Diversification From Traditional Assets

The Potential Benefits of Integrating Alternatives into a Portfolio

When considering an allocation to alternatives, it is useful to consider the objective of the alternative investment. In many cases, the ultimate objective of an alternative is diversification from traditional assets.

The resulting diversification to the portfolio may achieve:

• Lower volatility
• Enhanced returns
• Improved risk-adjusted returns
• Mitigated drawdowns
• Lower correlation to traditional assets

For some alternative categories, the goal is generally the same.

As an example, long/short equity and market neutral equity strategies that perform as expected generally result in lower volatility, mitigated drawdowns, lower correlation, and improved risk-adjusted returns for a portfolio. And they seek to do all of this while using an asset class that most investors already have, equities.

In contrast, some alternative strategies require a careful review of the implementation to understand the outcome. For example, a managed futures strategy may be implemented to lower volatility and mitigate drawdowns, but not necessarily to enhance returns. On the other hand, a higher volatility managed futures strategy may not lower volatility, but may enhance returns while mitigating the extent of drawdowns and lowering the overall correlation to traditional assets.

This is in part due to the correlation differences between alternative strategies and traditional assets. While virtually all alternatives seek diversification, some are less correlated to traditional assets than others.

Integrating Liquid Alternatives

When integrating alternatives, one must take several things into consideration:

Q. What are the client’s objectives and risk tolerance? A. This is likely already established from traditional portfolio allocations (i.e., more risk-averse investors will have a smaller stock allocation). If adjustments are needed, liquid alts can be a great tool.

Q. What is the primary objective of the alternative investment? A. Many institutional managers leverage alternatives to enhance returns and differentiate their practices. Others are looking to bring down risk and mitigate the extent of drawdowns.

Q. What will be sold to integrate the alternative? A. Please see below, and the pie charts, for some typical allocation breakdowns.

As we continue to reinforce, liquid alternatives vary significantly in terms of approach, scope, and goals, and even funds within the same category may have different approaches and return expectations. With that said, a rule of thumb often used for lower volatility alternatives is to take 75% from fixed income and 25% from equity to raise the capital needed to allocate to alternatives. In contrast, a rule of thumb for higher volatility alternatives may take 25% from fixed-income and 75% from equities.

The pie charts below illustrate how each of these approaches might look when integrating a 15% liquid alternatives sleeve into a client’s portfolio.

The idea behind the balanced approach to liquid alternatives is driven by the fact that many liquid alternatives are used with the goal of reducing volatility and mitigating drawdowns and tend to have risk/return profiles that fall in between stocks and bonds. The 75% fixed income recommendation emphasizes a lower volatility profile, like that of bonds, by incorporating a lower volatility alternative. Conversely, the 75% equities recommendation emphasizes a higher volatility profile, like stocks, to potentially enhance returns through a higher volatility alternative.

Although rules of thumb almost always come with caveats, the rules for liquid alternatives should be taken very lightly and rely heavily on your goals.

We recommend that financial professionals start by focusing on the goals they are trying to achieve with liquid alternatives. Some examples are outlined in the following table.

GOAL OF ALTERNATIVE:	More Defensive	Balanced	More Aggressive
Type of Alternative	Buffered Strategies Long/Short Equity Market Neutral Options	Managed Futures Hybrid Strategy Systematic Alpha Tactical Allocation	CTAs MLPs Private Equity Real Estate Venture Capital
Desired Portfolio Outcome	Lower volatility Mitigated drawdowns	Enhanced returns Mitigated drawdowns Lower correlation	Enhanced returns
Integration Options	Sell equities to lower overall portfolio risk Replaced fixed income being used for defense	Sell a balanced allocation of equities/fixed income to maintain same level of portfolio risk exposure Sell fixed income to increase portfolio risk Sell equities to reduce portfolio risk	Sell equities to replace source of risk Sell fixed income to increase portfolio risk

How Investors are Currently Allocating to Alternatives

On average, financial professionals have been increasing their allocation to liquid alternatives but we believe they continue to remain under-allocated.

Cerulli Associates conducted a survey of 200 financial advisors to understand how they were allocating to alternative investments.¹ The sample base tended to be advisors with clients that had higher-than-average net worth.

Tyler Wilkens, CFA, Head Portfolio Strategist at Catalyst and Rational, meets with advisors to help review portfolio objectives and existing models in order to analyze current allocations.

