All true diversifiers are alternatives, but not all alternatives are true diversifiers.
So, 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 as investment strategies that historically deliver both:
- lower risk (through lower correlation in declining markets)
- increased returns
We applied this definition to at least 15 years of historical data and 6 true diversifiers emerged.
When evaluating these asset classes for your own portfolio, it is important to consider the environments in which each has historically performed best. Click on each true diversifier to get the highlights, including its return profile, periods of outperformance/underperformance and a snapshot of recent performance:
- Managed futures
- Municipal bonds
True Diversifier: Gold
Gold is similar to cash in that it serves as a store of value. Gold investors receive an added benefit: protection against inflation, or the loss of purchasing power due to currency creation from a central bank. In fact, gold is rare in that it represents the only liquid financial asset that is not simultaneously someone else’s liability. So, it’s not susceptible to destruction through bankruptcy, breach of contract, transition of governmental regime or dilution by printing press. The downside to investing in gold is that it loses value during periods of deflation and can also be subject to shorter term speculative volatility.
Return profile: Since gold does not offer a yield or generate any kind of earnings or cash flow, it serves purely as a store of value. When similar stores of value, such as cash, are stable, gold tends to be stable as well. During times when cash loses value due to inflation, the value of gold is likely to increase—and vice versa when cash gains value to deflation.
Did you know? Gold’s rare ability to store value in a compact, readily transferrable and widely accepted medium has made it the most durable form of wealth, with a track record spanning 5,000 years.
This true diversifier:
- Outperforms during inflationary periods such as the 1970s and 2000s.
- Underperforms during periods of price stability and high interest rates such as the 20-year period from 1982 – 2002. Gold also underperforms during deflationary periods, like the commodities deflation from 2011-2015.
Recent performance snapshot: In 2016, Gold emerged from a 4-year bear market during the commodities deflation from 2011-2015. As commodities bottomed in early 2016 inflation increased, causing this recent outperformance. However, if the Federal Reserve follows through on its stated mission of raising interest rates in the coming years, gold prices could face headwinds.
True Diversifier: Managed Futures
Managed futures investments apply a trend following strategy to capture both up and down price trends across global futures markets. This diversified process targets price movements in over 100 commodities, currencies, equities and fixed income markets. Managed futures produces an uncorrelated return profile with positive skew. It produces this return profile by tapping into diverse markets and cutting losing trades quickly while letting winning trades extend. This complements the negative skew associated with traditional asset classes, like stocks and bonds.
Return profile: Managed futures has the potential to thrive during multiple different market environments, including inflation, deflation, economic growth or economic contraction. In fact, historically managed futures has generated positive returns during periods of up and down price movements across asset classes. Since broad-based price trends tend to occur during both inflationary and deflationary periods, managed futures has historically done well during a wide range of economic environments.
Did you know? Trend following strategies have existed in various forms for over 100 years, and today’s style of diversified, rules-based trend following came to prominence during the inflationary 1970s. Historically, these strategies have been confined to a hedge fund format, typically only available to sophisticated high net worth individuals. They started to become available to the retail investor in 2010 via ’40 Act mutual funds.
Historical performance: Managed futures has historically delivered mid-single digit returns while maintaining a correlation of approximately zero to the U.S. stock market over long periods of time. It has done well during periods of inflationary growth (mid-2000s), deflationary contraction (2000-2002 and 2008) as well as deflationary growth (2014-2015). The strategy underperforms during periods of relatively price stability, like from 2011 – 2013.
This true diversifier:
- Outperforms during periods of sustained price trends across multiple asset classes, including both inflationary and deflationary environments.
- Underperforms during periods of price stability across multiple asset classes, like the noninflationary growth environment of 2011-2013, or during transition periods from deflation to inflation and vice versa.
Recent performance snapshot: This true diversifier experienced gains during the 2014-2015 deflation, but as those deflationary trends reversed in 2016 managed futures performance suffered. The market appears to be potentially shifting into a new regime of higher growth and inflation, which could bode well for managed futures going forward.
True Diversifier: MLPs (Master Limited Partnerships)
Master limited partnerships are publicly traded partnerships, which are unique in their tax treatment as “pass through entities.” This preferred tax treatment shields most of the partnership income from federal taxation.
Return profile: A key feature of the MLP return profile has to do with yields and cash flows. Typical partnership agreements require MLPs to distribute all of their available cash flow to shareholders. This has made MLPs a favorable investment in recent years, thanks to their relatively high yields in a low-rate environment.
Did you know? The first MLP IPO was launched by oil and gas company Apache Corporation in 1981. While the MLP structure has expanded into other sectors over the years, the original formation of MLPs was focused on the oil and gas sector and remains so today.
Historical performance: We use the Alerian MLP as our proxy for the sector. Its performance is closely correlated with the current price, and rate of change in the price of crude oil. This makes MLPs a potential source of inflation protection within a portfolio.
This true diversifier:
- Outperforms during inflationary periods with rising oil and gas prices.
- Underperforms during deflationary periods with falling oil and gas prices.
Recent performance snapshot: MLPs followed the sharp price declines in energy markets over the last couple of years, but have since recovered alongside the recent recovery and stabilization in crude oil prices. Further, MLPs appear poised to deliver a potential hedge against a return to inflation in the years ahead if the new administration moves according to the market’s expectations.
True Diversifier: TIPS (Treasury Inflation Protected Securities)
TIPS are U.S. Treasury bonds designed to provide protection against inflation. They provide this inflation protection by adjusting the principle and interest rates of a regular U.S. Treasury bond according to the annual inflation rate, measured by the CPI. Effectively, this causes TIPS to increase in value during periods of inflation, and fall in value during periods of deflation.
Return profile: TIPS will outperform Treasuries when inflation is positive, and underperform Treasuries when inflation is negative (or, in periods of deflation).
Did you know? TIPS were first issued in the U.S. beginning in 1997, and are issued in 3 maturities: 5, 10 and 30-year bonds.
Historical performance: TIPS are similar to Treasuries when inflation is