Should I incorporate alternatives in my portfolio?

When you hear the word "alternatives," you may immediately think of high-risk, limited investments. What you may not know is that alternative assets and strategies can actually help reduce the volatility in your portfolio and help protect against downside risk when incorporated into a diversified portfolio.

Let’s look at how alternative assets and strategies can help you achieve more sophisticated diversification than a traditional 60/40 strategy.


Correlation of Returns

Over the last 15 years, correlations in the traditional asset classes of stocks and bonds have increased — these asset classes are now more likely to go up or down in value in the same direction at the same time.

The chart below illustrates correlations among different asset classes.

Front of Chart

Correlations among different asset classes

As the chart shows:

Correlations in equities and fixed income have tended to be higher (indicated by the purple and teal boxes). This means it has become increasingly more difficult to diversify your portfolio and provide downside protection if you’re investing only in stocks and bonds.
On the other hand, alternative strategies such as market neutral and managed futures have provided lower correlations over the past 15 years. You, like many investors, may assume these asset classes are inherently riskier, but they may actually reduce the overall risk of your portfolio due to lower correlations.
Similarly, alternative asset classes such as currency and commodities have low or negative correlations, which can help you reduce risk and increase return


 

Impact to Return and Risk Over Time

Should you make room in your portfolio for alternatives?

The chart below shows how adding alternative strategies and assets to several hypothetical portfolios would have simultaneously reduced risk and increased returns.

Back of Chart

Enchanced Asset Allocation

As the chart shows:

In this hypothetical, you start with a traditional 60/40 portfolio and reallocate 15% of your portfolio to alternative assets (e.g., investments in things other than stocks and bonds, such as commodities and currency).Within the 35% that remains in fixed income, you reallocate 5% to alternative fixed income strategies (e.g., investments in bonds that use a strategy other than buy and hold). Finally, within the 50% that remains in equities, you reallocate 5% to alternative equities strategies.
The result is a significant change in the “efficient frontier,” simultaneously reducing your risk and increasing your returns.

 

 

Investing involves risk, including possible loss of principal.

Incorporating alternative investments into a portfolio presents the opportunity for significant losses including in some cases, losses which exceed the principal amount invested. Also, some alternative investments have experienced periods of extreme volatility and in general, are not suitable for all investors.

Investing in alternative strategies such as a long/short strategy, presents the opportunity for losses which exceed the principal amount invested.

There is also the possibility that long and short strategies could both fail, thereby increasing volatility and potential losses.

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