“I frequently talk to advisors who have a 5% or 10% allocation to liquid alts,” Wilkens said. “Depending on the specific combination of traditional and alternative investments being considered for the portfolio, the ideal weighting may be significantly higher or lower. Generally, if the goal is to substantially mitigate drawdowns without compromising returns, a weighting above 5-10% may be warranted. In such instances, the average allocation may rise to north of 15%, as advisors come to appreciate the potential benefits of diversifying portfolios beyond stocks and bonds. This would move them closer to the profile of many institutional investors.”

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IMPORTANT DISCLOSURES

YOU SHOULD CAREFULLY CONSIDER THE INVESTMENT OBJECTIVES, RISKS, CHARGES AND EXPENSES OF LIQUID ALTERNATIVE INVESTMENT FUNDS. THIS AND OTHER IMPORTANT INFORMATION ABOUT ANY SUCH FUND IS CONTAINED IN THE FUND’S PROSPECTUS, WHICH CAN BE OBTAINED BY CALLING 866.447.4228 OR AT WWW.CATALYSTMF.COM OR WWW.RATIONALMF.COM, AS APPLICABLE. THE RELEVANT PROSPECTUS SHOULD BE READ CAREFULLY BEFORE INVESTING. BOTH THE CATALYST FUNDS AND THE RATIONAL FUNDS ARE DISTRIBUTED BY NORTHERN LIGHTS DISTRIBUTORS, LLC, MEMBER FINRA/SIPC. NEITHER CATALYST CAPITAL ADVISORS, LLC NOR RATIONAL ADVISORS, INC. ARE AFFILIATED WITH NORTHERN LIGHTS DISTRIBUTORS, LLC.

Risk Considerations

Though the objectives, strategies and assets traded may differ significantly across liquid alternative approaches, investing in liquid alternatives generally carries certain risks. These risks may include, but are not necessarily limited to, the following: Certain funds may invest a percentage of their assets in derivatives, such as futures and options contracts. The use of such derivatives and the resulting high portfolio turn-over may expose such funds to additional risks that they would not be subject to if they invested directly in the securities and commodities underlying those derivatives. These funds may experience losses that exceed those experienced by funds that do not use futures contracts, options and hedging strategies. Investing in commodities markets may subject a fund to greater volatility than investments in traditional securities. Currency trading risks include market risk, credit risk and country risk. Foreign investing involves risks not typically associated with U.S. investments. Changes in interest rates and the liquidity of certain investments could affect a fund’s overall performance. Other risks include U.S. Government securities risks and investments in fixed income securities. Typically, a rise in interest rates causes a decline in the value of fixed income securities or derivatives owned by a fund. Furthermore, the use of leverage can magnify the potential for gain or loss and amplify the effects of market volatility on a fund’s share price. All funds are subject to regulatory change and tax risks; changes to current rules could increase costs associated with an investment in a fund.

The value of a fund may decrease in response to the activities and financial prospects of an individual security or group of securities held in a fund’s portfolio. Investments in foreign securities could subject a Fund to greater risks, including currency fluctuation, economic conditions, and different governmental and accounting standards. A fund’s portfolio may be focused on a limited number of industries, asset classes, countries or issuers. Certain funds may invest in high yield or junk bonds, which present a greater risk than bonds of higher quality. Other risks may include credit risks and interest rate risk, particularly with respect to floating rate loan funds. Changes in short-term market interest rates will directly affect the yield on the shares of a fund whose investments are normally invested in floating rate debt. Floating rate loan funds tend to be illiquid, and a fund might be unable to sell the loan in a timely manner as the secondary market is generally a private, unregulated inter-dealer or inter-bank re-sale market.

Any or all of the foregoing risk factors may affect the value of your investment.

Hypothetical Performance Limitations

The blended portfolio returns set forth herein represent a series of differently weighted portfolios comprised of index returns; you cannot invest in indices and no fees taken out of indices; any such blended portfolio returns should be considered hypothetical in nature. You are cautioned that hypothetical performance results have many inherent limitations, some of which are described herein. No representation is being made that any account will or is likely to achieve profits similar to those shown or will not be able to avoid substantial losses. In fact, frequently there are sharp differences between hypothetical performance results and the actual performance results subsequently achieved by a particular portfolio of investments. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, the construction of a hypothetical portfolio of investments does not involve financial risk, and no hypothetical portfolio of investments can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or the implementation of a portfolio of investments which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual trading results. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.