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Deutsche Liquid Alts Outlook: Overweight Long/Short Equity

While global equities lost ground in the third quarter of 2014, liquid alternatives consolidated their gains from the first half of the year. Discretionary macro and trend-following strategies were among the top performers, according to a briefing paper published by Deutsche Asset & Wealth Management (Deutsche), as diverging central bank policies provided opportunities for alternative strategists in the fixed-income and currency markets. In the paper, Deutsche offers a brief review of each of the following alternative strategies and current recommendations for portfolio positioning of each strategy: Long/short equity Market neutral equity Discretionary macro CTAs Credit strategies Event-driven Distressed What follows is a summary of Deutsche’s analysis of each alternative strategy. Long/Short Equity The choppiness of the broad stock market in Q3 – “risk-off” in July; “risk-on” in August; and mixed in September – put the focus on stock picking, the long/short equity specialty, rather than trend following or asset allocation. U.S. stock pickers in particular found “the operating environment more supportive than in European markets,” according to Deutsche. Market Neutral Market-neutral equity strategies underperformed in the second quarter but bounced back in the third, with the HFRX Equity Market Neutral Index posting its second-largest gain in more than three years in August. According to Deutsche, “gains occurred across factor-based models as well as fundamental and trading strategies.” As the broad bull market in stocks led to a flight of assets from market-neutral strategies, it became easier for market-neutral strategists, less constrained by size, to find better opportunities. What’s more, the flow of funds out of market-neutral has led to the survival of the fittest managers, improving their prospects for Q4 and 2015. Discretionary Macro Deutsche says the third quarter of 2014 was a “defining period” for discretionary macro strategies, with the class advancing in each of the quarter’s three calendar months. Positive performance was delivered by substantial bets on the dollar vs. the euro, as well as directional positioning in long bonds, and relative-value equity trades. Returns over the quarter were broadly based across asset classes. Commodity Trading Advisors CTAs posted gains in the third quarter, despite the continued decline in most commodities markets. The HFRX Systematic Diversified CTA Index added 1.55% in August, thanks to currency trends, rising U.S. bond prices, and further advances in the U.S. stock market. Credit Strategies Credit-strategy managers that were net-short high-yield bonds or had balanced books in the third quarter were rewarded, according to Deutsche. The bearish turn for high yield was caused by the “valuations in this sector moving ahead of fundamentals.” Relative-value credit strategies benefitted from corporations’ continued and elevated levels of refinancing. Event-Driven Kiboshed tax-inversion mergers weighted on event-driven strategies in the third quarter, as Congress passed laws discouraging the tax-reduction strategy that had been a boon to M&A activity. Two unrelated deals also fell through in early August: Sprint’s proposed takeover of T-Mobile, and 21 st Century Fox’s proposed acquisition of Time Warner. Distressed Investors in distressed assets had “nowhere to go” in the third quarter, according to Deutsche. The HFRX Distressed Index gave back gains over the period “as spreads backed up across many segments of the market.” Conclusion Deutsche concludes its briefing with a list of nine expectations, as well as allocations to strategies ranging from “overweight” to “underweight” for each alternative class. Long/short equity, market-neutral equity, and event-driven are given “overweight” ratings; Discretionary macro and credit strategies are given “overweight/neutral” ratings; CTAs are given a “neutral/underweight” rating; and Distressed strategies are assigned a pure “underweight” rating. Overall, Deutsche’s 12-month forecast for alternative strategies is “neutral/positive” with a projected 9.1% return. For more information, download a pdf copy of the report .

What Do Passive Investors Really Mean By ‘Passive Investing’?

The term “passive investing” is actually a misnomer in the manner that most index fund investors use it. The reason why is simple. There is, at the aggregate level, just one portfolio of all outstanding globally cap weighted financial assets. And as soon as you deviate from that global cap weighted portfolio in your asset allocation, you become an “active asset picker” who believes he/she can generate a better risk-adjusted return than that portfolio can. You are, in essence, making a discretionary portfolio decision as opposed to just “taking what the market gives you.” Okay, so the whole idea of “passive investing” is a bit misleading. If you look at this through the macro lens it becomes clear that we are all active asset pickers deviating from global cap weighting. So what do the “passive” investors really mean? First, it’s nice to look at some of the history here because we can start to see why confusion over this terminology has persisted for so long. In The Intelligent Investor, Ben Graham wrote: “In the past we have made a basic distinction between two kinds of investors to whom this book was addressed – the “defensive” and the “enterprising.” The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor.” That’s pretty clear. To Graham the distinction is about security selection and trying to earn a premium over the market return. So, active managers are essentially stock pickers who try to “beat the market.” Of course, this was written long before there was an index for everything. Today, most of us don’t pick stocks. We pick an asset allocation by holding financial asset that already have a certain allocation to certain assets. We are still selecting securities of certain types. We just do it differently than one might have in Ben Graham’s day. So Graham’s definition is a bit dated. What about Eugene Fama? Fama has stated that active management is any fund that engages in security selection or market timing. Okay, but anyone who deviates from global cap weighting is “selecting” their own securities inside of index funds. So it really comes down to timing. But this too gets messy. After all, indexers engage in all sorts of active endeavors and simply call it something else like “rebalancing,” “factor tilting” or “dollar cost averaging.” These are all discretionary timing based decisions about how to engage in the markets. They’re just not marketed as “active management” for whatever reason. Okay, so it’s becoming even more obvious that the idea of “passive” investing is a bit messy. But that doesn’t mean the defenders of “passive investing” don’t have important points. In my view, they make many crucial distinctions about portfolio management that every investor should adhere to: You shouldn’t try to “beat the market.” Yes, we all deviate from global cap weighting, but you should build a portfolio that’s right for you as opposed to benchmarking yourself relative to some index. In the aggregate, we all underperform the global cap weighted portfolio after taxes and fees so the “beat the market” mantra is an impossibly high hurdle to begin with. You should keep your costs very low. Costs will destroy a much larger portion of your portfolio than you likely think. In general, my rule is never invest in funds or with managers who charge more than 0.5%. Keep your activity low. The more active you are, the more you’ll increase your tax burden. Like fees, taxes will crush you in the long-run. Pick whole asset classes rather than individual securities. This reduces your risk and allows you to take advantage of diversification. Create a plan that has staying power so you avoid tinkering with your portfolio regularly or letting yourself get in the way. That’s it. This really isn’t about “activity.” After all, we are all active by necessity. But we can be smart active investors. And that’s the key to understanding the distinction between what people call “active” investors and “passive” investors.