their existing due diligence process.
We offer a framework as a guide, mainly to clarify our assumptions and prevent misunderstandings. We are not looking to either encourage or discourage the use of liquid alternatives, and we are not promoting one investment approach over another. We hope that clear definitions and a clearly articulated structure allow for a coherent discussion, even for advisors who operate with a different investment philosophy and a different set of assumptions. We may agree or disagree with other investors about the proper definition, purpose, and role of liquid alternatives. Our main goal is to provide a framework that is internally consistent, and that provides a springboard for advisors who want to put these products to work for their clients.
Or perhaps an advisor will review the data and conclude that liquid alts are not worth their time and energy, given their clients' needs and their firm's resources.
Illustrations, Not Recommendations
This book offers a process for asset allocation and fund selection, and discusses specific ETFs and mutual funds. Any analysis or example in this book is for illustration purposes only, and is not an investment recommendation for any advisor or investor.
All written content is for informational purposes only. Material presented is believed to be from reliable sources, but the authors make no representations as to its accuracy or completeness. Individual investors should discuss all information and ideas in this book in detail with their individual advisor prior to implementation. Investment advisors should note that their parent firm may strictly limit the use of certain funds described in this book. This is especially true for leveraged and inverse ETFs. Both individual investors and investment advisors should note that certain leveraged products may rapidly lose value and are not suitable for all investors.
Legal Disclosures
One of the authors of this book, Robert J. Martorana, CFA, owns a registered investment advisory firm, Right Blend Investing, LLC, in the state of New Jersey. This content shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services. This is not a complete discussion of the information needed to make a decision to open an account with Right Blend Investing, LLC. There are always risks in making investments, including the investment strategies described.
Right Blend Investing, LLC, may have long positions in the ETFs and mutual funds described, and these positions may change without notice. Mr. Martorana believes that the position sizes at his firm are too small to have a material impact on any fund described in the book.
Guide to Chapters 3 through 13
Chapters 3 through 13 review each of the 11 Lipper classifications in detail. This analysis forms the core of this book, and the following describes each of the subsections in these chapters. We briefly explain why we used certain data, and some of the pros and cons of our choices.
The authors thank Tom Roseen, Head of Research Services at Lipper, for providing the data used throughout this book.
Synopsis
We offer a synopsis at the beginning of each chapter that covers the highlights and summarizes the key takeaways. This material may overlap with the conclusion of the chapter. But the synopsis is meant as a summary, while the conclusion focuses more on how advisors would use funds, and it presumes that advisors have actually read the chapter.
The synopses can be read as freestanding content, and the advisor should not have to read the entire chapter to get value. The synopses are written in general language, and may be particularly helpful when advisors are creating talking points for clients. If the client has follow-up questions, the advisor can be confident that the chapter explains the concepts in detail and offers a supporting rationale for the trends, themes, and investment conclusions.
Definition
We start with the definition of each Lipper classification, supplemented by a working definition derived from the fact sheets and disclosure documents of the most popular funds. These chapters assume a strict adherence to the Lipper classification system. So while we acknowledge that some funds and strategies may have fuzzy boundaries, we aim first and foremost to explain the funds that each Lipper classification includes.
Total Net Assets and Net Flows
This section examines the history of total assets in each classification and their development over the past 10 years. We evaluate trends in assets, net flows, fund launches, and fund closures. This analysis gives a sense of how investor interest in the classification has waxed and waned in light of market returns and the returns for the classification.
This section also explores the depth and breadth of fund choices for investors. Are there many funds with a variety of strategies? Or is the classification relatively homogeneous, with different flavors of the same basic strategy?
As part of this process, we note any blockbuster funds that dominate the Lipper classification. The dominance of blockbuster funds is critical to understand, since some funds comprise 50 percent or more of the assets and net flows in a classification. This may give a distorted impression of the trends in the classification, since the asset growth may be dominated by a single fund. It can seem that a certain strategy is growing rapidly, and is worthy of deep investigation. The truth may be that a certain fund is popular because of recent investment performance, and the popularity of the classification may rest on the success or failure of a single portfolio manager.
Risk and Return
We discuss the returns of each classification over the past year, three years, five years, and 10 years. Some classifications have a limited history, so the data are absent and there are blank spaces in some of the exhibits.
Our analysis focuses on the overall level of returns and on the dispersion of returns, which may be wide or narrow depending on whether the classification is homogeneous or heterogeneous. We also note when returns tend to cluster around some type of benchmark, reflecting the underlying factor exposures. Some classifications have high beta and high correlations to an index, whereas others are driven by idiosyncratic risks and decisions by the portfolio manager.
When we compare returns in the classification to the underlying factor exposure, we usually offer a comparison to the S&P 500. As a convenience, data on the S&P 500 appears as a table in each chapter, so the reader does not have to flip through the book to find out how the classification compared to the equity market under different market conditions.
We also show measures of risk: Sharpe ratios, Sortino ratios, and maximum drawdowns. There are many measures of risk we could have used, but our experience with these funds showed that returns and drawdowns were generally the most useful. These offer a thumbnail guide to whether the funds are offering an attractive mix of risk and return, though we must offer a major cautionary note: The five-year data coincide with a bull market, and this makes nearly all alternative strategies look poor in comparison to equities. Unfortunately, many of these products have not existed for a complete cycle of bull and bear markets, so it is impossible to definitively say how they might perform in a crisis.
Factor Exposures
This section of each chapter is intended to help advisors understand what drives the risk and return of each Lipper alternative classification. Fund performance can often be explained by equity beta, credit risk, and other factors, and these help determine the role that each fund plays in an investor's portfolio.
This book often refers to analysis by the research staff at Lipper, which has done extensive work on factor exposures. We discuss this in detail in Chapter 3, Absolute Return Funds, and this
