Why Alternatives

THE PROBLEM

A recent study of traditional 60% stock/40% bonds portfolios highlighted the problem most investors face today, saying:

“…balanced portfolios should expect returns 4% lower over the next 10 years compared to what a 60/40 portfolio delivered in the last 35 years. Investors will need to find a way to adapt.”

—Finding a New Balance With Alternatives, BMO Global Asset Management, April 2016

PAST 34 YEARS
9.6%
NEXT 10 YEARS
4.5%
Disclaimer

Past Performance is Not Necessarily Indicative of Future Results.  Source:  BMO Global Asset Management, showing a combined portfolio of 60% Stocks (S&P 500 Total Return Index) and 40% Bonds (Barclays US Aggregate Index).

How do I get truly diversified?

Most investors are “naturally long” stocks, meaning that even when we don’t have a direct investment in stocks and benefit from share prices rising, we have indirect exposure to the stock market via our jobs, the real estate market, corporate bonds, and even commodity investments tied to how the global economy is doing. That’s a problem because the stock market is known for some rather big down moves and bouts of scary volatility (see the dot.com bubble and credit crisis as the most recent examples).

Performance of "Diversifiers" During 2008 Crisis

stocks

STOCKS

hedge_funds

HEDGE FUNDS

real_estate

REAL ESTATE

commodities

COMMODITIES
Disclaimer

Past Performance is Not Necessarily Indicative of Future Results. Source: Attain Alternatives Blog, showing the worst peak to valley loss during the 2007/2008 financial crisis.

So, What Are My Options?

If that volatility happens at a time when you need some money (like retirement or your kids going to college), you’ve got a real problem. The game anyone who worries about such problems plays is finding investments which can reduce the risk of these volatility spikes and big down moves. We all want to sleep a little better at night. So how can you do that? How do you protect a stock heavy portfolio? The basic options are:

Negatively Correlated
Investments, such as:

  • Exit stocks all together
  • Buy insurance (puts)
  • Invest in negatively correlated strategies (short bias hedge funds, buy VIX futures);

Non Correlated
Alternative Investments

  • Commodities;
  • Hedge Funds; or
  • Managed Futures

Turns out this isn’t that easy of a game, however. Negatively correlated stuff (puts, short bias, VIX) is expensive, and non correlated stuff can become highly correlated over a short period of time, like real estate, commodities, and hedge funds did in 2008.

6-Month Correlation

(Stocks to Hedge Funds During Credit Crisis)

DISCLAIMERS

Past Performance is Not Necessarily Indicative of Future Results. Source: Hedge Funds = HFRI Asset weighted hedge fund index, Stocks = S&P 500

Alternatives Let You Be Proactive versus Reactive

A big reason investors choose Alternative Investments is because they let you do something about uncertainty. They allow investors to take action when faced with the tough questions of what to do when stocks are near all time highs, interest rates at all time lows, and the global financial system seemingly always on the edge of disaster awaiting the next European vote, Fed meeting, OPEC production cuts, and so forth. Alternatives let investors do something about global uncertainty.

Managed Futures:

The Best of Both Worlds

What investors really want from alternative investments is the best of both worlds – negative correlation during downturns, and positive or no correlation the rest of the time. Managed Futures is one type of Alternative Investment that can provide this true diversification. (Charts below from 1994-2017)

Average Managed Futures Performance Based on Stocks

Falling Equity Markets
Rising Equity Markets
DISCLAIMERS

Past Performance is Not Necessarily Indicative of Future Results. Data: Stocks = S&P 500 Total Return Index, Managed Futures = SocGen CTA Index.

Index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class.

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