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Alice Lowenstein, CFP®, is a partner and director of managed portfolios at Litman/Gregory Asset Management LLC, a California-based independent investment adviser and publisher of AdvisorIntelligence research service for financial professionals.

My company, Litman/Gregory, has spent the last 20-plus years primarily investing in traditional equity and fixed-income asset classes, and strategies and fund managers that operate within these asset classes. While various alternative strategies occasionally played a role in client portfolios, they were not a primary focus. With a powerful tailwind of falling interest rates and rising stock and bond prices, this focus served clients well, and our portfolios have performed strongly over this span.

But as we find ourselves in an environment of ongoing headwinds stemming from the aftermath of a global debt bubble, over the last year and a half we have intensified our due diligence on strategies that are not dependent on strong performances from stocks and bonds to generate their returns. These absolute-return-oriented (ARO) strategies are designed to generate consistent, mid-single-digit returns in almost any market environment, with relatively low volatility and downside risk, and low correlation to traditional asset classes and risk factors (such as equity risk, credit risk, and interest rate risk).

I expect many advisers are also looking at alternatives as a means of improving portfolio risk and return and as they do so are encountering a range of complex issues to work through. In this column, Ill outline a few of the key research questionsand challengesto address as part of a decision to employ ARO strategies.

For advisers, an increased focus on ARO strategies can make sense based on two factors. First, there is an increasing availability of absolute-return-oriented strategies in the mutual fund and ETF space. Second is the outlookshared by many of usthat returns for broad stock and bond indices over the next five years are likely to be subpar based on the combination of a tepid economic recovery, ongoing structural risks, and unattractive valuations (in my companys view). The potential for traditional asset classes to perform below their longer-term averages, and at a level that doesnt fully compensate for their potential risks, increases the relative attractiveness of absolute-return strategies.

If you can identify alternatives managers/strategies that you can confidently expect to deliver on their return objectives with low downside risk and low correlation to traditional asset classes, then adding them to client portfolios should increase the expected risk-adjusted return.

While adding ARO strategies to a portfolio may seem compelling in theory, the devil is in the detailsin evaluating the risk and return characteristics of each type of ARO strategy (a wide variety of strategies fall under the ARO umbrella), understanding each managers investment process, and evaluating their skill in executing their strategy. Moreover, all of us need to be honest with ourselves about our circle of competence and our ability to reach a high-conviction opinion about such complex strategies and widely varied managers.

For those taking a closer look at ARO options, however, the following are research topics to address

Lack of Track Record.Many, if not most, of the ARO mutual funds and ETFs introduced over the past couple of years do not have a historical performance track record that can be analyzed to see whether the manager was successful in meeting the strategys objectives. A track record is also useful in understanding what kind of performance to expect in various historical market environments and serves as a basis for questioning the manager about their investment process and their decision-making in those periods. By definition, a new fund wont have a track record. But in some cases, the manager of the fund may have a track record running a similar strategy in a hedge fund vehicle or institutional separate account that they can share. This is certainly helpful in assessing a managers skill and ability to execute. But there may be material differences in the managers hedge fund mandate (for example, use of leverage, risk/return objective, investment universe/opportunity set) that limit the usefulness of the data in evaluating the mutual fund.

With some ARO strategies, in place of an actual track record the manager may display back-tested results, in other words, hypothetical returns that the strategy would allegedly have produced had it been in existence for the prior 10, 15, or 20 years. Back-tested results have to be viewed with a large grain of salt; almost anyone can come up with a strategy that looks compelling based on back-tested returns, and so it is especially important when undertaking due diligence on such funds/strategies to deeply understand what drove those returns in the past and assess whether they are likely to continue going forward.

The bottom line is that without an actual track record, it is more difficult to gain the high level of confidence required to make any investment. This means it may take longer to gain conviction and it may be prudent to establish smaller positions in such funds than is normal. While assessment of a manager for possible inclusion in a portfolio should always be forward-looking, and strong past performance is not predictive in and of itself of strong future performance, the lack of a track record does reduce the ultimate level of confidence in a manager, no matter how positive the qualitative assessment of his or her process, skill, and ability to execute may be.

Complexity of ARO Strategies.Even for ARO managers who have a historical performance record, the complexity of the strategy and breadth of the investment opportunity set (global, long, short, currencies, bonds, equities, derivatives) creates a much more challenging task to analyze and, ultimately, gain conviction. Unlike traditional long-only managers who are focused on a particular asset class (for example, larger-cap growth stocks or emerging-markets bonds), ARO funds often have tremendous latitude in the investments and instruments they may usesome of which may be pretty esotericto try to achieve their objectives. And with ARO strategies, risk management is obviously of critical importance, because one is buying an ARO fund with an expectation of limited downside risk/volatility.

