Is AlphaClone For You?

Since we launched our investment account service a couple of months ago, I've been speaking to many of you about how to take advantage of the new service. While each investor is different, the three questions that come up the most often are:

• Is AlphaClone right for them?

• Which core strategies should they select?

• Should they apply any hedging or risk management to their portfolio?

Working through these questions systematically with clients has helped them take full advantage of our research and services. I summarize that framework below in the hopes that it can help you do the same.

Are Equities Right For You?

Perhaps the most important pre-requisite to benefiting from AlphaClone is understand whether you should be invested in equities and if yes, what proportion of your portfolio should be allocated. AlphaClone provides a basic suitability questionnaire as part of the investment account sign up process to help potential investors decide if AlphaClone is a suitable service for them. While a majority of those who have completed the questionnaire are suitable, not everyone is. Specifically, if any one of the following is true about the dollars you're thinking about allocating to equities, you should think long and hard about making that investment:

• Your main investment objective is capital preservation

• Regardless of investment objective you have little or no tolerance for loss of principal

• Your investment horizon is less than five years and you are relying on some or all of the dollars your investing to pay for your expenses during retirement.

Almost invariably, investors who are investing in equities should have a long term investment horizon for that portion that is allocated, OR if their horizon is short (less than three years), they are investing dollars that if lost completely would not impact their living standard. Answering the “should I” and “how much” questions is critical before you can move to the next step.

Understand Your Tolerance For Risk

If equities are right for you and you know what proportion of your net worth should be invested in the category, then the next most important consideration is your risk tolerance. Understanding your risk tolerance and what it means is perhaps the single most important aspect of investing. Setting a tolerance level that you are comfortable with greatly reduces the chances that you'll hit the panic button during tough times and bail out of your investments at exactly the wrong time. A good grasp of your risk tolerance also means you will have an easier time selecting between investments which, as we will discuss below, can be a daunting exercise.

AlphaClone provides several metrics on each of its backtested clone portfolios that help investors understand the risk/return relationship across different date spans as far back as 2000. The metrics include sharpe ratio, beta, alpha, volatility correlation to index and maximum drawdown. All of them are useful but, when it comes to understand tolerance, it's hard to beat the utility of “maximum drawdown”. Why? Well, two reasons:

• It forces you to look at risk on a standalone basis without also factoring in the associated returns.

• It's really simple to understand – which makes it easy for us to decide how we “feel” about the risk inherent in the investment.

Maximum drawdown is simply the “largest decline from peak value” across a specific date span (5 year, 10 years, exc.). For example, a maximum drawdown of 50% over the past ten years means that at some point during the past decade your investment portfolio lost half its value. That loss could have happened over the course of one month or one year but what is important, is to ask yourself how you would react under that circumstance. Would you a) panic, sell your investments, lose sleep OR b) stick to your investment, maybe even recognize that you just got handed a huge buying opportunity? If your reaction is “a”, then you don't have the tolerance for an investment with a 50% maximum drawdown and you should look for investment strategies with lower relative drawdowns over the same period. If your reaction is “b”, then it's time to look at the strategy's risk adjusted returns. Note how if you have disqualified the investment based on its drawdown, it doesn't matter what the investment's historical returns are (even if it is stellar performance) because the chances you will stick with the investment long enough multiplied by the likelihood that “stellar” returns repeat in the future, makes the probability that you would ever realize your investment objective very low.

To illustrate our point further, the table below compares the maximum drawdowns across AlphaClone's US Domestic Core Strategies when they are not risk managed (long only) vs. when they are risk managed. Note these are backtest simulations and are presented for illustrative purposes only. The hedged variants below assume you are using leverage to short the S&P500 index. Also, no trading, management or leverage costs are assumed in the simulations. By contrast, AlphaClone does not use leverage to implement hedging inside investment accounts opting to instead use inverse ETFs matched to the strategy being risk managed (i.e. we use ticker:SH for US Domestic strategies and ticker:EUM and EFZ for our international strategy). To learn more about how we hedge in actual investment accounts and to understand AlphaClone's fee structure, please read our Investment Account FAQs.

 

Understanding Diversification and the Tyranny of Choice  

Believe it or not, if you've actively determined that equities are right for you, figured out what your allocation to the category should be and developed a good sense for your risk tolerance, you've come further than most investors. These are important prerequisites because they will serve as your guide during the part of the investment process that trips up a vast majority of investors – selecting their investments and sticking to a strategy. 

There are literally thousands of possible investment choices when it comes to investing in equities. When mutual funds were first introduced they were meant to be a boon for investors who were overwhelmed by the shear number of stocks form which they were expected to select. Mutual funds were meant to offer investors active management (someone else picked the stocks) and diversification in one vehicle at a low cost. We all know it didn't work out that way – instead of being overwhelmed by the number of stocks to choose from, investors are now overwhelmed by the number of mutual funds and the fact they are “actively” managed has certainly not translated into investor returns which understandably has made investors hyper sensitive to the fees that mutual fund charge. Think about it, if your mutual fund manager was delivering great net returns, would you be anywhere near as sensitive to the fees he or she was charging? 

