December 6, 2016
No one knows for certain what’s going to be the best investment allocation over the coming months, years, or decades; however, striving to build the most diversified portfolio possible is the best option for tilting the odds in your favor to maximize your risk-adjusted returns. A simple 60/40 portfolio allocation (60% stocks & 40% bonds) may have ‘worked’ in the past, but there were times when the 60/40 portfolio really struggled, experiencing outsized volatility and major drawdowns. The major benefit of investing in a combination of stocks and bonds is primarily due to the historically low correlation between these two asset classes. All else equal, the less correlated each asset is with the others in the portfolio, the better, because poor performance of one asset can be offset by another asset that acts differently during periods of stress. It’s generally accepted that when stocks ‘zig’, bonds usually ‘zag’ to help offset the drawdown so the portfolio can hopefully benefit more from compounding returns during positive periods. This may be true over very long periods of time, since the correlation of US large cap stocks to government bonds over the last 90 years has been roughly 0.08, but over shorter periods of time the correlation between stocks and bonds can vary wildly, seen in the chart below.
If you were an investor who started investing in the 1970s, you might think that investing is a cake walk and that all you have to do is put a chunk of your money in the S&P 500 and another chunk in a US aggregate bond fund to achieve spectacular returns. Stocks have seen massive returns over that period, and bonds have also been in a 40 year bull market as well. With both asset classes having performed so well in recent decades leading up to today, it begs the question whether either stocks or bonds will be able to continue their upward climb in the coming years. Many investors simply expect returns on both equities and bonds to continue in future years as they have for the past few decades, but chances of that may be slim to say the least. The previous chart shows how much the correlation between stocks and bonds can vary in the short-term, illustrating the point that a lack of correlation between stocks and bonds can’t be heavily relied upon during all future market environments. If we experience an equity bear market in the near future, there’s a distinct possibility that investors might not see their bonds benefiting as they once did during previous market crashes.
To put it lightly, equity valuations are stretched, suggesting low future returns over the next decade. Looking at the graph below, starting values for the three long-term valuation metrics (Buffett Indicator, Q Ratio, & CAPE Ratio) have a lot of predictability when it comes to equity returns over the next ten years. All three valuation metrics suggest that domestic equities are at least a full standard deviation, if not two full standard deviations, above the mean valuation. In the past, these elevated valuation level has resulted in mediocre equity returns, suggesting a real return for domestic equities of roughly 0% over the coming decade. Yes, you’re likely to get no real return on your money (after accounting for inflation), even if you take on equity risk by holding the S&P 500. Ben Inker of GMO LLC makes the strong case in GMO’s Q3 2016 quarterly letter that one of two scenarios will play out in the coming years: either equities will see a significant bear market before resuming an upward climb, or equity prices will remain elevated in the long-term and equities will simply experience muted returns in coming years. No one knows which scenario will play out, but either investors will have to be content with lower returns in the coming years, or they’ll have to look to additional sources of return within their portfolios.
In addition to poor future equity returns, it’s unlikely that investors will be able to rely on bonds to boost investment returns. Bond yields are about as low as they’ve ever been, suggesting very low returns in future years. We all know that yields and bond prices are inverse – for instance, a falling interest rate will result in higher prices for comparable bonds that have the same maturity and promise a higher rate of interest. However, interest rate changes have the biggest effects in the short-term, especially if investors are trading bonds. On the other hand, returns over the long-term are much more predictable for bonds. Probably the best indicator for long-term future expected bond returns is the starting yield on those bonds. This makes sense, because if a Treasury promises to pay 5% interest until maturity, it’s assumed that there’s no default risk and the investor will receive all the payments as promised. Reinvestment risk is the only major concern over that coming years, because if rates fall further, the investor will have to reinvest the periodic interest payments at lower rates of return in order to stay fully invested. Understanding how strong of a predictor the starting yield is on future returns, investors need to take note of the currently low starting yields (10 yr Treasury at 2.31% as of writing) and prepare themselves for low returns in the coming years. There’s a chance that investors could still flood into Treasuries as a safe haven in the event of a broad equity selloff; however, it’s unclear how much lower yields can actually go from here.
With the grim outlook for both stocks and bonds over the course of the coming decade, investors should consider whether the traditional 60/40 portfolio will be able to meet their required rate of return as it once did. At the very least, they should be considering the benefits of diversifying into other asset classes to help reduce potential drawdowns in their portfolio value if equities and bonds don’t provide the diversification benefits of low correlation in future years. In a potentially worst case scenario when both equities and bonds experience bear markets at the exact same time, investors would clearly benefit from holding other asset classes as an alternative to equities and bonds. Traditionally, there have been only three major asset classes within investor portfolios: stocks/equities, bonds/fixed income, and cash/money markets. Investment professionals have recently become more widely accepting of other additional asset classes, such as commodities, real estate, and various alternative strategies. By recognizing that there are more than just the three asset classes available to investors for building more diversified portfolios, investment professionals are better able to help their clients achieve their financial goals in the future without taking on unnecessary risk.
