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.
A 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.
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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:
- lower risk (through lower correlation in declining markets)
- increased returns
We applied this definition to the last 15 years’ worth of data and 6 true diversifiers emerged:
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.
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.
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.
(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 Index includes bonds with maturities of 1 to 3 years. For each index, Barclays maintains two universes of securities: the Returns (Backward) and Statistics (Forward) Universes. The composition of the Returns Universe is rebalanced at each month-end and represents the fixed set of bonds on which index returns are calculated for the next month. The Statistics Universe is a forward-looking projection that changes daily to reflect issues dropping out of and entering the index but is not used for return calculations. On the last business day of the month (the rebalancing date), the composition of the latest Statistics Universe becomes the Returns Universe for the following month.
(MLPs) Alerian MLP TR: The index measures the performance of energy segment US equity securities. It is a composite of the 50 most prominent energy Master Limited Partnerships (‘MLPs’). The index is calculated using a float-adjusted, capitalization-weighted methodology.
(Muni Bonds) Barclays Municipal TR: The index measures the performance of USD-denominated long-term tax exempt bond market, including state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.
(Gold) S&P GSCI Gold Index: a sub-index of the S&P GSCI, provides investors with a reliable and publicly available benchmark tracking the COMEX gold future. The index is designed to be tradable, readily accessible to market participants, and cost efficient to implement.
(TIPS) Barclays Gbl Infl Linked US TIPS TR: The index measures the performance of rule-based and inflation-protected securities issued by the U.S. Treasury. It is a subset of the Global Inflation-Linked Index (Series-L).
(Commodities) S&P GSCI Index: The index measures the performance of general price movements and inflation in the world economy. It is designed to be investable by including the most liquid commodity futures, and provides diversification with low correlations to other asset classes.
(Convertible Arbitrage) Credit Suisse Convertible Arbitrage USD: The Credit Suisse Convertible Arbitrage Hedge Fund IndexSM is a subset of the Dow Jones Credit Suisse Hedge Fund IndexSM that measures the aggregate performance of convertible arbitrage funds. Convertible arbitrage funds typically aim to profit from the purchase of convertible securities and the subsequent shorting of the corresponding stock when there is a pricing error made in the conversion factor of the security. Managers of convertible arbitrage funds typically build long positions of convertible and other equity hybrid securities and then hedge the equity component of the long securities positions by shorting the underlying stock or options. The number of shares sold short usually reflects a delta neutral or market neutral ratio. As a result, under normal market conditions, the arbitrageur generally expects the combined position to be insensitive to fluctuations in the price of the underlying stock.
(Utilities Stocks) DJ Utilities Average TR: The index measures the performance of the large, well-known US companies within the utilities industry. It is price-weighted.
(Corporate Bonds) Barclays US Corp IG TR: The index measures the performance of the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers that meet specified maturity, liquidity, and quality requirements.
(Merger Arbitrage) CISDM Merger Arbitrage Index: Demonstrates the median return of hedge funds with merger arbitrage strategies. A typical merger arbitrage strategy involves exploitation of pricing inefficiencies between different parties in a merger or an acquisition transaction. Only funds that have reported net returns for the particular month are included in the index calculation.
(Long/Short Equity) Credit Suisse Long/Short Equity TR USD The Credit Suisse Long/Short Equity Hedge Fund Index is a subset of the Credit Suisse Hedge Fund IndexSM that measures the aggregate performance of dedicated short bias funds. Long/short equity funds typically invest in both long and short sides of equity markets, generally focusing on diversifying or hedging across particular sectors, regions or market capitalizations. Managers typically have the flexibility to shift from value to growth; small to medium to large capitalization stocks; and net long to net short. Managers can also trade equity futures and options as well as equity related securities and debt or build portfolios that are more concentrated than traditional long-only equity funds.
(Real Estate) DJ US Real Estate TR: The index measures the performance of all US stocks in the Dow Jones US Index classified into the real estate sector. The sector classifications are defined by the proprietary classification system which is used by S&P Dow Jones. It is a free-float weighted index which is calculated by taking the number of shares readily available in the market (floating) multiplied by the equity’s price.
(Emerging Market Stocks) FTSE Emerging TR: The index measures the performance of Large, Mid and Small cap securities listed in Advanced Emerging and Secondary Emerging countries.
(Private Equity) Red Rocks Global Listed Private Equity Index: The Index is designed to track the performance of private equity firms which are publicly traded on any nationally recognized exchange worldwide. These companies invest in, lend capital to, or provide services to privately held businesses. The Index is comprised of 40 to 75 public companies representing a means of diversified exposure to private equity firms. The securities of the Index are selected and rebalanced quarterly per modified market capitalization weights.
(Stocks) S&P 500: A stock market index based on the market capitalization of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor’s. In this presentation, the S&P 500 is presented as a total return index, which reflects the effects of dividend reinvestment.
Barclays U.S. Aggregate Bond Index: Is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indices are rebalanced monthly by market capitalization.