes during the period where sequence of returns is disrupted are so high and so costly, Robert, how effective were the strategies you analyzed at [00:16:00] managing risk over the past three years?
[00:16:02] Robert Wilson: When we looked at the data, there were a couple things that jumped out. So the first thing is that there would have been a positive contribution to a balanced portfolio, from incorporating the average liquid alternative fund over the three-year period. So there is definitely benefit there. You saw a meaningful drop in overall portfolio risk.
As well, if you compare the strategies relative to equities on a standalone basis, they also had lower volatility. Really, for someone focusing risk mitigation, it’s an attractive area to explore. But while you’re thinking about that, you might jump out at, you look at the slide, the market neutral category, which is by and far the most effective category over the three-year period at mitigating risk. But what you’d be missing is the dispersion within categories.
If you were just narrowing your search into that market neutral category, when you’re looking for risk mitigation, you’d be missing out on some fantastic strategies within the credit, multi-strategy, and equity buckets. [00:17:00] Really, having that goal-based framework, and thinking more broadly make sure you don’t miss out on the fact that, unlike traditional categories, there is such a wide dispersion in the kinds of outcomes the strategers seek to achieve.
It really makes sense to look at it at a more a granular basis, which is what we did here.
[00:17:17] Pierre Daillie: And Robert, the secondary goal of advisors, we’ve talked about diversification, how did the strategies score on that front?
[00:17:26] Robert Wilson: Yeah, so this is where it was very interesting. Because we saw in Environics Research how important diversification was in allocating to alts. But we also saw that the largest category flows went to the two alt categories that had the lowest scores when it came to diversification. So alternative credit, and alternative equity.
Now they’re still attractive strategies, they had the some of the highest returns over the period which makes sense overall during the three years you were rewarded for being net-long. But that net-long exposure, having beta to traditional markets, means you don’t get [00:18:00] quite as much diversification benefit there. Not to say that there weren’t strategies within those buckets, and typically those were the strategies that focused more on absolute return, or event-driven approach to investing. Those did have a high diversification despite being in the categories that overall had a lower diversification benefit.
But really, when you look into it, once again you see for that goal, the market neutral category, again, was the category that really shone. It really shined, and there was a high benefit there. And so that’s fantastic. When you think about what’s going on in the markets right now, as a Canadian investor, as we’re sitting here recording this, Canadian core bonds are down about 10% year-to-date, and in Canadian currency, global equities are also down 10%.
So you really haven’t seen any diversification benefit this year, from high-quality fixed income. And, we got used to the past 20 years to that negative correlation between stocks and bonds, but if you look back over longer time period, there have been multi-year periods where there were high positive correlations between [00:19:00] those asset classes.
And if you really want to fortify a portfolio, what you need to think about is having multiple levers in play to diversify, don’t just rely on one tool. And again, with this research that we saw, there were many strategies and particularly again, that mark initial category that really help provide that kind of benefit.
[00:19:18] Pierre Daillie: Wow.
[00:19:18] Pawan Vatvani: Yeah.
The only additional point I wanted to just double-down with here is Robert mentioned earlier that there is this trade-off between return generation and diversification, right? And that’s really a trade-off that every investor needs to navigate as they’re building portfolios right?
Typically, the best kind of diversifiers typically don’t generate returns meaningful returns, above cash over long periods of time. And sometimes you know investors might be better off selecting the exposure of our strategies that have moderate diversification, but on a standalone basis, do have the ability to contribute to generate returns at the overall portfolio level. [00:20:00] Really tough to decide, and it’s I wish there was a magic bullet for investors that they could get returns with diversification.
But a- as we all know investing is about managing tradeoffs.
[00:20:12] Pierre Daillie: Absolutely, that, that’s the problem that happens, right? Is you own diversifiers in your portfolio, and then ev- every evaluation period, you’re sitting there wondering, the end client is sitting there wondering, "Why do I own this? This thing’s doing nothing." And then, of course, when you have periods like we’re experiencing right now, those benefits come to light, right?
They become realized, like "Oh, that’s why we owned it."
And you really want to… That’s, and again, just going back to what I was saying earlier about diversification being the toughest nut to crack, I think that’s, that is the biggest problem is getting end-clients to continue to own diversifiers when they, through the, through all those long periods where they feel like they’re wondering "Why?"
And I wanna come back to [00:21:00] the quality of return point that Robert made earlier. Picton Mahoney and your team place a lot of importance on quality of return on when assessing investment strategies. What is it, why is it important, and how did the alternative strategies score in this area?
[00:21:18] Pawan Vatvani: Quality of return seeks to measure the return that you’re generating per unit of risk, right? How much are you being compensated per unit of risk that you’re taking? We basically use, we utilize four quality of return metrics. Return per unit of total risk, return per unit of downside risk, and there the key difference between total risk and downside risk is total risk you’re measuring both upside and downside vol. In the second risk measure, we’re only measuring downside vol right? Periods where you know the volatility of returns during down markets. A third kind of quality of return measure is a return per unit of max draw-down or return-per-unit of a large, realized loss. An- and [00:22:00] finally, the last kind of measure that we use is average upside return versus average downside return.
