Investment perfection. You’d know it if you saw it, right?
For an investment strategy to fit the bill, most investors would say it needs to consistently beat its benchmark by a healthy margin. The hypothetical fund above has outperformed the traditional 60/40 stocks and bonds portfolio by 200 basis points annually. Even better, it has beaten the 60/40 benchmark every single day since 2000.
We call this mythical unicorn the “perfect alpha” fund. It’s everything most investors want in an investment.
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But, how much value would this perfect alpha fund have really added to a traditional portfolio?
If you had reallocated 25% of your traditional 60/40 stocks and bonds portfolio to the perfect alpha fund for the last 16 years, you would have increased your annual returns by 50 basis points. However, your volatility and risk would have essentially remained static.
The perfect alpha fund would have added no meaningful diversification to your portfolio.
The downside of outperformance: correlation
This hypothetically perfect investment outperformed its benchmark 100% of the time, and in order to do so, was highly correlated to the market. As a result, it added little value to the risk-adjusted returns of your overall portfolio.
On a standalone basis, the perfect alpha fund delivers what most investors say they seek in an individual investment: consistent outperformance that increases returns. But at the portfolio level, most investors are actually aiming for true diversification: increased returns and lower risk.
The perfect alpha fund is fictional. But, if you’re truly seeking true diversification in your portfolio you wouldn’t want it anyway. I’ts only halfway perfect.
Seeking true diversification
There is a way for investors to potentially increase returns and lower risk—with investments that actually do exist. We call these true diversifiers.
True diversifiers won’t provide most investors with the constant outperformance they want. They won’t outperform the index every day, or even every year. They’re not supposed to.
But true diversifiers can provide the diversification investors need. Their role is to help investors take a different kind of risk, and this can potentially add significant value to your traditional portfolio by adding true diversification—potentially lowering risk and increasing returns in your portfolio over time.
Disclosures and definitions
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 except the SG Trend Index which is net of fees. Investors cannot invest directly in the indices referenced on this page.
All portfolios are rebalanced on a quarterly basis.
60/40 portfolio consists of 60% stocks, represented by the S&P 500 TR Index, and 40% in bonds, represented by the Barclays US Aggregate Bond Index.
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.
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.
Perfect Alpha: A hypothetical investment that tracks the movement of the S&P 500 TR, except with a symmetrical amount of additional upside and reduced downside each month in order to generate a consistent outperformance of the S&P 500 TR by 200 basis points each year.
True Diversifier: True diversifiers are investment strategies that have historically provided investors with at least 70% of the return of traditional 60/40 stocks and bonds portfolios while having less than .30 bear correlation to traditional 60/40 stocks and bonds portfolios.