The lack of correlation between these alternative asset classes and equities or bonds results in the ability to generate positive returns regardless of how equities or bonds are doing. Some of the more mainstream allocations that investors make to alternative asset classes are through REITs (Real Estate Investment Trusts), MLPs, and commodities. While I think it’s a step in the right direction of creating a globally diversified portfolio with at least some exposure to each of these, investors need to be careful by acknowledging that there are periods of time when these ‘mainstream alternatives’ can become highly correlated with equities and fixed income, especially if they’re representing the exposure through a fund that invests in companies/equities to achieve the targeted exposure. For instance, by investing in companies with commodity specific market segments in order to get the commodity exposure, the investor would be taking on equity risk in the process. This raises the important question of knowing what the key drivers of performance are for each asset class, so that investors can look to diversify their portfolios across truly different performance drivers or factors. If economic strength, starting valuations, and interest rates are the main drivers of performance for equities and bonds, and they’re also among the main drivers for these ‘mainstream alternatives’, investors would experience the largest benefits from adding other investments that don’t heavily rely on economic strength, low starting valuations, and falling interest rates. Low real returns are expected across the board for most asset classes, according to the most recent 7 year real return projection from Research Affiliates. GMO’s 10 year real return projections, which have proven to be remarkably accurate over the past 20 years, tell an even tougher story to stomach. These return predictions from RA and GMO can be seen in the following chart:
Whether it’s to reduce the risk of experiencing larger drawdowns or an attempt to add investments that could produce superior returns over the course of the coming years, there’s still plenty of room for further diversification into truly unique trading strategies. My view is that the true ‘alternatives’ are found in the following investing or trading strategies:
Each of the previously mentioned alternative strategies are rooted in academic research and have been shown to have unique drivers of performance, allowing them to profit whether equities or bonds are doing well. The unique opportunity set of these alternative strategies is largely due to a variety of market inefficiencies that often stem from behavioral biases, which are now being studied much more closely through the emerging field of Behavioral Finance. Although much can be written on the topics of our innate behavioral biases and how each unique alternative investment strategy is enabled, I will save specific discussions about the intricacies of each strategy for future blog posts.
Although I will address the specific characteristics of each of these alternative fund categories in more detail in the coming posts, there are some high level characteristics that really set them apart from most widely used equity or bond mutual funds and ETFs. On one hand, it’s been great to see the growing popularity of these alternative products in mutual fund form, because they have traditionally been available only to accredited investors through hedge funds that manage money through separately managed accounts or limited partnerships. For the vast majority of investors with less than $10 million to invest, it has been hard/impossible to initially access many of these specialized strategies without running into issues of minimum investment mandates, illiquidity when clients need access to funds, or excessively high fees.
In the past, it wasn’t uncommon for those who wanted access to these alternative products to invest through a separately managed account or limited partnership structure with a hedge fund that charged “2 and 20” (a.k.a. excessive fees, usually 2% of assets under management and 20% of any profits generated) and locked up the investor money for years with limited periods & amounts of liquidity. Especially given that the average minimum investment in a private hedge fund is between $500k and $1 million, and often much higher for top tier hedge funds according to Forbes, diversifying investible assets among multiple of these expensive, illiquid, alternative strategies was undesirable, if not downright impossible, for investors with less than $10 million!
Fortunately, the recent demand for these alternative products has resulted in more mutual fund versions of these previously inaccessible investment strategies, with the most liquid versions of the alternative strategies coming to market in mutual fund form first – often called liquid alternatives or liquid alts for short. Fortunately, investors have been demanding that the fee structure come down from the previous “2 & 20” fee structure, but these liquid alts mutual funds aren’t cheap by any means. A recent Morningstar survey still found the fees on alternative funds to be more than twice as expensive as U.S. Equity funds. In many instances, investment firms are using the funds they generate from higher expense ratios to plow back into researching their strategies and developing better signals or processes for executing trades to reduce slippage – a major problem for funds with high turnover and a large amount of assets under management. When examining fees on liquid alts funds, you’ll ultimately have to determine whether the fund is worth the fee on a case by case basis.
A word of caution when considering fees for liquid alts funds: Many of these liquid alternative funds charge unreasonably excessive fees for either proprietary strategies with no academic support to suggest that their fund is better than their peers, or worse, no evidence that it’s even a repeatable premium that can be captured in the future. For instance, I have encountered problems when some of the funds charge high fees and try to justify them by saying that their fund provides a “more sophisticated process” than their competitor, but there’s often no way of proving whether one systematic black box strategy is better than another systematic black box strategy because neither investment manager will disclose their special sauce to the world (in fear of being replicated). Take trend following managed futures strategies for example. If you’re looking to add a trend following fund to your portfolio, it’s probably best to just assemble a list of all trend following funds that broadly meet your required criteria (i.e. intermediate & long-term trend following, diverse set of investible asset classes, and a history of successfully implementing the trend following strategy over the past decade) and simply pick the fund with the lowest expense ratio. Trend following is probably the easiest example for comparison, but you might have a harder time picking the appropriate funds when considering the other alternative investment strategy options, especially if there may only be one or two investible liquid options available for investors. To be clear, the most important consideration when picking an alternative fund is understanding the options completely and finding the fund or group of funds that achieve your desired exposure; then finally further narrow down the list by selecting the one with the cheapest expense ratio.
