For years, paleontologists have referred to sharks and crocodiles as “living fossils,” a term coined by Charles Darwin in “On the Origin of Species.” The idea is that these animals evolved before many other species, allowing them outlive the dinosaurs while keeping their ancient and fearsome forms.
But recent research suggests that both animals are much more dynamic than previously thought. Relatively new adaptations like the unique gill supports of sharks have allowed them to survive and thrive over the years in almost any environment.
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Alternatives: misidentified and misunderstood
The same can be said for some alternative investments. On the surface, these strategies may all appear a bit ugly to some investors—all scales and teeth. Living fossils with little place in a portfolio.
But there is a difference between prehistoric DINOs—diversifiers in name only—and more evolved alternatives that bring true diversification to a traditional stocks and bonds portfolio.
Like a paleontologist, it takes some digging to unearth a clear definition of alternatives, which we believe are investments strategies that deliver both:
- Lower risk (through low correlation in declining markets)
- Increased returns
The problem is that most investors, and many financial advisors, have a hard time sifting fact from fiction. According to a 2017 study by Longboard and the Financial Planning Association, most advisors think REITs are the best diversifier, despite a nearly 60 percent correlation to the stock market.
At the same time, advisors misidentify MLPs, gold and managed futures as the least effective diversifiers. These asset classes historically have been among the most consistent portfolio diversifiers—providing balance and durability in any market environment.
Survival of the fittest
Given this confusion, it’s easy to see why nearly 75 percent of advisors have only allocated 10 percent or less of their portfolios to alternative strategies. That may work fine today, but if the market changes, those prehistoric portfolios could be facing another extinction event like 2008.
Longboard research suggests the best way to avoid that is by evolving to a balanced portfolio. That means allocating at least 20 percent to truly diversified alternatives and maintaining that amount over a full market cycle.
Advisors who have braved these waters admit that they had to do more education and expectation setting with clients up front. By design, non-correlated assets move differently than stocks and bonds.
But once clients really focus on achieving their long-term goals, true diversifiers can help advisors differentiate their firms, save time and increase their referral business.
That’s survival of the fittest—with lower volatility and the potential for mid-single digit returns.