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2. Alternative managers have much greater flexibility than traditional managers with regard to how they invest. Traditional portfolio managers typically invest on a long-only basis within well-defined strategy classifications (small-cap growth, large-cap value, emerging market, etc.). Thus, these managers generally employ similar approaches and invest across the same universe of investments. The opposite is true for alternative managers.

While the strategy classifications for alternatives are also well-defined, alternative managers have much greater flexibility with regard to how they execute their investment approach. Furthermore, depending on the strategy, alternative managers may have the freedom to invest on both a long and short basis across different categories of stocks (large cap, small cap, domestic, international, etc.).

They may also invest across multiple asset classes (stocks, bonds, currencies, commodities, etc.) and use a variety of complex trading techniques. In addition, alternative investments are more technical in nature and use more complex trading techniques that are impacted by market conditions. To deal with these factors, the investment approaches employed by alternative managers tend to vary greatly. This can lead to a wide dispersion of returns.

Two ways to help address manager risk

For these reasons, manager risk (the risk of selecting an underperforming manager) may be greater for alternatives than for traditional investments. It is critical that investors be aware of this risk and the role it may play when considering an investment in alternatives. In my opinion, there are two actions that may help mitigate this risk.

1. Conducting due diligence on the manager before investing. This may help investors select a quality manager. When conducting due diligence, it’s important to consider many key factors, including (but not limited to) the experience and pedigree of the manager, the investment process utilized, markets traded, assets under management, capacity of the manager’s strategy and the infrastructure in place supporting the manager. As part of this process, it’s imperative to clearly identify the manager’s “edge,” namely, the unique aspect of the manager’s approach that could help him or her succeed.

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2. Diversifying across multiple managers. This step further reduces manager risk by diversifying across multiple managers. This can happen through a multi-alternative fund (as highlighted in my previous blog) or by diversifying your alternatives allocation across multiple managers and/or strategies.

The two steps discussed are tools that may help investors mitigate manager risk. That said, conducting manager due diligence and diversifying across managers is a tall order for most investors and does not guarantee the investment will meet performance objectives. For this reason, I believe investors would benefit considerably from working with a financial advisor who is knowledgeable and experienced in alternative investments.

This article has been republished with permission from Invesco Powershares.