Session Recap: Uncorrelated Strategies: Preparing for the Ride Ahead
We all know the fundamental rule of investing is diversification. The more money that goes into any one area of a portfolio, generally the lower the returns. Diversification is especially critical in this Covid-19 era. Now more than ever families are looking for investments that can help them achieve the ideal asset allocation. Uncorrelated investment strategies can help.
By definition an uncorrelated investment strategy contains both liquid and private investments that should produce returns only loosely correlated with the public equity market. We typically label them diversifiers, or niche investments.
Equity risk typically accounts for 60-70% of a portfolio, making it the dominant risk factor in the portfolio. Fixed income is at the other end of the spectrum, but there’s only so much fixed income you want in a portfolio. What’s in the middle? Niche investments, which are evolving to include anything that has uncorrelated returns, over the short and long term, with that dominant traditional public and private equity risk in the portfolio.
Niche strategies help investors overcome potential drawbacks of traditional investment alternatives. In the past hedge funds were our great diversifier, at about 20-25% of the asset allocation. In niche investing, we look for something different from alternative investing, where the performance is wholly uncorrelated to the public markets, and should be limited to about 15-25% of a portfolio.
A huge benefit of niche investing is that it’s unlikely to go negative, which advisors can show through historical data. The appeal is protection on the downside. Niche investors give up a positive skew, but the niche asset will not go negative, and for a portion of a portfolio, that makes sense.
Niche investors cast a wide net, exploring many aspects such as traditional lower-beta strategies, commodity trading strategies, global macro, catastrophe insurance, litigation finance, life insurance settlement, distressed assets, alternatives, and alpha on beta-1 strategies. Current examples of uncorrelated assets include rail cars, barges, certain kinds of shipping, and cell phone towers. With niche strategies, we look for tax advantages, and the investor needs good leverages and a stable cash flow. Essentially, this can be anything that has a return over a 4-6 year period, where the end result will be disconnected from what happens in the equity markets. As well, there are a number of issues to consider, including expected returns, often higher fees, a greater tax drag, and the investor’s comfort level.
Competition to find these strategies and advisors who manage them is intense. The best returns seem to be made on niche strategies before they are widely accepted. This favors flexible investors such as families. In other words, you will get better returns before the masses gain interest.
Investors are often tempted to reduce their equity portfolio in favor of these niche asset classes. But you really only want 2-3% invested in any one of these niche assets. Over time the expected returns erode, and you need to find the next newest compelling idea. It’s a constant search to find good strategies, and then to consider what you get after you pay the fees and taxes.
As an advisor, how do you bring these niche strategies to your clients? In fact, correlation is very measurable, and history proves the benefits over time. Show your client how niche investments perform in a stressed market, when the market behaved unusually – and ask, did the asset remain uncorrelated to the public markets?
Do families feel uncorrelated strategies are too “nichey”? Sometimes this approach is seen as an unusual and unknown practice, and perhaps a new territory for families to learn and understand. To help families feel comfortable, stay with assets that are relatable, things that are real assets that people can get their arms around – such as a cell phone tower. Also clients need to understand from where in their portfolio the money is coming for this niche investment, so advisors must have the conversation about how diversifiers fit into a portfolio.
In niche investing you are really buying into a business. You are essentially hiring a management team, so understand the idiosyncrasies of the business and evaluate its resiliency. Apply the same basic process to evaluate these niche assets and determine good choices. Importantly, take plenty of time to perform proper diligence. Decisions do not need to be rushed to take advantage of uncorrelated strategies.
 | Charles B. Grace, III is a managing director at Family Office Exchange (FOX). In his role, he works on Advisory and Educational Services projects for families and family offices as well as advisor clients. Assignments have included projects focused on strategic planning, family office and family enterprise design, family governance, selection of investment or wealth advisors, best practices, and benchmarking, among others. On the membership side of the FOX business, Charlie works on select relationships and develops and delivers content using deep subject matter expertise. Areas of Expertise: Strategic Planning, Family Office Best Practices |