In addition to the previously listed types of unique alternative investment strategies available to investors, investors should also be aware of one additional group of liquid alternative mutual funds often referenced as multi-strategy alternative, or either multi-strat or multi-alternative for short. This group of multi-alternative funds acts as a fund of funds in which one manager invests in multiple other funds. There are some potential benefits and drawbacks to using one of these multi-alternative funds. They offer the ease of implementation for investors who only want to purchase a single mutual fund to get a diversified allocation to alternatives within their portfolio, and they suggest that the overseeing manager can spend more time and resources on selecting the best underlying fund managers and determining the appropriate allocations to each underlying fund. With that said, the biggest benefits that I see in combining multiple strategies (that either already do or could potentially stand alone) is that it can potentially take some liquidity pressures off of the underlying fund managers who might otherwise experience massive outflows or inflows during periods of weak or strong strategy performance. Performance chasing is prevalent across all major asset classes and has been shown to have clear negative effects on the investors’ experience, so there’s no reason not to expect investors to chase performance when it comes to alternatives that they are likely to understand even less than mainstream stocks and bonds. As long as the multi-alternative fund does a good job of matching different underlying fund strategies together that are uncorrelated and produce a less volatile return stream, it should help deter massive swings in performance that are experienced with each underlying strategy, effectively helping to reduce some of performance chasing. The only guarantee that any investor can make is that every investment strategy will inevitably go through difficult periods of poor returns. It’s often very difficult avoiding performance chasing within alternative strategies as investors see a short period of under/out-performance that isn’t intuitively explainable within some of these black box strategies, so sometimes it can really be beneficial to hold a multi-alternative fund that doesn’t outwardly show the performance of each unique underlying strategy at first glance.
Having given a few of the major potential benefits of using a multi-alternative strategy within your portfolio allocation to alternatives, most of these multi-alternative funds are simply way too expensive. With investors in these funds now paying for an additional layer of fees for the top level management (plus the already relatively high priced underlying strategies), should hint at the fact that these multi-alternative funds are some of the most expensive liquid investments available. It seems like robbery that most of these funds charge over 2%, and many even over 3%, annually for underlying strategies that are often only expected to generate 5-8% returns…factoring in a 3% inflation rate over time, there’s little profit left for investors! Additionally, my personal preference is to have complete control over exposures to each alternative strategy within my portfolio, and it’s no secret that allowing some other manager to make allocation decisions for me severely limits my ability to tailor my overall portfolio to my needs and views. Because of the realization that it’s often not worth paying for the top layer of fees for the overseeing fund manager’s due diligence on the underlying alternative fund managers, as well as the lack of customization within my portfolio, I find that there are only a few instances that warrant investing in multi-alternative funds (e.g. potentially bundling multiple different arbitrage strategies into one fund…more on this in a later blog post); the vast majority of alternatives exposure can be accomplished successfully with mutual funds that give access to a single liquid alternative strategy.
Considering how much of the total portfolio is appropriate to allocate to various alternative strategies is more art than science, but most advisors and academics agree that a minimum of 20% is needed to notice the benefits that alternatives provide. A fantastic piece by Equinox Funds, titled Allocating to “Liquid Alternatives”, made the clear case that it pretty much didn’t matter which of the nine various “managed futures” funds an investor added to their 60/40 portfolio over the past 8 years – just simply adding an allocation to any of them actually improved the Sharpe Ratio of the portfolio, reducing risk and often improving returns. Considering that adding alternatives was beneficial during that period, mostly due to reducing the drawdown of the portfolio in 2008, it makes a very strong case for including an outsized allocation to alternatives at present time, when that same 60/40 portfolio will no longer be expected to return anywhere close to 6% over the next 7-10 years. I don’t think there necessarily has to be an upper limit on how much to allocate to alternative strategies within the portfolio, though a prudent investor should probably hold at least a small allocation to each investible asset class within their portfolio. Take Meb Faber for instance; he takes a very academic approach to investing his assets and has produced a ton of research on building globally diversified portfolios. He finds it appropriate to hold 45% in tactical or trend following strategies, with the remainder in a mix of long-only stocks and bonds where he further seeks to optimize diversification. A portfolio allocation of 45% may or may not be the ‘right’ allocation to alternatives; it all depends on what your expectations are for your portfolio and your risk/return projections for the various investible asset groups. However, hopefully one thing has become abundantly clear: Liquid alternative investments deserve a sizeable allocation within every investor’s portfolio as part of a long-term approach to reducing risk and improving returns.
June 29, 2018