Enter ETFs. ETFs were meant to solve the problems of mutual funds. Since active stock selection wasn't working in mutual funds, why not just get rid of the “stock selector” and the fees that come with him/her? ETFs are passive vehicles that seek to match the returns of some index of stocks. They provided maximum diversification (or at least a very high degree) at very low costs. Best of all, an investor can buy them directly on an exchange for nothing more than their broker's commission. ETFs are really a brilliant idea in a world where the markets all go in one direction, up. Unfortunately we don't live on that world. If you invested in an S&P500, Nasdaq, Russell 2000 or Dow Index fund or ETF in 2000 your total return today would range between a gain of 24% to a loss of 47%. To make matters worse the number of ETFs that now trade means investors have been again revisited by their original nemesis; “choice”. 

No wonder investors are disillusioned. The truth is that the basic principles of successful investing have never changed:

1. Understand your allocation to an asset
2. Understand your tolerance for risk
3. Pick the best managers you can
4. Diversify (across managers, asset classes, geographies, sectors)
5. Manage your costs.

The world's wealthiest people, endowments and pensions have been investing this way for centuries and when it comes time for them or their advisors to pick the “best managers”, their preferred choices for public market investing are usually hedge fund managers. That should not come as a surprise. Hedge funds pay the most (the standard fee is 2% management fee annually plus 20% of the profits generated for investors) so they attract the best fund managers in the world and can pay for the best research. There are also less regulatory restrictions on hedge funds. Hedge funds have more latitude on how to hedge risk or use leverage and on what securities they can buy, how they are selected and what proportion of their portfolio is allocated to a certain position. Yet even the world's wealthiest investors also recognize the importance of diversification across managers and never put their eggs with just one manager 0r one investment style. 

I built AlphaClone so that the rest of us can follow the same formula as the world's wealthiest investors. Once you've decided that equities are right for you and how much to invest, AlphaClone allows you to:

1. Tailor your portfolio to your risk tolerance using simple hedging
2. Backtest and follow the investment moves of the best stock pickers in the world
3. Diversify across managers, asset classes, sectors and geographies (see bullets below)
4. Keep your costs down (principle 5)

Here's a closer look at how AlphaClone's Core Strategies help investors diversify: –

• Manager risk: all core strategies are derived from multiple managers which allow you to mitigate the risks of being exposed to just one manager. This includes the manager's performance risk as well as the unfortunately all too real risk of fraud.

• Geographic risk: our International core strategy will invest in foreign company ADRs only and our ETF core strategy invests in region specific ETFs (EFA, Korea, Brazil). The four remaining strategies are primarily US domestic.

• Asset class risk: our ETF core strategy, can invest in commodities (GLD, USO), real estate (REITs) and can even be short US Treasuries (as of 8/16/2010, the strategy holds an ETF that is short US Treasuries, ticker:TBT).

• Sector risk: our ETF core strategy can invest in sector specific ETFs and can either be long or short the sector! As an example, in early 2007 our ETF core strategy was short the financials sector by holding SKF (an inverse financials ETF). Also, the strategy currently holds XLP, a consumers staples ETF (long).

• Style risk: our Activist Masters core strategy tends to select deep value stocks while our Tiger Cubs strategy tends to like growth-at-a-reasonable-price (GARP) stocks. Conversely, our Value Masters Core Strategy will tend to favor low PE value stocks and our High Conviction strategy does what it says – invests in the ideas of managers who have invested a great deal in a relatively smll number of stocks (i.e. they have high conviction).

To help tie the above process together, let's look at an example. A recent client asked me to propose a mix of core strategies for him. He's a high net worth individual who has reached retirement age and is investing dollars that if lost would not impact his lifestyle. He prefers a mix of strategies as opposed to just one, wants some protection against downside risk and has an investment horizon of at least three years. The table below summarizes the backtested performance of our suggested approach for this client. We chose two US Domestic core strategies that had little to zero overlap because of the very different stock selection styles of the underlying managers; Value Masters and Activist Masters. We then combined those with our international strategy to give the client further diversification across managers, style and geography. Finally we hedged the client's portfolio by investing two thirds of the his capital across the long positions prescribed by his strategy mix and one-third in an ETF that seeks to return the inverse of the S&P500's daily returns. The results are summarized below.

AlphaClone Core Strategies – Portfolio Example

Portfolio assumes equal weighted allocation at inception on 1/1/2000 across all three core strategies; Value Master, Activist Masters and International. The portfolio invests two-thirds of its assets at inception in the prescribed long positions and one-third in the inverse of the S&P500 index. Results are backtested and theoretical. Please see important disclosures re: backtesting below.