With the recent prolonged recovery bull market, the relative underperformance of alternatives is not surprising. Figure 15 highlights how insignificant allocation decisions were between stocks and bonds in the 10-year period ending October 2010. During this period, equities provided more risk and less return than bonds, mirroring what happened in the 1930s and the 1970s. If U.S. equity markets migrated into another weak market cycle like they did from November 2000 to October 2010, the implication of negative or flat returns for an equity and bond portfolio is far reaching. This is why those who influence asset allocation decisions may want to consider utilizing tactical and alternative strategies to help extend the efficient frontier.
Investors who seek further diversification typically allocate
to international equities, growth and value equities, and equities of different capitalization ranges and sectors. Unfortunately, these efforts do not always combine assets that move independently of one another. When a bull market prevails, investors rarely complain. On the other hand, in a world of lower equity returns, advisors and planners turn to alternative assets such as real estate, global macro, commodities, long/short equities, managed futures and fixed income arbitrage (non-traditional bond). Why? Basically, because adding alternatives to a portfolio of traditional assets may potentially lower risk and increase returns. A clear understanding of how this happens requires studying alternative strategy returns and their correlation to the returns of stocks and bonds.
To realize the benefit of diversification, a portfolio’s underlying asset classes must behave differently in varying market conditions. Thinking about diversification requires investors to understand what negative correlation means and how a given investment instrument should be used when blending it into their portfolio. If an asset class goes up and down independently of traditional assets (equities or bonds), it means that there are times when they are doing the same thing as equities or bonds and times when they are doing the opposite. The biggest complaint on most alternative products is that they are not adding as much value during those downtrends for the targeted traditional asset and that they only add value when that traditional asset is going up. This is why investors need to look at the correlation of alternative vehicles under consideration. Look for investment strategies that are non-correlated to the asset that it will be replacing or complementing. Investors should also look at how the performance and risk of that strategy can deliver absolute returns to their portfolio.
Fig 15. Alternative vs. the Market — 10 Years as of 10/31/10
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow.
Many investors seek absolute returns through a low volatility approach. However, there are now strategies available that embrace the volatility. In some cases, utilizing higher volatility strategies allows the investor to utilize less to add value.
Most alternative categories contain funds that pursue strategies divergent in one or more ways from conventional returns generated from traditional assets. Many products in these categories describe themselves as “absolute return” portfolios, which seek to avoid losses and produce returns uncorrelated with the overall bond market; they employ a variety of methods to achieve those aims. The environment in the coming year could be poised for adding alternatives, especially in the event of a short-term market correction or even a recession. When adding an alternative strategy to a traditional portfolio, long/short methods are specifically designed to work with the ups and downs of the market. But again, a key metric to consider is correlation—specifically, a low correlation to the asset class that is presenting the reason for concern. It doesn’t make sense to add something with a high correlation to stocks
if the stock market is the cause for concern.
It’s easy to understand investors’ excitement over technology companies and the products and productivity these companies provide. Ultimately, the earnings and performance of big tech companies going forward must support the significant price advances of the last few years. As we look ahead, we recommend that investors get their exposure to the tech sector by other, more tech-centric approaches where holdings are selected and weightings are managed with more criteria than just capitalization size. Going forward, we believe “fundamentals” and the ability to shift when trends emerge or fail will matter. We recommend that investors consider tactical strategies that are nimble, managed futures strategies and global macro strategies.
Important Factors to Consider When Selecting Tactical or Alternatives:
Correlation: Look for investment strategies that are non-correlated to the asset that it will be replacing
or complementing.
Absolute Returns: Consider how the alternatives may provide performance and manage risk in all
market environments.
Complex: Provide access to sophisticated investments but in some cases, can provide higher risk and costs
when compared to traditional investments.
Fig 16. Alternatives in Active vs. Passive Investing Environments
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar and Barclay, calculated by Arrow.
Asset Class Proxy Disclosure:
Past performance does not guarantee future results. Categories display the returns of current funds in the Morningstar category during the time period shown, subject to survivorship and/or re-categorization. Index and strategy research returns assume reinvestment of dividends, but do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and are not available for direct investment.
Asset class proxies (in order as shown above by figure): Figure 13: S&P 500, Managed Futures (Barclay Top50), Global Macro (Barclay Global Macro), Morningstar Categories: Small Value, Mid-Cap-Value Figure 14: Agg Bond (BBgBarc U.S. Agg Bond), Equity (S&P 500), Morningstar Categories: Large Core Growth, Large Core Value, Mid Core Growth, Mid Core Value, Allocation--50% to 70% Equity, World Allocation; Figure 15: Bonds (BBgBarc U.S. Agg Bond), Equity(S&P 500), 6040 (60% Equity & 40% Bonds), Global Macro (AI Research: Global Macro DWGM Strategy), Long Short Equity (Barclay Equity Long/Short ) Commodity (AI Research: Extended Commodity AIEC strategy), Managed Futures(Barclay Top50), Multi-Alternative (Barclay Hedge Fund) Real Estate (FTSE NAREIT), Morningstar Category: Nontraditional Bond, Alternative Funds includes alternative mutual funds and private placements; Figure 16: U.S. Equity (S&P 500), Int’l Country Markets (average of 48 investable countries- Argentina, Australia, Austria, Belgium, Brazil, Canada, Chile, China, Colombia, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Malaysia, Mexico, Netherlands, New Zealand, Nigeria, Norway, Pakistan, Peru, Philippines, Poland, Portugal, Qatar, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, UAE, United Kingdom and Vietnam), Commodity (S&P GSCI), Real Estate (FTSE NAREIT), Managed Futures (Barclay BTop 50), Global Macro (Barclay Global Macro). |
