Q: What is the history of the company and the fund?

BMO Global Asset Management Corp. is a registered investment adviser established in 1989 and headquartered in Chicago. We are a wholly owned subsidiary of BMO Financial Group (BMO FG), a fully diversified financial services organization with total assets of $672 billion (as of January 31, 2015) and more than 47,000 employees.

The BMO Alternative Strategies Fund is relatively new, launched at the end of December 2014, and it is managed collaboratively by our Multi-Asset Solutions Team in partnership with our colleagues at CTC | myCFO. This partnership allows the fund and its investors to benefit from two highly experienced teams. CTC | myCFO offers 20 years of experience in hedge funds, while the Multi-Asset Solutions Team has managed multi-asset strategies for more than 20 years, including those with liquid alternatives. 

The team includes many of our most senior investment professionals, who offer decades of experience with dynamic asset allocation and risk management through multiple market cycles. The strategy currently has about $35 million in assets under management.

Q: How do you define your investment philosophy?

We designed this portfolio with the typical 60/40 investor in mind. Our philosophy is based on creating a portfolio that offers downside protection across various market cycles. Assets will be allocated among six to 12 managers who offer a diverse range of alternative investment strategies. The approach seeks to provide both lower volatility than broad equity markets and attractive risk-adjusted returns. In addition, the portfolio should offer lower correlations to strategies generally found in the traditional 60/40 asset allocation mix. 

Q: What is your investment strategy and process?

Rather than beginning with a set of desired portfolio characteristics, we began with a question: What does the typical 60/40 investor need from a multi-manager fund?

These investors aren’t looking to invest 100% of their assets with us. We do not represent the core of their portfolio; they may invest 15% with us. This product could be their first allocation to alternatives, and they may dislike the lack of liquidity and lack of transparency that typically accompany hedge funds. Instead, they prefer a portfolio that fits within their desired 60/40 construct. 

Consequently, we looked at what risks might be missing or underrepresented in a 60/40 portfolio. We found that when you strip out equities and bonds, you end up under-allocated to alpha risk (skill), and some diversifying betas (market exposures). Because we are a multi-manager fund, we wanted to put together a collection of managers who provide a substantial amount of underrepresented skills into this strategy.

The fund offers several exposures that are typically underrepresented in client portfolios. In addition to long/short equity managers, we employ managers that focus on distressed debt, currency, and volatility trading. The product’s purpose is to enhance diversification by leveraging the expertise of investment managers who use a wide range of alternative investment styles. 

Compared to many multi-manager approaches, we keep the number of managers low—between six (the current number) and 12. If we have 10 managers and a 60/40 investor allocates 10% of their capital to the fund that breaks down to about 1% to each manager. We believe this is an appropriate level of manager diversification. With too many managers—say, 25—less than half a percent would go to each manager, which simply does not provide the exposure necessary to make a material difference.

Q: What are some of the unique characteristics of the fund? 

We believe the typical 60/40 fund investor is too reliant on the direction of markets to achieve his or her return objectives. We designed the strategy to offer these investors a different option. The product is structured as multi-manager 40 Act fund; however, it provides exposure to asset classes and managers not typically found in balanced funds.

The 60/40 paradigm remains popular because it has been effective historically. An allocation of 60% to stocks and 40% to bonds has worked well for long-term investors in most cycles, with equities offering growth and bonds providing both growth and stability in returns. However, the current environment should prompt investors to question whether a traditional 60/40 approach will continue to work. The key issue is that the secular decline in yields that began 35 years ago and supported historically strong bond returns cannot continue, as we are starting from a historically low level of yields.

Many bonds are now yielding less than 2-3%, the lowest level in three generations. Going forward, we expect bond returns to be significantly lower and more volatile; as a result, the traditional 60/40 allocation is unlikely to deliver what investors have come to expect based on history. In the next decade, equities may very well outperform bonds, and in an inflationary growth environment fixed income is likely to be a more significant drag on performance than investors expect. 

