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Implementing Alternatives in a Portfolio: What You Need to Know

Discover the key considerations when determining the role of alternatives in a client’s portfolio with Nelson Yuan, alternative strategist.

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Text on screen: What are the key considerations for including alternatives in a portfolio?

Text on screen: Nelson Yuan, Alternative Strategist

Yuan: When we speak to clients about their alternatives allocation within their portfolios, we really think that there are two main questions that they should be thinking about.

Text on screen: TITLE – Key considerations:, BULLETS – What is the client’s objective?, SUB-BULLETS – Defensive allocation

The first is what is their objective to include alternatives? If it is a defensive allocation, meaning that ultimately investors are looking for greater diversification to their portfolios or to try to preserve capital within their portfolios, or to help mitigate volatility in their overall portfolio allocation, then we think that investors really should look at parts of the alternatives market that are more lowly or even negatively correlated to traditional asset classes, or to their broader portfolio allocation.

Some examples of strategies here would be trend-following strategies and also even things like insurance-linked strategies.

Text on screen: TITLE – Key considerations:, BULLETS – What is the client’s objective?, SUB-BULLETS – Defensive allocation, Potential higher returns or higher income

If, on the other hand, you are looking for either higher returns or to generate overall higher income, then we actually think that investors are really trying to identify additional risk factors or other types of risk factors that they can build into their portfolios to potentially capture those higher returns or higher incomes.

Examples might be trying to capture illiquidity or complexity premia that are offered by private credit markets or by structured credit markets that are a little bit more complex, or things like residential and commercial real estate debt or equity.

Text on screen: TITLE – Key considerations:, BULLETS – What is the client’s objective?, SUB-BULLETS – Defensive allocation, Potential higher returns or higher income, BULLET – Size of allocation in the portfolio

Now, once you’ve identified what your overall objectives are, then the second question becomes how should you be thinking about sizing the alternatives allocation within your portfolio?

One important thing that we think investors should keep in mind is that alternatives allocation should be large enough to have an impact on your portfolio but not necessarily so large that it has a meaningfully outsized impact on your overall portfolio.

Text on screen: Clients typically allocate around 5%–15% of their portfolio to alternatives

Images on screen: PIMCO Trade floor

Now, what that ultimately ends up meaning is that typically when we see clients implementing alt strategies they think about allocating at least 5% of their portfolio to alternatives as a whole, not to any individual single strategy. On a more modest or kind of conservative end, maybe get up to around 10% to 15% of their portfolio. And then some clients will be even potentially a little bit more aggressive than that and try to go even higher into the twenties, thirties, potentially up even to the 40%, again depending upon their overall objectives that they’re looking for.

Text on screen: How should investors think about risk management for alternatives?

Alternative investments are more complex than traditional investment vehicles and strategies and often have different risks from those seen in public markets, such as lower liquidity, lower transparency, lack of credit ratings, and oftentimes as well, less regulation.

Traditional risk return measures may not necessarily reliably represent the risks within alternative investments.

Text on screen: TITLE – Considerations for managing alternatives risk: BULLETS – Manager selection, SUB-BULLETS – Resources, Structures and policies, Track record, BULLETS, Investment strategy selection

So one of the key considerations, then, for investors to manage risk is actually manager selection. Investors should be asking, does the manager have the appropriate resourcing to pursue the investment strategy and effectively execute on it? Do they have the appropriate structures and policies in place, such as risk management and operations and compliance? And do they have a track record that demonstrates that they’ve been able to successfully do this?

Then in terms of the investments themselves, one of the things that we think investors need to be focused on is whether or not the actual strategy is really going to do what that investor is looking for.

For example, in the case of managed futures or trend-following strategies, as returns have been more challenged in recent years, there’s been a tendency for some managers to try and diversify their strategies by looking for other sources of alpha.

Examples include overlaying their trend-following strategy with things like carry strategies, short volatility strategies, or equity value strategies, all in an effort to improve returns.

In our view, though, there’s a potential for this type of additional creep or expanding out of the box to compromise the properties of the underlying strategy itself and therefore changing the overall objectives that the investor is going to be able to achieve by investing in those strategies, so investors should be careful and really dig into the details of how it’s being implemented.

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IMPORTANT NOTICE

Please note that the following contains the opinions of the manager as of the date noted and may not have been updated to reflect real time market developments. All opinions are subject to change without notice.

 

All investments contain risk and may lose value. Investments in residential/commercial mortgage loans and commercial real estate debt are subject to risks that include prepayment, delinquency, foreclosure, risks of loss, servicing risks and adverse regulatory developments, which risks may be heightened in the case of non-performing loans. The Fund will also have exposure to such risks through its investments in mortgage and asset-backed securities, which are highly complex instruments that may be sensitive to changes in interest rates and subject to early repayment risk. Structured products such as collateralized debt obligations are also highly complex instruments, typically involving a high degree of risk; use of these instruments may involve derivative instruments that could lose more than the principal amount invested. Private Credit funds will also be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond the fund’s control. Equity investments may decline in value due to both real and perceived general market, economic and industry conditions, while debt investments are subject to credit, interest rate and other risks. Investing in banks and related entities is a highly complex field subject to extensive regulation, and investments in such entities or other operating companies may give rise to control person liability and other risks. In addition, there can be no assurance that PIMCO’s strategies with respect to any investment will be capable of implementation or, if implemented, will be successful.

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