An essential part of the fund evaluation process is to gain an understanding of why and how the manager uses various instruments to hedge and manage the portfolios overall risk. This takes significant due diligence time and effort (as well as significant access to the managers, ideally, through meetings, conference calls, presentations, articles, etc.) to confidently assess.

Benchmarking.Another hurdle to overcome in gaining sufficient confidence in an ARO fund is determining the appropriate benchmark against which to evaluate its performance. (This is a relatively straightforward exercise for traditional mutual funds investing in traditional asset classes.) The benchmark used by most managers of ARO strategies is a short-term risk-free return, such as T-bills or LIBOR, with the managers expecting to generate returns anywhere from 200 to 800 basis points above the risk-free return. For ARO funds that are fixed-income oriented, T-bills make sense as one of the benchmarks. It is also useful to assess such funds performance relative to the core Barclays Aggregate Bond Index (as measured by an investible index fund proxy), because ARO fixed-income funds would potentially compete with core fixed-income exposure within client portfolios. Moreover, in an environment of low current T-bill rates, an attractive ARO investment would likely need to outperform the risk-free rate by a wide margin, perhaps 400 basis points or more. Setting this bar requires flexibility, though, and in different interest-rate environments the relative performance expectations versus T-bills and the Barclays Aggregate Bond Index could change.

An ARO strategys risk and return relative to its peer group makes another valid benchmark. However, while the ARO mutual fund universe is growing, the vast preponderance of ARO assets are in hedge funds, and there are many well-known problems with the accuracy/reliability of hedge fund indicies (for example, self-reporting and survivorship bias) in addition to potentially mixing and matching funds with different mandates within a single-strategy category. So drawing conclusions from such peer-group comparisons warrants some caution.

Gaining a sufficient level of confidence in the ability of an ARO manager to achieve his or her performance objectives is only part of the job. The question then becomes whether to add the fund to client portfolios, which would typically also entail selling an existing position. Like many advisers, my firm anchors our model portfolios to their respective risk objectives (which we define as a maximum 12-month loss threshold). Staying true to our risk discipline is one reason why it is essential to understand the downside risk of each type of ARO fund across various risk scenarios and to recognize that different strategies can be expected to perform differently despite all of them having an absolute-return orientation.

Operating with the view that equities will outperform bonds, generally speaking, over an intermediate (five-year) to longer-term horizon, the ARO position would be funded out of fixed-income exposure in order to improve the portfolios potential return (more so than if the ARO position were funded out of equities). However, the shorter-term downside risk for bonds is obviously much lower than it is for equities, even if one assumes a rising interest rate environment. So, we must weigh the potential additional shorter-term risk of reducing the bond allocation against the potential improvement in longer-term absolute and risk-adjusted returns.

Additionally, while all ARO funds seek to have low correlations versus traditional asset classes, the degree of correlation and beta will vary across ARO strategies. For example, weve looked closely at arbitrage-focused ARO funds. In this strategy, the beta between merger arbitrage returns and equities has typically increased during periods of sharp equity-market declines, just when youd most like to have no correlation. On the other hand, other ARO funds/strategies might be expected to have little equity correlation (or beta) in that circumstance.

Despite the remaining questions, some of which will only be resolved more fully by the passage of time, we have begun selectively adding ARO strategies to client portfolios, with an emphasis on manager and strategy diversification. As of early 2011, we have allocations to two arbitrage ARO funds and also own absolute-return-oriented fixed-income funds. Our portfolios are underweight in equities based on our assessment that we arent being well-enough compensated to take on full equity risk (as of December 31, 2010, and subject to change). In our estimation, the arbitrage strategies offer similar levels of return over the next five years or so, but at lower risk and with the added benefit of expected low correlations to stocks and bonds. In an environment where we anticipated a more-normal risk/return trade-off for stocks and bonds, we would likely garner ARO exposure through an underweight to fixed income. The arbitrage allocation totals about 5 percent in a balanced model, divided across the two funds we have selected.

On the fixed-income side, based on the view that plain vanilla investment-grade bonds also offer limited upside from here, we are underweight in more traditional bond funds in favor of funds that have wide latitude to position their portfolios for a variety of interest rate environments and to invest broadly in fixed-income markets around the world, as well as in relatively inefficient pockets of the bond market. We have allocated roughly 30 percent to 60 percent of our neutral investment-grade bond allocation to strategies we classify as absolute-return-oriented fixed income. Looking forward, other research priorities include long/short funds, managed futures, and other alternatives that represent a compelling strategy from solid management teams.

As investment advisers, we owe it to our clients to stay open to new and potentially useful additions to our toolkitsuch as ARO strategies. At the same time, the priority of fully researching and understanding anything we own or recommend for clients means we have to invest the necessary research effort firsthand and/or capitalize on the work others have done (for example, by choosing a fund of funds run by a reputable manager, though this, too, requires research in order to select the right option). While thoroughly evaluating a new idea requires a significant investment of due diligence time, it can be time well spent if the result is portfolio decisions that add value for clients over time.