Our belief is that there is a better approach than a traditional, fixed allocation between stocks and bonds. With the help of a multi-manager fund structure and a dynamic view to the asset classes, we hope to deliver a better risk-return profile to investors. 

Ultimately, we look to deliver a meaningful return beyond that generated by cash. More importantly, we want to be less reliant on broad market movements to achieve that return. In addition, the portfolio should provide lower volatility and less correlation to traditional equity and fixed income markets. 

An overdependence on historical perspectives is a key challenge for the industry today. We work to provide the support financial advisers and institutional investors need to help their clients think forward.

Q: What do you look for in a fund manager and how do you find them? 

We have six managers across four broad categories: two managers in long/short equity, two in relative value, one in fixed income, and one in macroeconomic event-driven.

Over time, we will have anywhere from 15% to 40% invested in long/short equity and 15% to 40% in relative value, with 15% to 30% in fixed income and 15% to 30% in the macroeconomic event space.

There is quite a bit of breadth within each category. You may have a bias toward long equity, long/short equity, or market-neutral equity. Relative value includes our volatility manager, as they are doing relative volatility trades. There are varying degrees of market exposures, and those are the spaces in which the managers seek alpha. The allocation to each strategy is primarily driven by its fit into the overall portfolio. We examine the overall characteristics of the portfolio and study how each manager derives alpha. Managers need to add diversification to the overall portfolio and complement one another in various market environments. 

Our colleagues at CTC | myCFO source the managers. They have longstanding relationships with the managers that BMO has used for some time. Several of these managers did not occupy much of the 40 Act space, but CTC | myCFO’s relationships facilitated their design of bespoke 40 Act–compliant versions of their strategies.

CTC | myCFO’s due diligence process for sourcing managers has many components. They examine the investment strategy, process and philosophy in order to fully understand the sources of returns and the approach to portfolio management. Each manager’s organization, culture, structure and governance are also carefully reviewed. The manager’s back office is increasingly important as well, because the funds need to be managed in ways that comply with 40 Act regulations.

Risk management is crucial to our approach with this product. While we think risk management tools are extremely important, we remain skeptical toward their use in isolation. We see these tools merely as a starting point for identifying and understanding the risks inherent in a portfolio. Our managers must have an in-depth grasp of risk culture, instead of relying exclusively on tools to assess risk.

As a result, our due diligence process is quite extensive in this area. We insist that each manager explain precisely how they manage risk. We assess how each manager complements the quantitative elements of risk. We want to know if they have a forward-looking view of the relationship between their positions and their overall portfolio. 

For example, a macro manager knows that German government bond yields and U.S. Treasury yields typically move very closely together. Therefore, being long on German yields and short on U.S. yields would, historically speaking, be a very low-risk position. However, in May 2015, German yields started to move significantly off their lows while U.S. Treasury yields were flat and moving a bit lower. A positively correlated asset class had suddenly become negative.

This example illustrates that relying solely on risk management tools can be misleading. A forward-thinking and qualitative approach is needed to complement quantitative risk tools in order to truly grasp the risks involved in a portfolio.

Q: How do your managers accomplish diversification?

Each of our underlying managers looks at diversification differently and some use concentrated strategies.

We monitor positioning based on our understanding of the manager’s strategy and how they generate alpha. We also monitor any type of allocation restriction given by the manager. For example, some managers have a restriction of no more than 20% in any one industry. We would ensure adherence to this constraint. 

The overall portfolio has guidelines in terms of both GIC sector and country. In addition, single issuer long/short is limited to no more than 7% in aggregate, while single security long/short is limited to no more than 5%. Various maximum exposures are also monitored at both the subadvisor and overall portfolio level. In addition, both estimated volatility and beta relative to equity and fixed income are monitored.

Q: What is your portfolio construction process?

