What is the Right Allocation Percent to Alternatives?

We couldn’t help but take interest in this Investment News headline, which prompts a question we hear all too often from high net worth individuals, to sophisticated advisors, and multi-billion dollar pension plans, what is the right number percentage allocation to alternatives? 

While many may understand that putting alternatives in their portfolios is a good move from all sorts of perspectives (diversification, crisis period performance, tax advantages, and exposure to unique markets, just to name a few), the more nuanced question of how much to invest in alternatives, is as clear as mud.

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Bad News = There is No Right (Allocation) Answer

So assuming you understand the need for alternatives, what should you expect from your alternative investment, performance wise, in order to fit it into your allocation framework?  And more specifically, what type of performance are you expecting from your alternative investment during the time you want it most, and does that align with your expectations for the rest of your portfolio? As a firm registered to introduce alternative investments to clients ranging from high net worth investors to pension plans, we couldn’t agree more with Investment News’ answer as what’s the best percentage to allocate.

“The trouble is, unlike more homogeneous long-only stock and bond products, alternatives come in a lot of different flavors. And unlike the oversimplified asset allocation strategy that loosely divides a portfolio of stocks and bonds based on an investor’s age, so far there is no such rule when it comes to alternatives.”

“How much to allocate is both an unanswerable question in general and one that absolutely needs to be addressed for each client.”

The general rule of thumb we see from clients is a very big thumb, ranging from 5% to 50%; with people basing that on everything from how much of the rest of their portfolio they’re willing to make room for an alternative allocation, to a more statistical approached, like the efficient frontier.

Matching Allocations with Return Expectations

What we don’t see a ton of investors doing is matching their allocation percentage with their return expectations. What are return expectations?  If you’re familiar with pensions, they are rather well known for having target return numbers, so they can meet their liability stream (pension payments), and equally well known for missing those targets terribly.

The issue for individual investors is that there is no committee or in-depth tables by the Wall Street Journal evaluating their return expectations. Because of this, most investors are left disappointed their alternatives are not providing the cushion they thought it would. We previously went into this, highlighting a great piece by Welton Investment Corporation, and it bears repeating just how much return you need from your Alts allocation to achieve your overall target portfolio returns.  If I ask you right now, off the top of your head, how much return you need from a 5% allocation to alternatives to hit your 10% target portfolio return, assuming stock and bond returns are 6.5% annually, do you know?

The answer is an annual return of 76.50%… Wowsers. That means your institutionalized, low vol, alternatives investment targeting 8% annual returns is going to leave you rather short on your target return. Here’s the full table, where you can see some outrageous numbers needed to achieve target returns.

Target Alts Allocation

This is just math (all of us can do it), but we’d like to think when we’re presented with this type of information, our expectations change. It isn’t understood nearly enough that a nominal 2% or 5% allocation to alternatives isn’t really moving the needle at all. Perhaps that’s the real reason Calpers got out of the game, knowing that they could never allocate as much as they needed to in order to move the needle. Perhaps that’s why other institutional investors are getting closer to the 50% level.

And what about alternatives being non-correlated and showing up in a crisis? Well, we’ve talked about how not all Alternatives are actually “alternative” in that regard, in our Truth and Lies white paper, and thought we would take it a step further here to see just how much of an allocation to alts (assuming certain alts return levels) is needed for alternatives to keep the overall portfolio at certain bear market target return levels.

For example, don’t want to be down more than -5% in a bear market when the 60/40 portfolio is off -12.5%? Then you’re going to need a 34% allocation to an alts product designed to make 10% during such a crisis period (hmm, hmm, better look up managed futures for that one).

Here’s the table on that one. Again, it’s just math… but worth while to put down on paper:

Bear Market Return Alts Allocation

If the Glove Fits

The bottom line – if you want more return, you need to take on more risk – there are no two ways about it. That risk can come in the form of an increased allocation to alternatives, increased expectations out of your stock/bond/cash allocation (perhaps shifting into small cap stocks, foreign markets, junk bonds or something else to bump that expectation (and risk) up a bit), or increased expectations out of your alternatives allocation (perhaps using notional funding to turn a 10% return into a 30% return on cash, for example). [Disclaimer, the use of leverage greatly increases the chance of loss]

The bigger takeaway for us is the point that investors may need to both allocate more and in order to have realistic expectations for their alternatives returns. You see, in the spirit of “you can’t get something for nothing,” it’s important to remember that there just isn’t a way to turn a bunch of sub-10% returns across assets into a total portfolio return of more than 10%. The power of a diversified portfolio having alternatives may mean 3 + 3 + 3 equals 10… but this analysis shows us not to expect 3+3+3 to equal 20 or more.

This takes a little of the magic out of investing, where we dream of getting in on the next Apple or being a seed investor in Facebook. We want to believe that a small allocation to something risky can turn into something big – but it’s very hard to escape the math on this one. The simple truth is that the smaller your allocation to alternatives is, the larger the alternatives return has to be to move the overall needle.

The question now is, will your allocation to alternatives move the needle, or is it just there because you know you need “alternatives” in your portfolio?

 

 

 

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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.