A Guide to Alternative Investments and Their Place in Your Portfolio

One of the biggest choices investors face is deciding which assets they should own in their portfolio. It’s well understood that simply saving and holding cash won’t cut it when saving for retirement and for years, the generally accepted rule has been that investors can utilize stocks as the growth engine of their portfolio and bonds to manage risk and provide stability. What’s more, allocating 60% to stocks and 40% to bonds is commonly viewed as the optimal approach when building a portfolio to invest in towards retirement. It’s only fair to ask though, is relying solely on stocks and bonds and the 60-40 allocation appropriate for your portfolio, or is there more an investor can do to branch out beyond the traditional 60-40 portfolio and improve returns without taking on additional risk?

A Historically Good Decade for the 60-40 Portfolio

The 60-40 portfolio had done extremely well for investors in the decade leading up to 2022, outpacing its own performance in the 2000s by a significant margin and over the long run by a smaller but still noticeable amount.

And one of the main drivers of good returns for the 60-40 portfolio over the 2011-2021 decade appears to be lower than average correlation between stocks and bonds during the period.

This means that lately, stocks and bonds had either both exhibited good but different returns or, when one of these asset classes was performing poorly, the other would step in and perform relatively better, supporting the returns of the overall portfolio.

How a Great Decade for the 60-40 Portfolio Can Get Investors into Trouble and What They Can Do About It

This relationship is all well and good, however as an investor, one can easily fall prey to recency bias and assume that the low correlation between stocks and bonds that had been so attractive recently would persist going forward irrespective of what the historical data suggests. And doing so can result in gaps in a portfolio that otherwise go unnoticed until the relationship that had existed recently breaks down. 2022 provides us with a perfect example of just that dynamic when for the first time, stocks and bonds both saw double-digit declines and left many investors with doubts as the traditional 60-40 portfolio that had been widely viewed as optimal no longer provided the diversification investors had come to expect from it.

This phenomenon of stock and bond correlations rising during market selloffs has happened before both in 2008 and briefly in 2020 and while history doesn’t necessarily repeat itself, it often does rhyme. It is impossible to predict when the market will sell off again however selloffs are a natural feature of the market and one of the main goals of building a diversified portfolio is to prepare for just those periods of market volatility and rising correlations that investors can’t see coming. Doing so can lead to better outcomes for an investor’s portfolio.

Fortunately, investors do have an option to address the phenomenon of rising correlations of stocks and bonds during market selloffs. This involves shifting allocations away from the traditional 60-40 stock and bond mix and towards a portfolio that incorporates an asset class called alternative investments. Adding alternative investments such as managed futures which exhibit low correlations to stocks and bonds across bull and bear markets can result in a portfolio with greater returns, lower risk as measured by a portfolio’s standard deviation, and greater risk-adjusted returns as measured by a portfolio’s Sharpe ratio, or how much return an investor gets for each unit of risk they take on.

Examples of Alternative Investments

So what exactly are alternative investments? Alternative investments refers to a broad category of investments that can’t be grouped with traditional stocks or bonds. Some of the most common alternative investments and definitions of those alternatives are:

Not every alternative investment is created equal and while some alternatives such as managed futures, private credit, private real estate, and private equity can have a place in an investor’s portfolio, others may conversely not add value. It is important to consider this and other features of the various alternative investments when deciding what alternatives to add to a traditional portfolio of stocks and bonds.

Considerations for Investors When Evaluating Alternative Investments and Alternative Investment Funds

Increasing Risk-Adjusted Returns

The alternatives asset class covers a wide range of assets, and some alternative investments do better than others when it comes to improving risk-adjusted returns of a portfolio. There are other benefits of alternative investments aside from purely increasing risk-adjusted returns, however doing so is one of the main reasons to add alternatives to a traditional 60-40 asset mix. Managed futures are a great option in this area and evaluating the other alternative investment options through this same lens can help ensure that adding them to a portfolio is worthwhile.

The low correlation of managed futures to traditional stocks and bonds can also be seen as a bug that makes it difficult to stick with. When the stock market is rising (as it tends to do each year on average), managed futures can in some cases lag behind. This can make it difficult behaviorally to hold managed futures through these periods however this uncorrelated return feature is exactly why a portfolio with managed futures can hold up better during market selloffs and have better risk-adjusted returns overall.

Manager Selection

Selecting the right alternative investment manager is important to justify the often higher fees associated with many alternative investment funds. And specifically with private alternatives funds, managers source their investments from their network of connections within the industry such that the best deals go to a handful of top managers in the space. This can result in performance persistence for these top managers (i.e. the top performing managers one year tending to remain the top performing managers in the year ahead), while performance for those managers outside of this group can be lackluster. This means having access to the top performing private asset managers is critical for success when investing in private alternatives.

Access

Some alternative investment funds, specifically those of the private variety, can be more difficult to access since investors must meet certain net worth and/or income requirements to invest in them. Also, some funds can be unavailable to buy and sell through retail brokerage accounts. Fortunately, these barriers to entry have been declining more recently.

Illiquidity

Some alternative investment funds have limited liquidity as the underlying investments in the funds are not liquid themselves. This, in fact, can lead to an illiquidity premium, as an investor is compensated for tying up their assets for a period of time. However knowing whether a specific alternative investment is liquid or not at the onset helps manage expectations once it is added to a portfolio.

Challenges with Investing in Alternative Investments

Investors are faced with a wide range of choices as well as added layers of complexity and fees when deciding to add alternative investments to their portfolio. On top of that, deciding how to size your allocation to alternatives is an important part of the process, too. This is why for decades, alternative investments have mostly been utilized by sophisticated or institutional investors like endowments and pension funds. Fortunately, the transparency around alternatives has been increasing lately while barriers to entry have been decreasing, making now a great time for investors to consider adding alternatives to their portfolio.

Taking the Next Step into Investing in Alternative Investments

Adding the right alternatives to the traditional 60-40 mix of stocks and bonds can add significant value by filling in the gaps in an investor’s portfolio that may have previously gone unnoticed. There are challenges with adding alternatives to a portfolio, however it is now more possible than ever for investors to gain the benefits of alternatives investments.

Reach out to us to learn more.