We expect the market beta of the portfolio to be relatively low. While we see a threshold around 0.5, we prefer a range of 0.25 to 0.35. The smaller the beta, the lower the volatility will be compared to the market. We want very little duration in the portfolio. With those defining characteristics, we seek managers that will, in combination, provide those characteristics. In general, the volatility should be between 40-80% of the MSCI All Country World Index

We consider each manager within their space. Our colleagues at CTC | myCFO provide insight into how the managers behave in different environments, which helps us to take only compensated risks in the portfolio.

We also look at each manager’s performance in extreme markets—we want to be comfortable with our managers’ historical performance in those environments.

It is important for us to understand how our managers work, both in isolation and in combination, when dealing with a base case or various outlier scenarios. That knowledge makes us comfortable with our approach.

Trading costs also represent a challenge, particularly in spaces such as distressed, so when we designed this portfolio, we set up an overlay sleeve that allows us to put less risk into the portfolio ourselves. If we find that equities are cheap or we are overweight in equities in our models, we consider whether to take more or less equity beta risk. Our team does the tactical allocations.

Alternatively, if valuations are too cheap or expensive in terms of standard deviations, we might adjust some of the exposures on the margin.

All the managers we hire focus solely on the risks in their individual portfolios. The overall portfolio is our responsibility. When we combine the managers, we look at risk with the understanding that it can and will change over time.

For example, without our risk management overlay, if our long/short equity managers started in combination with a beta of 0.4, but drifted up to 0.5 or 0.6, we would have to sell, and buy more of an asset class with less volatility. Instead, our overlay allows us to keep the capital and risk allocations to the underlying managers and simply short some equity futures to bring the overall portfolio beta to an amount where both we and our clients are comfortable.

In addition, we are very sensitive to liquidity and want to have the ability to quickly move market exposures, without having to resort to pulling capital out of an asset class that is under stress. 

Q: How do you assess the performance of your managers?

There are structural exposures that we know and expect managers to have over time, based on asset class. We look at whether their characteristics are aligned with what we expect from them. 

We recognize that performance cycles go in and out of favor, and we do not rely too heavily on peer groups for our assessments. Our approach to performance evaluation comprises an understanding of what we expect each manager to achieve and a benchmark that represents more systematic exposures. 

While we compare portfolios and performance relative to benchmarks, we are more concerned about overall fit of the strategy, managers straying from their area of expertise, or distractions that might exist in an organization, such as personnel turnover or loss of assets. These are the types of structural factors we consider. 

If performance is problematic outside of a typical cycle, with markets that are not behaving in a way that is ideal for that strategy, often the roots of underperformance are found in structural or cultural issues within the organization. These factors carry more weight with us than isolated performance data. 

Q: What is your approach to risk?

We begin by examining risk in each underlying strategy. Our due diligence process includes evaluation of each strategy’s risk management process. Every manager’s approach to risk is important and must lend itself to overall portfolio positioning and the generation of alpha.

We look at individual managers in isolation and set guidelines that we monitor on an ongoing basis. We apply our own risk tools to each manager’s portfolio and compare the results to the risk they report. We assume the role of the risk management team within the individual strategy and develop our own ideas as to the types of risks we think exist in the portfolio.

The 1940 Act gives us complete access to the underlying portfolios, which means that we can monitor individual positions for each manager directly rather than relying on their reports. We have the holdings our custodial account and feed them directly into our risk management tools. 

We compare their assessed risk and exposures to our own analysis and hold regular discussions with them regarding the portfolio. We seek a clear sense of each manager’s view of risk. For example, if a manager uses a very short-term risk model, say, a three- or five-day versus a one-month model, we get a sense of how the manager uses such a model and what they consider to be its benefits.

We then develop a view of risk at the total portfolio level. When we allocate to the six managers (and as we add managers), we study how the risks of the managers offset. 

Additionally we can implement a risk management overlay to add under-represented risk and/or reduce overrepresented risk without having to incur trading costs resulting from re-allocating capital. We also don’t want to perfectly offset risks such that we essentially reduce the portfolio to cash. In certain situations we could manage risks to position the portfolio to benefit from different economic environments, whether in a base case or outlier scenarios.