Portfolio Diversification via Alternative Investments

The Times They Are A-Changin

Come gather 'round, people
Wherever you roam
And admit that the waters
Around you have grown
And accept it that soon
You'll be drenched to the bone
If your time to you is worth savin'
And you better start swimmin'
Or you'll sink like a stone
For the times they are a-changin'

- Bob Dylan

The words of Bob Dylan ring true in today’s investment landscape. Alternative investment strategies have grown by leaps and bounds since the turn of the century. Subsequent to the subprime crisis, this phenomena has only accelerated. Investors, especially and predominantly the high net worth investors, have embraced this asset class to equip their portfolios in the rapidly changing economic times. They have sought to be nimble in the ever evolving financial markets and have placed an inordinate amount of importance on innovative investment products.

Current Conditions

Current market conditions are volatile with daily swings on mere headlines, political rhetoric and sabre rattling. With the US bull market having reached its eleven-year milestone with a 300%+ return in that same period, it is unquestionably the longest bull market in history. Savvy investors are concerned about equity valuations, the potential for capital loss in fixed-income markets, and the trajectory for economic growth going forward. These challenges are causing investors to consider alternative asset classes and strategies. Ergo, it is crucial to gain an understanding of alternative strategies and how they can give your portfolio that diversification edge to help you sleep better at night.

This paper seeks to shed light on how alt strategies fit in a retail portfolio and via research, help set risk-reward expectations for the individual investor.

The Alternative Investment Spectrum

Alts come in a variety of flavors. Any asset that does not fall in the stocks, bonds or cash category is referred to as such. Most alts are held by institutional or accredited investors because of their perceived complex nature. However, the JOBS Act of 2012 has turned this perception on its head and now, alts are making their way into mainstream investing.

In an attempt to classify alts, we have used subjective judgment as many alts have less opportunity to publish verifiable returns. Most alts are also fairly illiquid, but that too is undergoing a rapid change. Here are the main alt categories:

• Returns Amplifier: Private equity asset class seeks to outperform the traditional classes.
• Inflation Hedge: Objective is return of capital and maintaining purchasing power parity.
• Risk Reduction: Seeks to reduce volatility and risk at the expense of outsized return expectations.
• Market Uncorrelated: Returns are uncorrelated to the markets. Seeks to provide absolute returns in rising or falling markets.

Risk-Reward Comparison

The diagram below shows the returns of the various alternative asset classes versus the traditional pools of investment. The “alt” strategies that 99Rises is focusing on fall under the “Uncorrelated” and “Macro” umbrellas where the returns are generally uncorrelated to the market.

As shown, our bucket of alt uncorrelated strategies almost always outperform the traditional investment products like stocks, bonds and cash in the longer term. While private equity is the best investment class, it is beset with the problems of liquidity and high minimum commitments.

Therein lies the advantage of our liquid alt strategies which give the user the ability to liquidate for cash at any time, and have the luxury to invest long-term where they can avail of the power of compounding, protect against downturns and generate returns in rising or falling markets.

Of course, in investing today, no asset class or strategy is considered for its return potential alone. Investment risk is also a paramount concern. Therefore, we delve further by bringing volatility, as measured by standard deviation, into the framework, using the Sharpe ratio of each strategy.

Sharpe Ratio or Quality of Returns

Sharpe Ratio is defined as the difference between the returns of the investment and the risk-free return, divided by the standard deviation of the investment.

The primary use for alternatives is to complement traditional asset classes, but not to replace the traditional allocations entirely. To determine which alternatives are best equipped to complement traditional asset classes in specific economic scenarios, our study also analyzes the correlation and beta statistics of each alternative versus stocks and bonds.

• Returns Amplifier: Private equity generates the highest absolute return over our entire sample period, while also delivering fairly attractive risk-adjusted returns.
• Inflation Hedge: The category appears to offer some attractive diversification benefits to both traditional stocks and bonds, however, its overall returns are muted.
• Risk Reduction: This category appears to balance the providing of stable absolute returns with fairly low volatility, resulting in some of the most attractive risk-adjusted returns over the full sample period.
• Market Uncorrelated: Though returns of this category are in the range of approximately 5%–7% over the full sample period, there are clear return divergences within economic scenarios.

Our research indicates that a good alternative investment strategy is really a prudent combination of the above mentioned investment classes. While 99rises is focused on introducing the penultimate two categories to the retail investor, it is up to the investors to decide on the actual asset allocation.

Final Observations

Our goal with this research is to offer insights to help you understand which “alts” can buttress a portfolio to pursue its return expectations with downside protection.

It is clear, that over long time horizons such as 20+ years, alts have met or exceeded the expectations of their performance objectives.

We conclude that alternative strategies can represent valuable innovations to the toolbox of portfolio choices. While past performance is not a guarantee for future gains, we posit that in specific types of market conditions, the performance of some alts can diverge from their long-term characteristics.

These observations about long-term performance characteristics, and how the strategies can diverge from expectations in specific types of economic scenarios, provide a framework for us to differentiate the strategies and apply them to serve our customers’ portfolio goals.

References
1. Putnam Investments