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PIMCO Interview with Plante Moran At PIMCO, we are increasingly focused on democratizing access to alternative strategies. In particular, given the current late cycle environment, we believe that there is significant opportunity for clients of all types to take advantage of complexity and illiquidity premia to achieve potentially higher returns and greater diversification.
We recently sat down with Doug Coursen, Senior Associate, and Erin Goss, Senior Alternative Investment Analyst, at Plante Moran Financial Advisors, a leading provider of holistic wealth management services with roots in one of the nation’s largest certified public accounting and business advisory firms, to discuss the role of alternative investments in individual client portfolios. In the following interview, we hear from Doug and Erin on how they are incorporating alternatives into client portfolios and key considerations.
Erin Goss: We tend to differentiate “alternatives” from traditional investments if the investment strategy, structure or holdings ultimately provide exposure to something other than diversified long-only, common stocks, bonds or cash. Typically, alternatives would exhibit lower correlations and diversification benefits relative to traditional asset classes and broad market indexes. While not universally the case, other common characteristics may include a lack of daily redemption rights, less stringent regulatory governance and increased tax complexity.
Doug Coursen: Alternative investments can be used in seeking to achieve a variety of investment objectives in client portfolios. They can potentially enhance returns through illiquid structures, reduce correlation to equity or credit markets through the use of managers that may also short or hedge positions, or take advantage of a specific investment opportunity in a more esoteric asset class. Still, they are not appropriate – or even necessary – for every investor.
Given the vastness of the alternative investment universe, along with differentiated client situations, we don’t believe that there is a boilerplate approach that can be appropriately applied to their usage. The growth and development of alternative investment platforms, feeder funds and vehicles such as interval funds has made accessing alternative investments easier for investors who may not have otherwise been able to access certain strategies given traditional investment minimums and the size of their portfolio. However, there are material risks and implications of making smaller investments into alternatives that potential investors must be aware of before investing, even in the case of liquid alternatives.
Goss: We would consider alternatives to be a separate and distinct allocation from an investor’s traditional holdings, although they may have some common characteristics. We want to ensure that clients have a sense of the degree of complexity and risk, as well as the potential for tracking error relative to traditional market indexes that accompanies such allocations, by designating alternatives separately. We break down alternatives even further into various sub-categories, including hedge funds, private market funds and real estate/real asset strategies, among others. This provides us the ability to consult with clients and help them manage desired exposures to alternatives on a more granular level.
Coursen: The increased complexity associated with many alternative investments can make them more difficult to understand, and this barrier to understanding certainly makes them inappropriate for some investors. Moreover, it’s not as simple as determining that alternatives are – as a group – right or wrong for a given client. It really boils down to the individual client’s preferences, risk tolerance, liquidity requirements, tax situation and a host of other factors.
Even among clients that are good candidates, we often see differences in the types of alternatives that are of interest or appropriate for investment. The range is quite broad. Some clients may be interested in quantitative trading strategies that may deliver returns that exhibit extremely low correlation to traditional asset classes, even though they are more opaque and difficult to understand. Other clients may gravitate toward strategies that are more straightforward, such as direct real estate.
We spend considerable time sourcing opportunities and establishing relationships with a broad selection of managers and firms that meet a range of criteria and will meet our clients’ needs. At the same time, we look for opportunities to negotiate reduced minimums or identify access points that can improve accessibility to attractive strategies for our clients.
Goss: We start by spending time educating clients about the potential benefits and risks involved in allocating to alternatives. We typically frame the benefits as centering on some combination of volatility mitigation, return enhancement, access to outstanding management talent and inflation protection. Risks and considerations discussed include illiquidity, higher administrative burden, expected tracking error to traditional market indexes, reduced regulatory oversight and potential tax complexity. These discussions occur before any recommendations related to specific managers or strategies are considered. This approach allows us to better understand the client’s interest, concerns or preferences so we can tailor individual strategy and portfolio construction recommendations.
Once we’ve gauged a client’s interest and goals, we then discuss a variety of specific implementation options. Having access to outstanding managers is critical in alternative investing, and at this point in the process, we share details of specific firms and strategies with clients and our convictions surrounding them. Given the complexities associated with alternatives, it is important that the client clearly understand the nuances of any potential investment prior to investing. That encompasses a host of factors including management’s experience and a firm’s culture and reputation, portfolio construction expectations, performance expectations across both favorable and unfavorable market environments, the full range of potential risks, and specifics including investment minimums, fees, liquidity and tax reporting.
