The Application of Alternative Investments: An Historical View | Moneta

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Benefits of alternative investments. The advantages of diversification within an investment portfolio are often not obvious. Certainly, during dramatic market declines, diversified portfolios have the ability to provide investors with some loss mitigation. But how does a diversified portfolio benefit the investor in more normal markets, or even, when markets are rising?

The goal of this article is to help answer this question and to provide insight on how a diversified portfolio with alternative investments would have performed over the past 20 years. Of course, past performance is not always an indicator of future returns; there are many variables and past events to consider. However, we hope this analysis will offer an investor additional perspective that can be used to frame expectations going forward.

Return. For this analysis, we have used a portfolio with a 60% stocks and 40% bonds allocation (60/40). Though this portfolio mix is very popular, it is certainly not intended to represent the most appropriate portfolio mix for all clients and was chosen for illustrative purposes only. The 60/40 portfolio is compared to a portfolio which includes a 20% allocation to alternatives: 40% stocks, 40% bonds and 20% alternatives. The make-up of the stock, bond and alternative allocations is based on our current recommended mix of diversified asset sub-classes1.

As illustrated in the table, over the longer term (greater than five years), the portfolio with alternatives consistently produced higher annualized returns2.

Total Return Performance (Annualized)

3-Year 5-Year 10-Year 15-Year 20-Year
60% Stocks / 40% Bonds 10.1% 2.4% 5.1% 6.0% 7.2%
40% Stocks / 40% Bonds / 20% Assets 8.3% 3.3% 5.6% 6.9% 8.0%
Diversification Benefit -1.8% 0.9% 0.5% 0.9% 0.8%

1The current recommended Moneta allocation is as follows:
Bonds: 5% Citigroup 3-MonthT-Bills, 10% Barclays Capital 1-3 Yr Govt, 85%Barclays Capital U.S. Intermediate Govt
Stocks: 45% Russell Top 200, 15% Russell Mid Cap, 15% Russell 2000, 20%MSCI EAFE, 5% MSCI Emerging
Alts: 50% HFN Hedge Fund Aggregate, 25% HFN CTA/Managed Futures, 25% NCREIF

2All returns are annualized total returns (all distributions are considered reinvested) and net of all fees. The impact of taxes is not considered in this analysis. Source: Bloomberg, Zephyr & Associates

The following graph illustrates the impact of the positive net performance of a $100 investment since January, 1992. As can be seen, the performance of both portfolios was similar until the volatile markets of the late 1990s. The performance of the portfolio with alternatives has continued to outperform the more traditional allocation during the recent widely fluctuating market environment.

historical_performance-100

Risk. Over the long term, alternatives could have enhanced the return investors received. But is the difference in return worth it? It is imperative that investors balance their return ambitions with their risk tolerance. Many believed their risk/return objectives were properly aligned prior to 2008, only to find that they could not stomach the losses as easily as once believed.

One way to view risk is to compare a portfolio’s historical return versus risk. Typically, in this context, risk is measured by the volatility or the variation in returns over a given period of time. A highly volatile portfolio can provide an investor superior returns, but it can also suffer significant losses. A less volatile portfolio can also provide return, though potentially lower, but with a reduced probability of significant loss. The chart below illustrates this relationship across a variety of different assets:

historical_performance-RvR

As illustrated, the diversified portfolio that includes alternatives provided the highest level of return per unit of risk. Marginally higher returns could have been achieved, for example, by investing in only small cap stocks, but at a much higher level of risk (approximately three times higher).

Another way to measure risk is the more obvious—and painful—drawdown risk. That is, the risk of compounded loss in a declining or ‘correcting’ market. The primary goal of implementing a diversified portfolio approach is to limit the potential for sizable compounded loss, while shortening the time to recovery. Over the last 20 years there have been a number of periods where the markets (equity) experienced sharp declines. The following table identifies five of the worst drawdown periods and the performance of the diversified portfolios relative to the S&P 500, as a reference.

sp500

During all five drawdown periods, the portfolios with greater diversification lost less than the S&P 500 by a notable amount. However, the portfolio with alternatives lost less and recovered faster than the diversified portfolio without alternative investments.

Note, the illustrations above reflect past performance. Past performance does not guarantee future returns or risk exposure.

Investing basics revisited. Though we all have been taught the basic tenets of investing, it is sometimes good to revisit them on occasion. The following three of these tenets are applicable to this analysis:

  • Diversification works. Portfolios that are more diversified have proven to provide higher risk-adjusted returns over the long-term. It is important to note that there are as many ways to diversify a portfolio as there are investors. We believe alternative investments can be very effective vehicles in achieving diversification.
  • Do not attempt to time the markets. Market timing rarely (if ever) results in positive returns over the long term. There is a difference between investing and gambling. Some of the largest moves in the markets are quite unexpected, both positive and negative, and nobody possesses the ability to see into the future. We believe investors are best served by a properly diversified portfolio that is aligned with their long-term needs and risk appetite.
  • Invest for the long-term. Because investing is more of a marathon than a sprint, a portfolio’s performance should only be graded over the longer-term. Allow time for diversification to work; three years should be the minimum.

There are no guarantees in investing. Investors face many risks that cause them to fall short of their investment goals: They face the risk of loss by investing too aggressively; and, less obvious but just as punitive, by investing too conservatively, they risk of loss of purchasing power. A truly diversified portfolio is the best weapon to overcome both the known and unknown risks and it gives the investor the best odds of reaching their financial destination.

Christopher Jordan, CFA, CAIA, FRM
Director of Alternative Investments
Moneta Group>

A client’s investment return may be lower or higher than the performance shown in this paper. Clients may suffer an investment loss by investing in alternative investments.

Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express of implied, is made regarding future performance.

This report has been prepared for the exclusive use of MGIA and its clients. MGIA is not responsible for any use of this report to any other than those for whom it was intended.

The information contained herein has been prepared from sources believed to be reliable but MGIA makes no representations as to their accuracy or completeness. This report is provided to you for information purposes only and should not be considered as an offer or solicitation to buy, sell or subscribe to securities or other financial instruments. The opinion expressed is subject to change without notice and should not be relied upon in substitution for the exercise of independent judgment.

Alternative investments are often complex investments, typically involve a high degree of risk and are intended for sale only to sophisticated investors capable of understanding and assuming the risks involved. The market value of any alternative investment may be affected by changes in economic, financial and political factors, time to maturity, market conditions and volatility, and credit quality of any issuer or reference issuer. Any client interested in purchasing an alternative investment product should conduct their own investigation and analysis of the product.