First, looking back over the past 20 years (as shown in the chart1 below), a portfolio holding a diversified set of alternatives would have generated higher returns with lower volatility and a lower maximum decline when compared to a standard 60% stock/40% bond portfolio.
Second, the most common mistake I see investors making with regard to alternatives is investing “after the fact.” In other words, they add alternatives to portfolios following a period when equities struggled and alternatives performed well.
For example, many investors flocked to alternatives2 in the five years following the global financial crisis of 2008 (GFC), seeking to generate returns and reduce risk. However, the benefits of diversification may have been better realized if investors held alternatives before the 56% decline in the S&P 500 Index that occurred during the GFC.3
Why haven’t investors embraced alternatives?
We are in the midst of an unusual period in financial markets, featuring extremely accommodative monetary policy by the world’s central banks, historically low interest rates, and a US stock market that is generating returns well above (and volatility well below) long-term historical averages.4 Against this backdrop, alternative investments have fallen out of favor because many of their unique benefits are not highly valued by investors, such as:
- Unique timing of returns. One common objective of many alternative strategies is to outperform stocks when equity markets are doing poorly. While alternatives have, over the long term, generated returns similar to that of equities, the timing of these returns has differed. As seen in the chart5 below, over the past 20 years alternatives have consistently outperformed stocks during periods of equity weakness (although at times the returns were negative), while underperforming stocks during periods of equity strength. With equities enjoying an eight-year bull market and with the GFC bear market moving further into the past, many investors are now more focused on the underperformance of alternatives in bull markets rather than the outperformance during bear markets.
- Risk reduction. The ability to help reduce risk is one of the main reasons investors allocate into alternatives. As shown in the following chart,5 alternatives have historically generated returns with lower volatility and lower maximum drawdowns than those of stocks. With stock market volatility at record lows and with recent pullbacks being short-lived, investors have become less focused on the notion of risk reduction.
- Diversification. The returns of alternatives may have low correlation to traditional equities and fixed income. As a result, they can help diversify a portfolio. While diversification is important, in my experience many investors only like diversification when it works in their favor (when equities are experiencing weak performance). These same investors tend to dislike diversification when it means allocating to anything that is underperforming equities.
Today’s market conditions won’t last forever
In fairness, it needs to be pointed out that one big reason alternatives have been out of favor is the underwhelming performance of many alternative products. In my opinion, performance has been hurt by the market distortions created by the extremely accommodative monetary policy that has been in effect post-GFC. Specifically, we have seen essentially a one-way bull market for stocks, along with historically low volatility and interest rates. These factors have combined to create a challenging environment for alternatives, especially those seeking to generate returns through actively trading across the global markets on a long and short basis.
While I have no idea how long the current market environment will last, I am confident that the combination of high stock returns and low risk won’t last forever, and that these will ultimately revert to be more in line with long-term historical averages. Furthermore, I think current valuations are high, as evidenced by record-setting US stock market indexes, and I also believe that risk is being undervalued, as shown by the low level of the VIX.6 On a global basis, there are a number of potential risks to markets, such as the ability of central banks to unwind their accommodative monetary policies, the impact of the nomination of a new chairman of the US Federal Reserve, the future of the European Union, the ability of Britain to execute its exit from the EU, instability in North Korea, and potential fallout from the renegotiation of trade agreements, such as NAFTA.
In many ways, today’s environment reminds me of the tech-led bull market of the 1990s. Back then, investors poured into high-flying tech stocks and self-directed brokerage accounts. It appeared that picking stocks was easy and advice from financial advisors was unnecessary. Today, investors increasingly turn away from active management in the belief that a passive, low-cost approach is the way to go.
When the tech bubble finally burst in early 2000, resulting in a two-year bear market and an 80% decline in the Nasdaq Composite Index, investors realized that the stock market was more challenging and risky then they imagined. Furthermore, they once again appreciated the value of a skilled and experienced financial advisor, as well as the importance of diversification and risk mitigation. Many such investors then took a fresh look at alternative investments.
I have no doubt that investors will learn similar lessons when the inevitable happens and more challenging conditions replace the current desirable environment we have enjoyed for years. Given where we are in the current market cycle, I strongly encourage financial advisors and investors to consider adding alternatives as they begin the process of reviewing and adjusting their portfolios for the upcoming new year.
