Ultimately advisors, and their clients, are turning to alternative strategies because they provide an additional tool that can increase diversification and boost returns.
Alternative investments were originally the sole province of institutions and the wealthiest of families, but in recent years access has been democratized as an increasing number of alternative strategies have been packaged in ’40 Act mutual funds. A primary reason advisors are including alternative strategies in their clients’ portfolio is that they broaden diversification and give investors a risk/return profile different from that provided by equities, bonds or cash.
Investment theory continues to evolve, and a contemporary approach starts with the idea that a fully diversified portfolio does not just hold long, unlevered positions. In order to realize the maximum benefit from a particular strategy the portfolio might also hold potentially levered positions, where more than 100% of the portfolio is invested, or it could be betting against a stock and hold short positions.
Although it is popular right now to call this diversified approach an alternative strategy, it has become so mainstream that an argument can be made that it is actually at the core of modern portfolio construction. Some investors look at alternative strategies as a seasonal play as in, “I think stocks are expensive right now, so I need some alternatives to reduce the risk,” or “We think stocks are very cheap and so need some alternatives to bring a new set of tools to the portfolio.” That kind of thinking can severely limit the investors’ chances of long term success by ignoring the benefits that alternative strategies can bring in any market environment. Investing by looking in the rear view mirror and chasing last year’s winners can be a dangerous game to play.
Generally speaking, most alternative strategies fall somewhere between stocks and bonds in the overall risk profile they bring to the portfolio. They almost universally have a lower volatility or a lower risk than an all equity portfolio and depending on the strategy they probably have higher risk than a bond portfolio. Over time these strategies also have, after adjusting for the higher risk level of stocks, been shown to have a higher return.
Most advisors look at alternatives as portfolio diversifiers because they don’t have a high correlation with stocks or bonds and fit somewhere between the two in terms of risk profile. It’s important to remember that the lack of correlation can mean different things at different points in the market cycle.
For example, the dominant asset class for the last few years has been large cap US stocks and by comparison virtually every other asset class appears to have underperformed, but most people aren’t investing only for today or for the next five or six years. The reason that diversification is important in portfolio construction is because investing is a long-term proposition, and it is performance over time that should be most important to investors.
A superficial look at returns would seem to indicate that US stocks have been a great place to park your money. However, closer examination reveals that even in the current environment, there’s a price to pay for this approach relative to a portfolio containing a good multi-strategy alternative. From the standpoint of absolute returns, US stocks have done better than other asset classes, but in terms of how they’ve done versus the risk in the portfolio, the best multi-strategy hedge fund managers, net of fees, have still done better.
Source - wealthmanagement.com
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