Goss: Broadly speaking, alternatives that exhibit a low correlation to traditional markets are appealing relative to long-biased mandates at this point in the market cycle. Some long-short equity strategies fit the bill given the potential for alpha generation in an environment where traditional equity beta may be more challenged. We also see value in midstream energy infrastructure, in light of improved balance sheets, attractive distribution yields with favorable tax characteristics, and the potential to benefit from continued growth by the U.S. as a global energy market player. Pockets of venture capital are interesting to consider for the long-term, given the rapid pace of technological advancements. We are also interested in some forms of private credit that have conservative loan-to-value ratios.
We are cautious about some areas of the credit markets. While opportunities to deploy capital into new distressed opportunities may not be as prevalent today, we believe it’s a good time to evaluate and identify potential managers and strategies that may be attractive when shifting economic and market conditions create a more attractive entry point.
Goss: Certain attributes are desirable in any investment manager, such as experience, organizational stability, a proven track record of success and reasonable expenses. Still, certain elements of due diligence should be emphasized to a greater degree when evaluating alternatives candidates. Among those are transparency (particularly in the form of access to key personnel) and our ability to effectively complete operational due diligence.
Additional risk can arise from the more limited regulatory constraints and the air of exclusivity that often accompanies alternative strategies. As such, looking beneath the surface to truly understand the organizational culture, structure and internal controls is critical. Background checks on key members of the firm’s leadership and fund management is advisable too. We also believe that evaluating the adequacy of staffing and technological resources, segregation of duties, disclosure and management of conflicts of interest, and consideration of independent counterparties (such as independent auditor, administrator and legal counsel) are critical to explore and understand.
Coursen: Liquidity needs are different for every client. For some clients where an increased degree of balance sheet illiquidity exists, the risk-adjusted returns of certain alternative structures may not compensate them appropriately to further limit their already constrained liquidity, and thus should not be used. Over time, a client’s financial situation may change, creating capacity to consider illiquid structures like alternatives. Illiquidity risk is covered broadly during introductory conversations with clients, allowing them to specifically address this risk factor prior to any discussions on alternatives taking place. Further, the liquidity provisions of any specific alternative investment are covered in detail prior to investments being made.
Goss: We do consider these structures for clients and believe that they may be attractive for some investors. At the same time, they may be very disruptive to several private placement alternative strategy types, such as more liquid and/or less levered hedge funds. As such, while interval funds may be suitable for some non-qualified purchasers, we carefully discuss the potential benefits and risks with each client to ensure that they fully understand both before implementation.
As with any investment, interval funds won’t be a fit for every portfolio or investor. Nonetheless, some investors have the ability to sacrifice a bit of liquidity for a portion of their portfolio to invest in a fund with an expanded opportunity set. Clients that don’t require daily liquidity, but who may also not have the appetite for the long-term lock-up associated with a private-equity style fund, might find an interval structure to be a suitable compromise.
Past performance is not a guarantee or a reliable indicator of future results.
Alternative investments, hedge funds, and private placements involve a high degree of risk and can be illiquid due to restrictions on transfer and lack of a secondary trading market. They can be highly leveraged, speculative and volatile, and an investor could lose all or a substantial amount of an investment. Alternative investments may lack transparency as to share price, valuation and portfolio holdings. Complex tax structures often result in delayed tax reporting. Compared to mutual funds, private funds are subject to less regulation and often charge higher fees. Alternative investment managers typically exercise broad investment discretion and may apply similar strategies across multiple investment vehicles, resulting in less diversification. Trading may occur outside the United States which may pose greater risks than trading on U.S. exchanges and in U.S. markets.
An investment in an interval fund is not appropriate for all investors. An interval fund’s shares are not typically listed on a stock exchange. Although interval funds provide limited liquidity to investors by offering to repurchase a limited amount of shares on a periodic basis, investors should consider shares of an interval fund to be an illiquid investment. Investments in interval funds are therefore subject to liquidity risk as an investor may not be able to sell the shares at an advantageous time or price. No secondary market is expected to develop for interval fund shares. There is no guarantee that an investor will be able to tender all of their requested shares in a periodic repurchase offer.
This Q&A contains the current opinion and views of the Manager interviewed, and not necessarily those of PIMCO. These opinions are subject to change without notice. PIMCO is not responsible for the information or views communicated by representatives of other companies. This material is not indicative of the past or future performance of any PIMCO product and should not be considered as investment advice or a recommendation by PIMCO to purchase, sell or hold any securities or strategies discussed.
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