The investment world is starting to more clearly articulate a definition of alternative investments: strategies that produce returns by taking risk other than equity and bond risk. We’re taking steps toward clearly defining quality, too.
A common definition and a clearer threshold for quality are two pieces of the puzzle. The third is a way for investors to determine which alternative strategies make the most sense for their portfolios. Unfortunately, this can still be confusing.
This is partly because the alternatives space is still relatively new, and its strategies often reference unfamiliar descriptions and terms. These don’t quite parallel how we classify and evaluate traditional investments.
As a result, Wall Street has had a difficult time properly labeling and categorizing alternative strategies. One firm will group them differently than another, and many use the same language to describe different strategies. This leads to a lot of confusion among investors who are uncomfortable, and rightfully so, with allocating a large amount to alternatives without clear expectations.
All of these factors have combined to heighten frustration with alternative investments. Investors need tools to get past this barrier and begin to understand the role that alternatives should play in their portfolios.
Cage the DINOs
Nearly every alternatives manager claims his strategy will diversify traditional 60/40 stock and bond portfolios. Very few can give a simple description of what risks they are taking. Fewer still can truly diversify.
We call these DINOs: diversifiers in name only. These strategies may make money, but they take too much equity or bond risk to help during market declines. They might belong in a portfolio, but based on their historical performance, it’s best not to lean on them for diversification.
All true diversifiers are alternatives, but not all alternatives are true diversifiers.
A truly alternative allocation
We did some research to help investors identify what really belongs in their alternatives allocation. As a result, we’re offering a clear definition of true diversifiers:
Investment strategies that historically deliver both:
- lower risk (through lower correlation in declining markets)
- increased returns
We applied this definition to the last 15 years’ worth of data and 6 true diversifiers emerged:
Adding a 20% true diversifier allocation to a traditional 60/40 stocks and bonds portfolio reduced risk (in the form of maximum drawdown) and increased portfolio performance.
We didn’t get the same result with any of the asset classes in the lower right quadrant: the DINOs. In some cases, adding a 20% allocation increased returns, but it also increased risk (or vice versa).
This doesn’t necessarily mean that DINOs are bad investment strategies, as some can help investors make money and often belong in a diversified portfolio. But these DINOs need the proper risk allocation—likely in either equity or bond risk. Obviously, time frame and market conditions will also affect how each strategy performs.
Choosing an appropriate true diversifier
When evaluating true diversifiers, it is important to consider the environments in which each has historically performed best. Treasuries and municipal bonds tend to perform better when interest rates are declining and their yield is enhanced by the resulting capital appreciation. MLPs and gold tend to perform better when the prices of oil, natural gas and gold are appreciating.
Inflation protected treasuries (TIPs) have historically benefitted from both inflation and deflation because the principal investment is inflation-protected by nature.
Managed futures strategies have the ability to benefit from either environment as well because they’re structured with the ability to go long or short. What’s more, they seek premiums on the types of risk that could occur whether current quantitative easing and negative interest rates remain or retreat. In our research, managed futures strategies are represented by the SG Trend Index, which is a pool of the largest managed futures funds that employ trend following strategies.
Alternatives are still relatively new, but that’s no excuse for continued ambiguity in this space.
The Street was right about one thing: a larger allocation to alternatives can make a difference in portfolio diversification.
Empowered with a definition and understanding of the benefits of true diversifiers, investors now have the tools they need to forge a clearer path toward achieving true diversification—and toward better allocations of capital to stocks and bonds, too.