Last year the global equity markets (save the emerging markets) produced robust double-digit returns, whereas most alternative investments had modest results. This glaring performance contrast has left some investors feeling a strong sense of disappointment, thinking it may be time to drop alternatives from their diversified portfolios.
But this reactionary response may be shortsighted: In fact, the current state of the capital markets heightens the potential applicability of alternative investments within portfolios even more. With the domestic equity markets trading at or beyond all-time high levels, the current levels of downside risk may be greater now than they were at the start of 2013. If you accept the notion of unpredictable asset class performance, it’s unlikely that these high equity returns are sustainable, which means investors should maintain adequately diversified portfolios to protect against this downside risk. This makes having alternative investments in your portfolio an important thing to consider.
Let’s take a step back and examine why alternatives became so important in the first place—and how the proliferation of products categorized as alternatives in recent years has led to a muddled understanding of alternative investments themselves.
Benefits of Alternative Investments
To better highlight the value of alternatives within portfolio structure, let’s consider the investment period between 1994 and 2010. Specifically, we’ll take a look at hedge funds—one type of alternative investment. According to a 2012 article in the Financial Analysts Journal, during the period from 1994 through 2010, the Dow Jones and Credit Suisse Hedge Fund Indexes outperformed the S&P 500 with a return of 9.4 versus 8 percent, respectively, while incurring only half the volatility and little systemic risk.
The table below depicts the annual total return performance for selected indexes representative of equity, income, and alternative investments (highlighted in blue) from 2005 through 2007:
We can glean a number of observations from the information above. First, during the noted period—especially for hedge funds and commodities, given their outperformance—returns were higher than both the pure equity and pure bond examples. Next, it’s important to point out that the prior year’s performance had little bearing on the direction or magnitude of the following year’s returns, with perhaps the exception of income. Thus, it’s virtually impossible to predict with a reliable measure of consistency how each asset class will perform from period to period.
Using this example we can generally see that diversifying across asset classes can mitigate portfolio volatility on a period-to-period basis—but how does volatility reduction actually lead to better performance in the long run? The example below is a simplistic representation of two portfolios, intended to illustrate how less volatility among returns can lead to better long-term results.
Based on the annual returns in the table below, which portfolio do you think has a higher value at the end of the period?
The answer is Portfolio B.
That might be somewhat surprising, but the table below provides the mathematical evidence of our results based on a portfolio starting value of $1 million.
The example above represents portfolios constructed based on the allocations below and uses index proxies to represent equity, alternatives, and fixed income asset classes.
The dollar difference between portfolios at the end of the period is $30,209 greater for Portfolio B. If you only glance at the return percentages, you may be led to the conclusion that Portfolio A has a higher value at the end of the period: In the positive performing years, Portfolio A’s returns are often higher than those of Portfolio B. But it’s the wide variation in its performance—the swings between the positive and negative returns—that leads to a lower ending value for Portfolio A. This is precisely the effect alternative investments can help mitigate. Although Portfolio B doesn’t capture all of the upside in the bull markets represented, it does a better job protecting value on the downside. Including alternative investments mitigates volatility and better positions portfolios for the next market upswing, with less to make up and more to gain.
The maturing capital markets of today and the recent financial crisis further the argument for alternatives as a part of a diversified portfolio. Today’s capital market environment has a greater number of asset classes in which to invest—and therefore an increased set of opportunities. Furthermore, many of these investments have similar return profiles and less disparate correlations.
A diversified portfolio, by definition, implies varied performance among the asset classes within it. Therefore, the selected asset classes—equities, bonds, and alternatives—should have different performance behavior characteristics from each other. But we want to take this even further: It’s not enough to simply select alternatives uncorrelated to equity or income securities on an individual basis; it’s important to choose a range of alternatives where the potential returns are also uncorrelated from each other.
The alternative category has expanded greatly in the past five years and is virtually unrecognizable compared with 10 years ago, when alternatives was a seldom-used term reserved primarily to categorize commodities and real estate. At the present time, there’s dissent on what falls into the alternative investment category. However, there’s general agreement in the asset management profession that hedge funds, commodities, real estate, and other forms of “real assets,” such as listed infrastructure companies, are considered alternatives. Hybrid investments with characteristics of equity and income, such master limited partnerships and preferred stock, are commonly considered alternatives as well.
The hedge funds subcategory encompasses a wide range of strategies, from long or short equity and credit to global macro to market-neutral to multistrategy funds. Overall, expectations for the alternatives category should be long-run returns that are uncorrelated to equity or income securities or that provide—as a range of alternatives—a combination of characteristics common to both equity and income assets.
Incorporating Alternative Investments
Despite the modest results alternative investments provided in 2013, many performed as expected. Dissatisfaction among investors—primarily concentrated in the retail segment—is an outcome of relative comparisons, and it’s only been reinforced by the financial media’s narrow focus on stock market performance. But it’s important to note that alternatives aren’t meant to keep pace with equity market performance; rather, alternatives incorporated into an investor’s portfolio should be designed to mitigate the volatility that emanates from equity and income securities. It’s important to continuously review vehicles that provided mid-single-digit returns with low-single-digit volatility not only for 2013 but over a full market cycle. Also it’s important to evaluate those investments that have provided a consistent stream of income and have capital appreciation potential alongside those that have historically exhibited performance behavior independent of traditional asset classes.
In conclusion, it takes a high level of expertise to successfully discern which alternative strategies are appropriate for an investor’s portfolio, especially given the plethora of new offerings inundating the marketplace. And it’s critical to remember the reason your alternatives are incorporated in the first place: to provide diversification benefits that can mitigate volatility and provide risk-adjusted returns, better positioning your portfolio for long-term growth.