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The Role of Alternatives in Portfolios Today

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By Josh Harlan & Cindy Gatlin

 

 

On August 22, 2018, the U.S. stock market (as measured by the S&P 500 Index) set a record of the longest bull market on record. Since March 9, 2009, its widely acknowledged start date, this stretch of time without a 20% downward correction in the market has run for 3481 days as of today, with the S&P 500 Index increasing over 300%. The previous record was from October 1990 to March 2000 when the Dot-Com bubble burst, for a total of 3439 days. Needless to say, we are living a historic moment in the market.

The bond market is undergoing significant changes now that a decade of zero-interest-rate policy and quantitative easing (purchases of U.S. Treasuries and Mortgage Securities) by the Federal Reserve is gradually being unwound. The Fed has begun increasing short-term interest rates and selling bonds purchased during and after the financial crisis.

These changes affect bond holders in particular: as interest rates rise, existing bonds with lower yields fall in price, while newly issued bonds with higher yields become more attractive to investors. These circumstances will likely affect the yields of conventional portfolios, and thus leads us to the discussion of alternatives in portfolios.

Conventional Portfolios

Conventional portfolios typically consist of a mix of stocks and bonds. While these types of portfolios are still excellent long-term sources of capital appreciation and income, there have been long stretches of time within the last 50 years when they’ve failed to generate the wealth that most investors have come to expect. A case in point is the “lost decade” from March 2000 to October 2011 that unfolded between the longest and second-longest bull runs in the U.S. stock market: this period delivered a S&P 500 cumulative return (dividends included) of zero.

Bonds, in contrast, are generally thought to be a complementary asset class. Indeed, over this same period, the Barclays US Aggregate Index (a benchmark index for investment-grade bonds) more than doubled.

Have there been periods of time when a portfolio of stocks and bonds failed to perform well? Yes. Consider the 17-year stretch from 1964 to 1981, when short-term interest rates rose and a standard 60/40 portfolio of stocks and bonds underperformed cash (represented by 3-month Treasury Bills) by -1.4% per year. Conventional portfolios did not meet investors’ expected returns during this period.

Whether or not we’re poised for a similar environment going forward, investors can take prudent steps to diversify their investments beyond stocks and bonds by exploring alternatives in portfolios.

Graph showing returns that don't match investor expectations

Alternative Investments

Alternative investments are a broad category that covers real estate, private equity, venture capital, credit, commodities, insurance, and absolute return strategies. In general, anything that isn’t stocks or bonds would fall into this category.

The alternatives landscape is vast, worth more than global stocks and bonds combined. Considering the recent periods of underperformance from stocks and bonds, incorporating alternatives into client portfolios can serve as a third pillar of differentiated sources of return.

Over the past ten years, the alternative investment world has dramatically changed, mostly to the benefit of investors:

  1. Fees have been reduced. Instead of the previous requisite 2% management fee and 20% fee applied to any profits, today’s standard involves a single management fee or lower percentages of each, leaving more of the total return to investors.
  2. Transparency has significantly improved. Essentially, this means investors’ ability to understand what a fund manager is doing. Investors today expect to be treated as partners, and in turn, fund managers are more open about their processes and methodology.
  3. Liquidity has improved. The ability to redeem your money for cash is also important for individual investors who don’t have the time horizons of institutions. Luckily, this is moving in investors’ favor, with many funds offering daily, quarterly, or yearly liquidity.

Even with the numerous favorable changes in the use of alternatives in portfolios, the asset class still poses real challenges to investors. One notable difficulty is the sheer volume of investment opportunities to consider. According to the Financial Times, in January 2018 there were approximately 2300 private equity firms as well as over 9000 active hedge fund managers (according to the SEC). Add to that the 9500 mutual funds and 2000 ETFs that currently trade (according to the Investment Company Institute) and it becomes clear why evaluating alternative investment funds can be so challenging and time consuming.

Adding Alternatives in Portfolios

Due diligence and implementation are crucial when adding alternatives in portfolios as a third pillar of returns alongside stocks and bonds. To get the most value from the alternatives portion, those investments should have different, non-correlated economic drivers of return from stocks and bonds. This approach will improve the chances of alternatives generating return when stocks and bonds are underperforming—precisely the time when alternatives would add the most value.

Another important consideration is where alternative investment allocations are sourced from in a pure stock and bond portfolio. Taking too much from either source could result in unexpected outcomes in investment returns and risk.

The desired outcome of adding alternatives in portfolios is to better increase the likelihood of investment outcomes to match investor expectations. There’s a very real possibility that a portfolio consisting solely of stocks and bonds will materially underperform should recent history repeat itself, as the graph below illustrates.

Graph showing 60/40 portfolio unlikely to match investor expectations

We know that, while history may not exactly repeat itself, it does rhyme, to paraphrase Mark Twain. Alternative investments have matured to a state where, if done properly, they can serve as a non-correlated third pillar of return.

About the authors: Josh Harlan is Director of Investments Research and Cindy Gatlin is a Senior Vice President at Delphi Private Advisors. The firm offers institutional wealth management in a boutique, personalized service model for high-net-worth individuals and family foundations. Cindy can be reached via email at Cindy@delphiprivate.com.

 

Disclaimers: Past performance may not be indicative of future results. Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of investment management fees, or the impact of taxes, all of which would have the effect of decreasing historical performance results. Indices are unmanaged and cannot be invested in directly. It should not be assumed that your account holdings correspond directly to any comparative indices.