We’ve been waiting… and waiting… and waiting… for the markets. to. finally. move. With the election over, we’re now seeing it unravel. The U.S. Dollar Index is at levels not seen since 2003, Copper has roared up 20% in a week, and Gold is getting crushed. And that short list doesn’t include the biggest “market” – the U.S. stock market’s push to new all-time highs.
All {Time Highs} — All Time. All {Time Highs} All Time. $SPY $DIA $DJIA https://t.co/kNHLsGW5LO pic.twitter.com/ReLPIXBdJ0
— RCM Alternatives (@rcmAlts) November 22, 2016
It’s time like these where logging into your investment account is a great idea if you’re a firm believer of the “buy, hold, and forget” club. What’s not to like? We all know about the market being up big since the 2009 lows, but now the market is up roughly 50% from its 2007 peak and looks as though it’s showing signs of breaking out of a 16-year range. It’s rainbows and lollipops all around…
…except in the world of Alternatives. Sure – there’s been an explosion of assets into alternatives since the 2008-2009 financial crisis. Sure, they are developing ever new and innovative ways of finding alpha or offering cheap alternative beta in the markets. But for all the effort, nobody seems to be able to keep up with the mighty US stock market. It seems easier to just buy a low-cost index fund.
Which got us to thinking. How much do stocks need to outperform alternatives in order for the long term benefit of alternatives to be made insignificant? In short, when is the excess return worth the increased risk? For all of those who decry hedge funds for underperforming stocks over the past few years – the answer is not very much. They seem to think a year or two of stocks outperforming stocks + alternatives means there’s no need for the diversification. Raise your hand if you’ve read an article about the massive shift into passive investments recently, or such and such pension fund dropping hedge funds because they aren’t seeing the value.
So what’s going on? Are alternatives no longer needed, or are lots of people suffering from a massive dose of recency bias? We decided to put the numbers to the theory, comparing a Diversified portfolio (36% stocks, 24% bonds, 40% Managed Futures) against a simple 60/40 portfolio going back to 2011, 2006, and the start of the millennium – 2000.
Given the headlines, it should be no surprise that the past five years show the basic 60/40 portfolio out performing a portfolio with alternatives. It would be hard to argue against complex alternatives investments and the wisdom of just sticking with simple passive indexing without such a graph.
(Disclaimer: Past performance is not necessarily indicative of future results)
Source: Stocks = S&P 500, Bonds = Barclays Aggregate Bond Index
Managed Futures = SocGen CTA Index
The portfolio with alternatives underperformed a traditional portfolio just about the entire time, reminding us of an old line from the hoops classic Hoosiers: “Sun don’t shine on the same dog’s ass every day, but, mister you ain’t seen a ray of light since you got here.” Here are the stats for those into the nitty gritty.
So why has there been such growth and interest in Alternatives? Look no further than the comparison between a traditional portfolio and one containing alternatives over the past 10 years, going back through the financial crisis. Now, these two “lines” have ended up at essentially the same place over 10 long years, but just like you and that hippy cousin at Thanksgiving, the paths that were taken to get there were quite different.
(Disclaimer: Past performance is not necessarily indicative of future results)
While the “lines” might not do the difference between these two paths all that much justice, we can really see the benefits of an alternatives allocation in the statistics – with the max drawdown roughly cut in half, and the volatility about 2/3 that of the 60/40 portfolio. But this just begs the question: is a savings of 16% on the downside over the long term, worth an underperformance of 16% over the short term (past 5 yrs).
We might rush to say this is a wash, with the 16% savings offsetting the 16% loss, and the 10-year chart sort of bears this out with both strategies finishing around the same place. But it’s a bit more nuanced than that. Ask yourself whether you panicked during the 2008 crisis. Ask yourself how much more likely you’d be to throw in the towel when your portfolio is down -30% versus -15%. It’s easy to say you’re sticking with passive investing while we’re here at all time highs -it’s quite another when you’ve lost a third of your investment account and staring at world markets falling 50% or more during a crisis. What the stats don’t show is the diversified portfolio’s ability to keep you in the game… to keep you from getting out at the wrong time.
Which brings us to the very long term, looking back to the start of the SocGen CTA index in 2000.
(Disclaimer: Past performance is not necessarily indicative of future results)
And this – my friends – is why alternatives are worth it. Unless you’re getting started when you’re 85, investing isn’t a 5-year test. It’s hardly even a 10-year test. We’re talking 25, 50, and even 75 years of assets at work in the “markets” for some people, where the benefits of compounding and diversification show up more and more the longer you’re allowing them to work.
And what benefits they are, with the return higher, the volatility lower, and max drawdown still roughly half of what it is in a non-diversified portfolio. Past performance is not necessarily indicative of future results, and that’s the whole point. Alternatives may look nothing like their return stream since 2000, but neither may stocks. The non-correlation and mixture of the two are what makes it work over the long term.
In the meantime, we’ll always have periods of underperformance and over performance and everything in between as assets cycle into and out of beneficial market environments, leading to broad proclamations that hedge funds are dead, stock markets are broken, and so forth and so on. But those with a longer view see something different. They see non-correlation in action – with different return drivers producing different looking return streams over short periods of time. They see better risk adjust performance over the long term even when employing a strategy that is underperforming in the short term.
As they say, don’t miss the forest for the trees.
