The Winton Global Alpha Fund has provided Australian investors with access to Winton’s quantitative investment strategy for more than a decade.
This article – the first of a three-part series – draws on Winton’s 21 years of experience of quantitative investment management to explore some of the key considerations of investing in alternatives.
Alternative investments, or “alternatives”, describe a range of investments capable of generating returns that differ to those of equities and bonds.
The term usually describes two groups of strategy:
1. Those investing in alternative markets such as private equity, real estate or bonds of distressed companies;
2. Those taking an alternative approach to investing in mostly conventional markets, including quant macro, trend following and long-short equities. This second group is sometimes referred to as “liquid alternatives”
Alternative investments can offer portfolios benefits including: exposure to new markets and investment styles; diversification from traditional investments; and a potential improvement in risk-adjusted returns.
Alternative investments, or “alternatives”, have become an important component of many portfolios. Their rise to prominence began with the Yale Model, pioneered by David F. Swensen, the Chief Investment Officer of Yale University’s endowment during the 1980s.
The model advocates constructing diversified portfolios with large allocations to alternatives and has been highly influential. Once limited to institutions and high-net-worth individuals, alternative investments have become increasingly available to a wider audience. The Winton Global Alpha Fund, for example, has provided Australian investors with access to Winton’s quantitative investment strategy for more than a decade.
DID YOU KNOW? Allocations to alternatives have grown from 4% to 25% of aggregate assets in seven major pension markets between 1997 and 2017, according to consultant Willis Tower Watson.1
1. Alternatives come in different shapes and sizes
Alternatives are not a homogenous asset class – a fund buying and renting out commercial property will have different performance characteristics to a strategy seeking to capture price trends in futures markets. Even strategies that pursue similar styles can vary hugely. Long-short equities, for example, can range from hedged and diversified low-volatility investments, to concentrated portfolios taking large, leveraged bets on specific companies. Not only does the risk profile of the two strategies differ, but so does their interaction with the rest of an investor’s portfolio. The more concentrated strategy, for instance, is more likely to move in tandem with an investor’s equity holdings.
2. Strategies can vary: sorting the sheep from the goats
Assessing an individual strategy’s performance presents its own challenges. Investors should be suspicious of strategies that show exceptionally high Sharpe ratios over short time horizons, as there is a strong chance that the track record is the result of luck rather than skill. The downside of waiting, however, is that strategies with proven track records of delivering exceptional returns often have limited capacity and are closed to new investments.
In the world of quantitative investment – of which Winton is a part – investors must also be wary of overly optimistic back tests, as such simulations are prone to overfitting and selection bias. These are topics for which there is plenty of empirical evidence. Some systematic managers also promise to offer “crisis alpha” or “tail-risk protection” − a claim that can also be dubious.
3. Assess liquidity… or the lack of
Liquidity, or the ease with which an investment can be bought or sold, is another important consideration. Popular investment fund structures − such as Australian unit trusts − offer investors the ability to redeem their shares at regular intervals, often daily. But with alternative investments, there can sometimes be a mismatch between the liquidity offered to investors and that in the underlying portfolio. Several Australian property funds, for instance, were forced to suspend trading in the final quarter of 2008, when large numbers of investors sought to redeem their holdings during the Global Financial Crisis.
Liquidity is far more plentiful for some strategies. As the name would suggest, “liquid alternatives” trade highly liquid instruments. By way of example, the Winton Global Alpha Fund’s strategy is implemented across an investment universe of around 100 futures contracts that are assessed for liquidity.
4. Ensuring you get what you pay for
Finally, there are the fees. Alternative investments have a reputation for being expensive, particularly private equity funds and hedge funds. Yet our analysis shows that hedge fund fees in fact range widely.
Moreover, an alternative investment strategy will incur higher implementation costs relative to, say, an equity index tracker. Fees are therefore used to offset the costs of the infrastructure and technology required, as well as to fund the research needed to give a strategy the best chance of maintaining an edge.
Investors should thus focus on net performance when assessing a strategy’s track record.
In our view, a strong commitment to research and development has helped the Winton Global Alpha Fund produce creditable long-term returns after fees since its launch in May 2007 (see below).
 WillisTowersWatson, Global Pension Assets Study, February 2018
 See Blinded by Optimism and Hypothetical Performance of CTAs, both available to read at www.winton.com.
 Winton’s founder and co-CIO David Harding shares his views on this topic in Crisis Risk Offset, Positive Convexity, Tail Risk Hedging and Smart Beta, available to read at www.winton.com.
 See How Big is the Hedge Fund Industry?, available to read at www.winton.com.