Alternative investments can improve your portfolio outcomes – if you know how to choose them.
Investors could hardly lose over the past decade as both stock and bond markets pushed higher. But stock market returns are expected to be lower for the foreseeable future. Volatility is trending higher and low yields are limiting the ability of bonds to diversify risk. As we enter this new market regime, most investors will need to change tack to stay on track.
And so it is that advisors are increasingly interested in learning how to use alternative investments. These non-traditional assets can offer both the potential for enhanced returns and risk reduction. Introducing alternatives to a portfolio may help you deliver better risk-adjusted returns than a portfolio of core assets alone.
Access to alternatives does not require an investor to qualify as accredited, nor does it require locking up funds for a long period of time. Some alternative investments come packaged in traditional vehicles, like mutual funds, so you can sell on any day.
Yet only 24% of advisor model portfolios hold exposure to alternative investments, with an average allocation of less than 9%. We believe the slow adoption of alternatives can be attributed to the strong performance of stocks and bonds over the past decade. Advisors didn’t need to look beyond traditional exposures to deliver attractive returns, so why fix what wasn’t broken?
Advisors have been hesitant to use alternatives
Source: BlackRock, as of 12/31/20211.
However, in the past few years, some advisors have dipped their toe in the water. But without a user manual, they often selected the wrong tool for the job and were disappointed with the results. This frustration created some skepticism about the effectiveness of alternative investments, but all the while, the problem boiled down to a mismatch between intention and execution. More on that in a moment.
The most important thing to know about alternative investments is that they do not all behave the same way. They can be bucketed into four categories based on the purpose they serve in a portfolio: hedge, diversify, modify or amplify. The first three describe varying degrees of risk reduction, while the fourth – amplify – is intended for those seeking to enhance returns or income. All four are differentiated by their sensitivity to the core assets in the portfolio, or beta – a product of correlation and relative volatility.
You can’t comb your hair with a spoon
You wouldn’t use a spoon to comb your hair and you wouldn’t serve soup with a comb. The successful use of alternative investments begins with understanding the different purposes they serve.
The first step to using alternative investments is considering the outcome you want to achieve. Roughly one fourth of advisors who use alternatives are seeking to enhance returns and thus would look for amplifiers. The democratization of private investments is providing more opportunities for advisors to access true amplifiers through vehicles such as closed-end funds.
The majority of advisors using alternatives are seeking to reduce risk in their portfolios.1 Diversifiers are an efficient way to lower risk by adding unique portfolio exposures. Hedges and modifiers, while helpful in some contexts, can be ineffective, costly or both.
This brings us back to that “mismatch” mentioned earlier. Many advisors have been frustrated with their outcomes because they had selected a modifier when they actually wanted a diversifier. They tried to comb their hair with a spoon. This mismatch between intention and execution is the first pitfall in alternatives investing.
The best may not be the best (for you)
The second pitfall lies in product selection. When you shop online, do you instantly choose the product with the highest rating? A hot new video game may have a 5-star rating from thousands of consumers, but if it isn’t compatible with your gaming system, disappointment will be delivered to your doorstep. Choosing an alternative investment product based on its ranking can have similar consequences. It is important to ensure the product has the features that suit your needs.
Morningstar categorizes funds based upon the asset classes or strategies in which they invest – not by the role they are intended to play in an investor’s portfolio. Likewise, a fund’s category rank is based upon measures other than its effectiveness in playing that role. While this distinction has little relevance in the universe of traditional investments where the goals of the funds are fairly aligned within a given category, it is paramount when selecting an alternative investment to serve a particular purpose in your portfolio.
During a bull market, performance and rankings will be favorable for products with a higher stock market beta, which is exactly what you don’t want if you are seeking to diversify equity risk. Compared to traditional investment categories, there is a vast dispersion of returns and risk between the products included in the same alternative investment category, which is an indicator of the wide range of stock market correlations among those products. Filling the role of a diversifier with a multi-alternative fund that has a 0.21 correlation to stocks will likely be a far better choice than the fund with a 0.94 correlation.
Source: BlackRock, Morningstar as of 9/30/20. Morningstar Category Average 3-year correlation to the S&P 500 Index for all funds with at least a three-year history. Category expenses include all share classes of category funds. Past correlations are no guarantee of future correlations. As this chart only considers liquid products, it may be limited in its translation to private vehicles outside the realm of correlation. For example, “average expenses” depicted in the chart only pertain the average expense ratio within the illustrated categories of liquid mutual funds. The chart is not meant to provide any guidance on the expenses involved in private investments and should not be taken as such.
Past returns and category rankings can be helpful in selecting traditional investments, but in the universe of alternative investments, they can lead you to a product that does not serve the purpose you intended and can even have a detrimental effect on your portfolio.
Choose alternative investment products using a process that first identifies its intended purpose, and then evaluates its potential effectiveness. You may want to use a risk factor-based model, or you may want to use a combination of product screening and due diligence. Either of these methods can help you select the right type of tool for the job.
How you then incorporate an alternative investment allocation into your portfolio is also critical to success. What you choose to sell from your portfolio to fund your purchase – and the size of that trade – could have a meaningful impact on the effectiveness of your strategy and overall portfolio outcomes.
