Do Alternatives Really Boost Portfolio Performance?

Morningstar research shows ETF-managed portfolios emphasizing alts are not strong performers

Arguments over the importance of alternative investments in the average investor’s portfolio continue. Meanwhile, their results when incorporated into ETF-managed portfolios are not keeping up with more traditional portfolios, according to a new Morningstar study.  

Emory University's professor Klaas Baks recently argued in favor of including alternatives and cited the usual benefits: “diversification, a wider set of investment opportunities and access to leverage,” Baks says in the Wall Street Journal.

Financial advisor George Papadopoulos, though, argued against alternatives.

“Exotic assets may make a portfolio seem a lot sexier, but they may not get it to perform better over the long term. Factor in risks and expenses, and alternative investments just aren't worth the trouble,” Papadopoulos explained in the piece.

Jeremy Radcliffe, president of the asset management firm Salient Partners in Houston, has a more nuanced take on the debate. (Salient manages multiple alternative-asset funds, including those focused on master limited partnerships, or MLPs.)

Many investors have pursued alternative strategies that “have been too fee-laden or too beta-laden or without enough volatility to make a difference in their portfolio,” Radcliffe stated. He cites some long/short equity strategies and hedge-fund strategies that don’t make sense, at least not in the structures in which they’re being offered.

Q1’14 Analysis  

Morningstar analysts, led by Ling-Wei Hew, just put out a report that looks at managed ETF portfolios, including those that emphasize alternatives, and their first-quarter returns.

The research group defines alternative strategies as those that seek returns uncorrelated to equities and bonds by removing an asset class to shift beta or otherwise shift the impact of a return driver – such as long/short funds.

Such ETF-based alternative products had a big jump in assets in the first three months of 2014, rising by $61.5 million to a total of $368.1 million, Morningstar says.

This group of managed-ETF portfolios represents a fast-growing but still limited product group. Overall, investors have some $103 billion of assets into managed-ETF products portfolios.

As for results, global-alternative ETF portfolios produced median losses of 7.07% on a one-year basis as of March 31. Their three-year results were a positive 0.42%, while their five-year returns were 4.39%.

In contrast, global-asset ETF portfolios had one-year results of 6.63%, three-year returns of 5.62% and a five-year performance of 10.66%. (All figures represent the median or midpoint of returns, rather than a numeric average.)

Further Issues

Alternatives’ low correlation is still a valuable benefit, Radcliffe maintains, but investors should realize that strategies’ correlations could vary in different market environments. For instance, some strategies with low historical correlations become more positively correlated with equities when market volatility spikes.

The Salient executive calls these “convergent” strategies and considers them to be readily available; examples include momentum trades for equities, currencies and commodities, and carry trades in commodities, currencies and volatility. (Carry trades take long positions in high-yield assets and short positions in low-yield assets within the same asset class.)

In contrast, “divergent” strategies tend to become negatively correlated to equities when volatility increases. These can include trend investments (i.e., directional plays); long/short positions on equity values, and commodity carry trades.

There are fewer divergent strategies available, Radcliffe says, but having both convergent and divergent strategies in the portfolio can result in more balanced overall returns. It’s also important for the alternatives’ returns be sufficiently volatile to make a difference in a portfolio, he adds.

Evaluating alternatives in terms of fees, divergence and volatility increases the likelihood that investors will receive the desired results, according to Salient leader.

“Then alternatives absolutely can be additive to portfolios that can help protect from market drawdowns and just build a more resilient portfolio that’s going to do well in different economic environments,” he explained.

“But I think the investors should be choosey about the types of alternative strategies that they pursue,” stressed Radcliffe. “They really should try to identify what strategies are just beta that are dressed up maybe with some higher fees vs. what strategies are actually diversifying and appropriately priced.”

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 Janet Levaux contributed to this report.

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