The investment world is starting to more clearly articulate a definition of alternative investments: strategies that produce returns by taking risk other than equity and bond risk. We’re taking steps toward clearly defining quality, too.

 

AlternativeInvestments-DefinitionA common definition and a clearer threshold for quality are two pieces of the puzzle. The third is a way for investors to determine which alternative strategies make the most sense for their portfolios. Unfortunately, this can still be confusing.

This is partly because the alternatives space is still relatively new, and its strategies often reference unfamiliar descriptions and terms. These don’t quite parallel how we classify and evaluate traditional investments.

As a result, Wall Street has had a difficult time properly labeling and categorizing alternative strategies. One firm will group them differently than another, and many use the same language to describe different strategies. This leads to a lot of confusion among investors who are uncomfortable, and rightfully so, with allocating a large amount to alternatives without clear expectations.

All of these factors have combined to heighten frustration with alternative investments. Investors need tools to get past this barrier and begin to understand the role that alternatives should play in their portfolios.

Cage the DINOs
Nearly every alternatives manager claims his strategy will diversify traditional 60/40 stock and bond portfolios. Very few can give a simple description of what risks they are taking. Fewer still can truly diversify.

We call these DINOs: diversifiers in name only. These strategies may make money, but they take too much equity or bond risk to help during market declines. They might belong in a portfolio, but based on their historical performance, it’s best not to lean on them for diversification.

All true diversifiers are alternatives, but not all alternatives are true diversifiers.

A truly alternative allocation
We did some research to help investors identify what really belongs in their alternatives allocation. As a result, we’re offering a clear definition of true diversifiers:

Investment strategies that historically deliver both:

  1. lower risk (through lower correlation in declining markets)
  2. increased returns

We applied this definition to the last 15 years’ worth of data and 6 true diversifiers emerged:

clarifyingtruediversification2x2

Adding a 20% true diversifier allocation to a traditional 60/40 stocks and bonds portfolio reduced risk (in the form of maximum drawdown) and increased portfolio performance.

We didn’t get the same result with any of the asset classes in the lower right quadrant: the DINOs. In some cases, adding a 20% allocation increased returns, but it also increased risk (or vice versa).

This doesn’t necessarily mean that DINOs are bad investment strategies, as some can help investors make money and often belong in a diversified portfolio. But these DINOs need the proper risk allocation—likely in either equity or bond risk. Obviously, time frame and market conditions will also affect how each strategy performs.

0816_79-Blog-DefiningTrueDiv_PlotChart-1024x643

Choosing an appropriate true diversifier

When evaluating true diversifiers, it is important to consider the environments in which each has historically performed best. Treasuries and municipal bonds tend to perform better when interest rates are declining and their yield is enhanced by the resulting capital appreciation. MLPs and gold tend to perform better when the prices of oil, natural gas and gold are appreciating.

Inflation protected treasuries (TIPs) have historically benefitted from both inflation and deflation because the principal investment is inflation-protected by nature.

Trend strategies have the ability to benefit from either environment as well because they’re structured with the ability to go long or short. What’s more, they seek premiums on the types of risk that could occur whether current quantitative easing and negative interest rates remain or retreat. In our research, trend strategies are represented by the SG Trend Index, which is a pool of the largest managed futures funds that employ trend following strategies.

Alternatives are still relatively new, but that’s no excuse for continued ambiguity in this space.

The Street was right about one thing: a larger allocation to alternatives can make a difference in portfolio diversification.

Empowered with a definition and understanding of the benefits of true diversifiers, investors now have the tools they need to forge a clearer path toward achieving true diversification—and toward better allocations of capital to stocks and bonds, too.

 

Source Information:

Common indices were used to represent the investments in this graphic.

Short Equity represents the Credit Suisse Dedicated Short Bias USD.

Market Neutral represents the Credit Suisse Equity Market Neutral USD.

Trend represents the SG Trend Index.

U.S. Treasuries represent the Barclays 1-3 Yr US Treasury TR.

MLPs represents the Alerian MLP TR.

Municipal bonds represent the Barclays Municipal TR.

Gold represents S&P GSCI Gold Index.

TIPS represent the Barclays Gbl Infl Linked US TIPS TR.

Commodities represent the S&P GSCI Index.

Convertible arbitrage represents the Credit Suisse Convertible Arbitrage USD.

Utilities represent the DJ Utilities Average TR.

Corporate bonds represent the Barclays US Corp IG TR.

Merger arbitrage represents the CISDM Merger Arbitrage USD.

Long/Short Equity represents the Credit Suisse Long/Short Equity TR USD.

REITs represent the DJ US Real Estate TR.

Emerging Markets represent the FTSE Emerging TR.

Private equity represents Red Rocks Global Listed Private Equity Index.

Stocks represent the S&P 500 TR.

60/40 represents a 60% allocation to the S&P 500 TR Index, and a 40% allocation to the Barclays US Aggregate Bond Index.

Disclosure Definitions:

(Short Equity) Credit Suisse Dedicated Short Bias USD: The Credit Suisse Dedicated Short Bias Hedge Fund Index is a subset of the Credit Suisse Hedge Fund IndexSM that measures the aggregate performance of dedicated short bias funds. Dedicated short bias funds typically take more short positions than long positions and earn returns by maintaining net short exposure in long and short equities. Detailed individual company research typically forms the core alpha generation driver of dedicated short bias managers, and a focus on companies with weak cash flow generation is common. To affect the short sale, the manager typically borrows the stock from a counterparty and sells it in the market. Short positions are sometimes implemented by selling forward. Risk management often consists of offsetting long positions and stop-loss strategies.

(Market Neutral) Credit Suisse Equity Market Neutral USD:  The Credit Suisse Equity Market Neutral Hedge Fund Index is a subset of the Credit Suisse Hedge Fund IndexSM that measures the aggregate performance of dedicated short bias funds. Equity market neutral funds typically take both long and short positions in stocks while seeking to reduce exposure to the systematic risk of the market (i.e., a beta of zero is desired). Equity market neutral funds typically seek to exploit investment opportunities unique to a specific group of stocks, while maintaining a neutral exposure to broad groups of stocks defined for example by sector, industry, market capitalization, country, or region. The index has a number of subsectors including statistical arbitrage, quantitative long/short, fundamental long/short and index arbitrage. Managers often apply leverage to enhance returns.

(Trend) SG Trend Index: A leading benchmark for tracking the performance of a pool of the largest managed futures trend following based hedge fund managers that are open to new investment. The SG Trend Index is equal-weighted and reconstituted annually. The SG Trend Index is formerly known as the Newedge Trend Index.

(US Treasuries) Barclays 1-3 Yr US Treasury TR: The index measures the performance of US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. It is the subset of the US Treasury

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