Adding Alpha to Beat Risk On/Risk Off

For the past few years, many asset classes have moved in sync, making it hard for investors to enjoy the benefits of diversification. (See: Maximizing Returns When Markets Move in Sync.) Plenty of finance pundits are trying to predict when this risk on/risk off pattern will shift or break down, essentially hoping for a return to "normal" or more typical correlations between asset classes.

Even more folks are trying to sell investors on one particular asset class (usually expressed as an exchange traded fund, or ETF), which they think will move favorably in the near term. (Buy oil! Buy gold! Buy Brazil!)

Neither option strikes me as a great idea for a disciplined, long-term investor. My suggestion is actually quite simple: When asset allocation seems to be failing, add some alpha to your portfolio. Genuine alpha, delivered by skilled active fund managers, delivers two things:

1. Better performance in the form of benchmark-beating results
2. Greater diversification from uncorrelated returns

The challenge, of course, is to figure out which managers are likely to give you the kind of high-quality money management I'm suggesting. You have to find managers who can really deliver genuine alpha when it counts. And granted, this is an extremely hard task (one I'll have much more to say about in other posts).

But as a start, let me suggest this: One of the keys to delivering real alpha is the ability of a manager to have a flexible, long/short investment style that provides plenty of leeway to find the best investment opportunities. Most actively managed mutual funds underperform in part because they lack this kind of flexibility. Some are long-only and constrained to narrow benchmarks regarding what they can own.

Hedge fund managers, on the other hand, typically have access to a broader set of investment opportunities and wield the flexibility to be long or short. So it's no surprise that hedge funds offer both outperformance and a lack of correlation.

For instance, the historical performance of the Dow Jones Credit Suisse Core Hedge Fund Index (an index of several high-quality hedge funds) has beat the S&P 500 by more than 5% since 2006, while being only 57% correlated. Sub-indices of hedge fund strategies like emerging markets and managed futures have delivered even better results for investors.

Unfortunately, for the typical investor, it's practically impossible to access hedge fund strategies. Just a handful of mutual funds offer the kinds of approaches likely to generate diversifying true alpha. And most of these funds either lack credibility or are closed to new investors.

Nonetheless, I prefer to put my capital with managers who at least have a chance of outperforming others. That's why I'm intrigued by the new Palmer Square Absolute Return Fund.

While this new open-ended mutual fund doesn't offer a ton of transparency about the manager's underlying strategies, Palmer Square has a good reputation for investing in up-and-coming hedge fund managers. So I think it's worth keeping an eye on.

Similarly, a fund like AQR's Diversified Arbitrage offers access to a great manager with a compelling track record. Unfortunately, AQR recently instituted a $1 million minimum to invest, so it's not an option for most investors. (Full disclosure: I own shares in this fund.)

The point, however, is that there are funds that attempt to give investors access to the best practices of alpha generation. You just have to dig around for them, and determine which one is best for you.

But in looking for a good active manager, remember that real alpha occurs by diversifying your portfolio. Don't focus solely on the performance of a manager. Focus on whether or not the strategy that manager uses is likely to give you the edge you're seeking. It's the best way to protect yourself for the long run, especially when markets are highly correlated markets, as they are today.