There’s no “one size fits all” answer for how much investors should allocate to alternative investments. But we need more to go on than: “enough to make a difference.”

Wall Street is always going to be more interested in selling you product than information. That’s why we’ve broken down 3 things to consider when evaluating how much to allocate to alternatives:

  1. A clear definition of what an alternative investment is, and a standard for quality
  2. The different lens you need to use to evaluate alternatives versus traditional strategies
  3. Prioritized goals for diversification

 

We’ve talked extensively about #1 in other posts. So here, we’ll focus on items #2 and #3.

A traditional evaluation skews alternatives
When analyzing a traditional fund, investors focus almost exclusively on performance by comparing its benchmark and peer group’s performance over a 1, 3 and 5-year basis. This makes sense because the type of risk associated with a traditional strategy is relatively consistent to its benchmark and peer group.

It’s fair to compare a large cap manager to a large cap index, like the S&P 500, or to other managers that only invest in large cap stocks. This is because the risks in each type of investment are the same. So, comparing performance gives an investor a better chance of identifying funds that have outperformed in the past. It’s also somewhat logical to assume that they will outperform in the future.

When analyzing alternatives, using both benchmark and peer group analysis may make your forecast foggy.

Unlike the traditional world, there are not really any appropriate and investable indices to benchmark alternatives against.

At best, the indices available today self-report performance statistics, and these are somewhat biased due to survivorship. What’s more, investors often cannot own these actual indices. At worst, today’s alternatives indices are not a representation of the risk that a given alternative strategy is taking. In this case, the relative performance of these indices is almost irrelevant.

Conducting a peer group analysis on alternative investments may also yield invalid results. Alternatives are currently classified into such broad categories that it’s difficult to identify the risk that any given strategy is taking. There’s a wide variance of security types, timeframe, gross exposure, net exposure and leverage of alternative strategies—even within categories. Though two alternatives strategies may claim to do the same thing, the types and amount of risk that they’re taking can be very different.

More than enough to make a difference
Without a proper understanding of risk and performance expectations, investors often lean towards only making a small allocation to alternatives. This seems logical: start small and increase the allocation as it proves itself worthy of a larger allocation.

However, a small allocation to alternatives is doomed to fail.

If the markets move lower, the allocation is not big enough to offset the losses. Even when you narrow the field of alternative offerings to a true diversifier, such as trend, [link to Clarifying True Diversification], adding only 5% to a 60/40 stocks and bonds portfolio only reduces the max drawdown by a meager 91 bps: from -30.75% to -29.84%.

In rising markets, when there is little perceived need for diversification, a small allocation to alternatives will eventually be seen as a drag on performance.

Either way, it’s not much help since investors are likely to lose patience and inevitably have a bad experience with alternatives.

So, how much is enough?
Adding a new asset class to a 60/40 portfolio can be challenging. However, investors should be empowered to decide how much to allocate for themselves—ideally under the guidance of a financial advisor.

By understanding that alternative strategies take different types of risk than stocks and bonds, and that true diversifiers help in down markets and make money, they are better prepared to make a meaningful allocation.

QualityAlternativeInvestments-Definition

Alternatives can augment portfolio diversification in 3 areas:

  • Increase performance
  • Less volatility
  • Reduce maximum drawdown

Prioritize your current needs accordingly, in rank order. Then you’ll be able to decide for yourself what allocation makes the most sense. The chart below will give you a mathematical range based on what you’ve decided.

We analyzed Morningstar data from the S&P 500, Barclays U.S. Aggregate Bond Index and the SG Trend Index to compile these results over a 15-year period.

Historical performance is not indicative of future results, but this can serve as a handy guide to making the right size allocation for a diversified portfolio.

0816_83-Blog-HowMuchToAllocate

Index performance on this page was sourced from third party sources deemed to be accurate, but is not guaranteed. All index performance is gross of fees and would be lower if presented net of fees. Investors cannot invest directly in the indices referenced in this document.

Source: Chart contains data from 12/31/1999 to 6/10/2016. S&P 500 and Barclays US Agg Bond for 60/40 data, S&P 500 for Stocks data, and S&P500, Barclays US Aggregate Bond Index, and SG Trend Index for Equal Weight blend of Stocks, Bonds, and Managed Futures data. 20% trend portfolio includes 32% bonds and 48% stocks. 30% trend portfolio includes 28% bonds and 42% stocks. 40% trend portfolio includes 24% bonds and 36% stocks.