And we think the, these different four quality of return measures, if employed in the right way, can really help advisors really understand the standalone role and purpose of every single holding in their portfolio. But also, these kind of measures are really useful at assessing the additive nature of alternative funds at the overall portfolio level.
In terms of how the alternative universe fared on this particular measure. As Robert mentioned what we had found is we found wide dispersion of results within each CIFSC category. Whilst on average, the liquid alternative universe has been additive from a quality, portfolio quality of return standpoint, one key takeaway is not just relying on the category classifications but really requiring advisors to spend time [00:23:00] doing their manager due diligence and assessing every single strategy on a standalone basis is really important in the alternative sleeves.
What we think is a bit more important than than assessing or allocating to strategies within traditional equities or traditional fixed income.
[00:23:14] Pierre Daillie: Very interesting, the quality of returns is not a commonly-used term in everyday investing speak. Thank you Pawan, that was great. How can an advisor incorporate the findings of your research into their practice?
[00:23:33] Pawan Vatvani: We have three broad ideas on how to do that, Pierre. The first is we keep coming back to this concept of goal-based framework. We can’t really emphasize how important that is, and especially in the alternative space. It really helps you to narrow down the universe and we think relying on the category classifications in this particular construct-
… relying only on the categat- cut- cat- category classifications is, it can sometimes [00:24:00] be detrimental here. And the only reason why that’s the case is based on our research coming down to this point again about just a wide dispersion of outcomes, even strategies within a category can deliver, right?
Pivoting back and going back to this goal-based framework is going to be really useful there. And also it’s going to be helpful to help navigate and educate clients, right? That’s the first strategy. And the second strategy, Robert mentioned this earlier, is using quantitative tools and scorecards to screen funds based on key criteria.
Some examples might be standalone risk, or correlation to equities, correlation to bond markets is an example. We can do this is, then what advisors can do is then once they’ve got a a set of criteria established, they can create a short list of funds that, that they can use to to facilitate ongoing manager monitoring.
What we found as well, is in some of our [00:25:00] conversations with advisors, is they have a very solid and robust initial due diligence, manager process, but they lack the time to be able to do that on an ongoing basis, right? Having a quantitative scorecard to do that will help them save time.
And then, finally is and again, Robert mentioned this earlier this, be thoughtful about selecting the metrics for including alternative managers in the first place, right? If you are, if the primary objective is including an alts fund is to diversify a risk, then make sure you are selecting, metrics that accurately capture and measure that diversification benefit.
And in a nutshell, those three things will really help advisors navigate the alternative investment fund universe to be able to identify funds that, that really will be able to be additive to their portfolio.
[00:25:52] Pierre Daillie: Fantastic.
Robert, any final thoughts you’d like to share?
[00:25:56] Robert Wilson: Yeah, I think it really comes back to this idea of [00:26:00] creating alignment. Because alternative strategies are such flexible tools. And there’s so many different use cases depending on what kind of outcome you’re seeking to achieve. There’s probably a strategy out there, purpose built to try to help you achieve that goal of greater certainty.
Really, having alignment of, what is your client’s goal, okay? What asset allocations am I making to align the asset mix with the goal? And then how am I adjusting my manager selection framework to be lined up with that asset mix, and with that investor goal? I think we’ve come up with a a simple, practical, and actionable framework for doing that. Anyone who’s interested we’ll be thrilled to discuss that, with advisors this is the kind of stuff I, love talking about day-in, day-out.
And I really do think that kind of alignment is what’s going to give you the best chance of a good outcome from alternatives. And it was great to see over the last three years a positive outcome from the average allocation into an alt fund. But if you could really nail down that [00:27:00] alignment aspect, I think you’re putting your client into the best possible position to get a positive outcome over the next three years as well.
[00:27:05] Pierre Daillie: Awesome. Thank you so much, Robert and Pawan. I absolutely love what you guys are doing. To get a copy of the research from Picton Mahoney Asset Management, visit pccs.pictonmahoney.com, or email firstname.lastname@example.org.
Thank you, gentlemen.
[00:27:23] Robert Wilson: Thank you, Pierre.
[00:27:44] Pawan Vatvani: Thanks, Pierre.
Listen on The Move
Financial advisors have rapidly adopted liquid alternatives in portfolios to the tune of over CA$25 billion* since the Canadian Securities Administrators democratized access to alternative assets and strategies for Canadian retail investors three years ago.
Research undertaken by Picton Mahoney’s Portfolio Construction Consultation Service (PCCS) takes a deep dive to uncover how effective Canadian liquid alternative strategies have been at delivering on the outcomes that advisors and investors are seeking.
We speak to Robert Wilson, Head of PCCS and Pawan Vatvani, Director, Portfolio Construction on the results of their research and the proprietary scorecards they built to measure how effective alternative strategies have been at reducing portfolio risk, providing portfolio diversification and improving the quality of returns in portfolios. Robert and Pawan also provide key considerations for advisors who are seeking to add liquid alternative strategies into their client portfolios.
*Morningstar Direct. As at February 28, 2022.