1 Source: StyleADVISOR. Alternatives portfolio represented by a portfolio comprising allocations to each of the following alternatives categories: Inflation-hedging assets, represented by 15% FTSE NAREIT All Equity REIT Index and 5% Bloomberg Commodity Index. The 15%/5% split reflects Invesco’s belief that investors tend to invest in strategies with which they are more familiar. Principal preservation strategies, represented by 20% BarclayHedge Equity Market Neutral Index. Portfolio diversification strategies, represented by 12% BarclayHedge Global Macro Index and 8% BarclayHedge Multi-Strategy Index. Multi-strategy is underweighted in this example due to its potential overlap with global macro. Equity diversification strategies, represented by 20% BarclayHedge Long/Short Index. Fixed income diversification strategies, represented by 10% S&P/LSTA US Leveraged Loan Index and 10% BarclayHedge Fixed Income Arbitrage Index. Equities represented by the S&P 500 Index. Fixed income represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Risk is measured by standard deviation, which is defined as a measurement of a portfolio’s or index’s range of total returns in comparison to the mean. Maximum decline refers to the largest percentage drop in performance.
2 Source: The Cerulli Report, Alternative Products and Strategies 2014, data from January 2009 to March 2014.
3 Source: Bloomberg L.P., data from Oct. 9, 2007 to March 5, 2009.
4 Source: Lipper, Inc., data through Nov. 30, 2015.
5 Source: StyleADVISOR. Alternatives are represented by a portfolio comprising equal allocations to alternative assets, represented by FTSE NAREIT All Equity REIT Index, Bloomberg Commodity Index; relative value strategies, represented by BarclayHedge Equity Market Neutral Index; global investing and trading strategies, represented by BarclayHedge Global Macro Index, BarclayHedge Multi Strategy Index and BarclayHedge Currency Traders Index; alternative equity strategies, represented by BarclayHedge Long/Short Index; and alternative fixed income strategies, represented by Credit Suisse Leveraged Loan Index, HFN Fixed Income Arbitrage Index and BarclayHedge Fixed Income Arbitrage Index. The performance of individual alternative investments will differ from that of the index. Equities represented by the S&P 500 Index. Fixed Income represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Traditional 60/40 Portfolio represented by 60% S&P 500 & 40% Bloomberg Barclays U.S. Aggregate Bond Index. An investment cannot be made directly in an index. The period represented is January 1997 through December 2016. Past performance is not a guarantee of future results.
6 The VIX is a measure of volatility of the S&P 500 Index.
For purposes of this analysis, only the performance of liquid alternatives is included. The reason for this is that liquid alternatives are widely available to all investor types. In contrast, illiquid alternatives (e.g. private equity, venture capital, direct real estate, etc.) are only available to high net worth and institutional investors and are not available to retail investors.
BarclayHedge indexes reflect performance of hedge funds, not of retail investment strategies, and are used for illustrative purposes only solely as points of reference in evaluating alternative investment strategies.
The BarclayHedge Currency Traders Index is an equal-weighted composite of managed programs that trade currency futures and/or cash forwards in the interbank market.
The BarclayHedge Equity Market Neutral Index includes funds that attempt to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country.
The BarclayHedge Fixed Income Arbitrage Index includes funds that aim to profit from price anomalies between related interest rate securities.
The BarclayHedge Global Macro Index includes funds that carry long and short positions in any of the world’s major capital or derivative markets.
The BarclayHedge Long/Short Index includes funds that employ a directional strategy involving equity-oriented investing on both the long and short sides of the market.
The BarclayHedge Multi-Strategy Index includes funds that are characterized by their ability to dynamically allocate capital among strategies falling within several traditional hedge fund disciplines.
The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index considered representative of the US investment grade, fixed-rate bond market.
The Bloomberg Commodity Index is a broadly diversified commodity price index.
The Credit Suisse Leveraged Loan Index represents tradable, senior-secured, US dollar-denominated, non-investment grade loans.
The FTSE NAREIT All Equity REIT Index is an unmanaged index considered representative of US REITs.
The HFN Fixed Income Arbitrage Index includes funds that attempt to exploit pricing inefficiencies between credit sensitive instruments which may include government or corporate debt, structured securities and their related derivatives.
The NASDAQ Composite Index is the market capitalization-weighted index of approximately 3,000 common equities listed on the Nasdaq stock exchange.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
Past performance is not a guarantee of future results. An investment cannot be made directly in an index.
Alternative investments can be less liquid and more volatile than traditional investments, such as stocks and bonds, and often lack longer-term track records.
Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.
Investing in stock involves risks, including the loss of principal and changes in dividend policies of companies and the capital resources available for dividend payments. Although bonds generally present less short-term risk and volatility than stocks, investing in bonds involves interest rate risk; as interest rates rise, bond prices usually fall, and vice versa. Bonds also entail credit risk and the risk of default, as well as greater inflation risk than stocks.
Diversification does not guarantee a profit or eliminate the risk of loss.
The PowerShares DB Commodity Index Tracking Fund ETF (DBC) was trading at $16.35 per share on Wednesday morning, up $0.01 (+0.09%). Year-to-date, DBC has gained 3.22%, versus a 18.67% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of Invesco.