The Death Of Alternatives Has Been Greatly Exaggerated by Christine Johnson & Richard Brink 

Is the bell tolling for alternatives? Investors seem to think so. But despite recent poor performance, alternatives have a long life ahead and will be vitally important in the years to come, in our view.

It’s clear from our conversations with clients that many people are losing faith in alternative investments. “I tried alternatives,” they tell us, “and they didn’t work.”

As far as their own experience goes, they have a point. Alternative strategies, which invest in a wider universe of assets than traditional strategies and depend more heavily on manager skill for returns, have not performed well over the last several years.

That doesn’t mean the strategies are broken. In fact, many alternative strategies have done what they were designed to do—they diversified exposure away from stocks and bonds, reduced volatility and provided downside protection.

When Beta Ruled

Unfortunately, anything that diversified you away from traditional stock or bond strategies cost you dearly over the past six years. By mid-2015, the S&P 500 Index on a total-return basis was nearly 250% above its March 2009 post-crisis trough. Meanwhile, global central banks’ unprecedented monetary easing boosted bond markets and drove sovereign yields lower.

In that environment, even passive exposure to stocks and bonds was highly effective. Beta, or exposure to broad market movements, ruled.

This great beta trade was singularly unfavorable for alternative strategies, which try to protect investors by hedging away broad market exposure and leaning on alpha—outperformance through individual security selection—to generate returns.

For instance, the S&P 500, which has been in positive territory for seven straight years, rose by more than 32% in 2013. A long/short equity strategy with a beta of 0.5 would have returned just 16%. What’s more, abnormally low volatility and dispersion among assets—another feature of the beta trade—would have made it hard to make up the difference with alpha.

Time to Praise Alternatives, Not to Bury Them

Over the past 25 years, the story’s been very different. As Display 1 illustrates, alternatives have over time been better at boosting returns and reducing risk than traditional 60/40 portfolios of stocks and bonds.

Alternatives, Beta Trade

As investors, we all know that no asset class wins all the time. We accept that—grudgingly—with regard to stocks and bonds. So why have we been so much less forgiving with alternatives?

It may be because so many investors were attracted to alternatives for the first time over the last five years or so. This makes sense. With valuations in stock and bond markets looking expensive, the time seemed right to diversify.

When Treasury yields spiked and stocks sold off in 2013 during the “taper tantrum,” investors rushed into alternative strategies. By year end, though, stocks had rallied sharply, yields fell and alternative strategies broadly underperformed.

Some investors concluded that these strategies simply don’t work. But as our colleague, Marc Gamsin, noted in a recent post, there’s a long history of pundits writing what turned out to be premature obituaries of entire asset classes—and of investors selling at the worst possible time.

Investors who took their cue from a now infamous 1979 Business Week article titled “The Death of Equities” would have missed the great bull market for stocks that followed. Predictions of doom for hedge funds in the late 1960s and again after the Long-Term Capital Management crisis in 1998 were off-base, too.

As Gamsin put it, “performance chasing—selling out of investments after a period of poor performance to reallocate into investments that have just had a good run—undermines the benefits of diversification and generally leads to poor results.”

After the Beta Trade

This is worth keeping in mind, because the great beta trade won’t last forever. In fact, the days when all investors had to do to win big was chase an index are already fading. Last year, US stocks rose just 1.4%, and rising volatility presented challenges in markets around the globe.

In several instances over the past 18 months, including sell-offs sparked by Chinese growth concerns, plunging commodity prices and the Brexit shock, alternative strategies performed as intended, providing vital diversification and downside protection (Display 2).

Alternatives, Beta Trade

We think volatility is likely to increase, especially as US interest rates rise, and we expect most assets to deliver below-average returns. The good news here is that asset correlations tend to fall as volatility rises. That creates better short-selling opportunities and more chances to generate alpha. In other words, we’re moving into the type of environment in which alternative strategies thrive.

Select Your Strategies Carefully

There are thousands of different alternative strategies—long/short equity, global macro, credit/relative value, event-driven, and so on—and a lot of dispersion among managers within categories. Knowing what you want from an alternative strategy and finding the manager that matches up best with your objectives is critical.

The last six years were unusual ones throughout financial markets, and there’s no denying that alternatives struggled. But markets are moving into a new era, and we think alternatives will be an indispensable part of a well-balanced portfolio in the years to come.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.