Alternatives are often a source of confusion for our clients and the investing public, and with good reason: there is no uniform standard for the definition of an alternative, and there is no investable benchmark to represent the asset class.
How to Define Alternatives
If there is one thing everyone can agree on, it is that “alternatives” are not old-fashioned stocks (think S&P 500) or old-fashioned bonds (think treasuries, high grade corporates, and the Barclays Aggregate index). I consider this the “smell test definition” – does it smell and taste like a stock or a bond? If not, it’s an alternative. This is oversimplified, but it’s a decent starting point – it highlights the reason for owning alternatives: to own different types of investments and diversify your portfolio. Successful diversification is defined by achieving your desired results with the smoothest ride possible. (This is not the same as achieving high returns with a smooth ride, which is impossible.)
The smell test definition, despite good intentions, is flawed. Consider a balanced fund that always invests in 50% stocks and 50% bonds in the same fund. This would seem meet the smell test criteria, however should not be considered an alternative. This is just a simple way of obtaining the two primary asset classes in one purchase, but it does not add any diversification to a portfolio that already owns stocks and bonds.
Wealthspire Advisors classifies alternatives as asset classes or strategies that over the medium to longer term will exhibit low/no correlation to U.S. equity markets (S&P 500) as well as to U.S. interest rates (Barclay’s U.S. Aggregate). This builds on the smell test definition using investment concepts from Modern Portfolio Theory. In the example above, a fund with 50% stocks and 50% bonds will be very highly correlated (above 0.9 out of 1) with stocks, because the much higher volatility of stocks will drive the returns of this fund. Thus, it fails our alternative definition test.
No/low correlation means no predictive power between how stocks and interest rates do vs. the performance of alternatives. Alternatives are not hedges that shine only when stock or bond markets do poorly – that is “inverse” correlation and represents a form of predictive power. Instead, consider alternatives as a separate stream of returns that moves in a distinct path from the rest of the portfolio.
How Much Should be Invested in Alternatives?
We are not believers in a specific, optimal percentage allocation. Relying on quantitative tools to come up with a “number” has multiple flaws:
- There is no uniform methodology to represent alternatives in such an analysis.
- Most analyses will use different time periods and methodologies, and are entirely backward looking.
- Alternatives can be funded from different sources; 15% alternatives funded entirely from fixed income leads to different outcomes than if 10% is taken from fixed income and 5% from equity.
Instead, we prefer to think about an acceptable range of exposure to alternatives. Allocations below the range generally fail to make a material impact on reducing risk. An overly large allocation to alternatives may not be “bad” in its own right, however it will create a lot of tracking error vs. the standard benchmarks and periods where returns are significantly lower as a result, especially during bull markets.
We believe the lower bound of allocation to alternatives is 10%. Below that level, alternatives have limited impact on the portfolio. The high boundary of alternative exposure isn’t a question of right or wrong, but more of client preferences and the goal of the exposure. If the goal is to reduce risk without a material impact on absolute performance, then we believe 20% is a reasonable upper bound. However, if the goal is solely to improve risk-adjusted returns via reduced volatility, or to diversify away as much equity and interest rate risk as possible (for example, if such risks are highly present in your life in other ways), with a willingness to accept both reduced absolute returns and significant tracking error vs. common benchmarks, then the upper bound of alternatives can be quite high.
Finally, the source of funding is critical: funding with fixed income will not necessarily reduce volatility but may increase returns, while using only equity to fund alternatives will absolutely reduce volatility, but at a significant cost of absolute returns.
- The decision to invest, and how to invest, in alternatives is quite different for individuals vs. institutional investors, more so than in standard equity and bond investing.
- We define alternatives as investments with low/no correlation to U.S. interest rates and equity markets. As you research alternatives, you must always examine how the research has defined the asset class, as it varies greatly by source.
- We believe that alternatives deserve a strategic, long-term allocation in a diversified portfolio, but they can be used for different purposes. Wealthspire Advisors holds alternatives to diversify and therefore improve the risk-adjusted returns of the portfolio; as compared to a portfolio with no alternatives, our target is a reduction in risk for a similar or better return, rather than an increase in return for a similar amount of risk.
- We believe that an appropriate allocation for alternatives, for most individual investors, is 10-20%. Below 10%, the alternatives have little impact. Above 20% is acceptable as long as the investor is comfortable with increased tracking error from standard benchmarks, and has a large percentage of their worth in tax-advantaged vehicles. Alternatives are generally tax inefficient and therefore become less attractive in taxable accounts for individuals in high tax-brackets.
- In order to reach the above goal, we fund alternatives from both equity and long-only fixed income allocations. Funding from only equity has been shown to reduce volatility but often at the expense of absolute returns, while funding from only fixed income has been shown to often increase volatility, but with mixed results in increasing returns.
For more information or if you have any questions, please reach out to your advisor.