Professional investors face a daunting challenge: how to generate real returns sufficient to meet the needs of clients over the next decade or so, while protecting against the inevitability of bear markets and black swans. We believe that this will be the defining challenge for the advisory industry over the next decade, and it won't be easy to overcome.
To understand the extent of the dilemma, we need to travel back to September 1981, which marked an inflection point that has had lasting repercussions for financial markets. Take a moment and try to identify that event from the following list of actual occurrences:
The USDA issued proposed regulations — quickly withdrawn — classifying both ketchup and pickle relish as vegetables for the purposes of defining a balanced meal for the school lunch program.
Sandra Day O’Connor's appointment to the Supreme Court was confirmed by the Senate, 99-0.
Home Depot went public.
The United States’ debt ceiling was raised to $1 trillion (it now stands just shy of $20 trillion).
The yield on the 10-year Treasury peaked at 15.3% (using month-end data).
With all due respect to the lobbying efforts of the condiment industry, Justice O’Connor's shattering of a major glass ceiling, the impact that Home Depot has had on our Saturdays and the true grit that our national debt has shown in overcoming all obstacles placed in its path, it was the peak in yields that truly changed the decades to come for investors.
Since that time, the tailwind of declining rates helped U.S. stocks generate a return of 11.4% per year based on the Russell Index from September 1981 through August 2017, and propelled U.S. bonds to an 8.2% annual return, based on the Bloomberg Barclays US Aggregate Bond Index over the same period.
With inflation running at only 2.8%, real returns have been rather spectacular. In fact, a 60/40 balanced portfolio would have annualized at 10.5% nominal or 7.7% real return; those were indeed the days.
But investing is always a forward-looking endeavor, and the future isn't so bright. The yield on the 10-year stood at 2.12% at the end of August, and the cyclically adjusted price-to-earnings ratio for U.S. stocks hovered around 30 (compared to only 7.5 in September 1981).
A survey of capital market assumptions from the likes of GMO, Research Affiliates, AQR, BlackRock, and JPMorgan, along with our own estimates, suggests that U.S. bond investors can expect to earn about 0.1% real, and U.S. stock investors shouldn't expect much more than 1.5% real over the next 5-10 years. And that 60/40 balanced portfolio? About 1% after inflation. Not exactly the ingredients for satisfied clients.
Institutional investors are acutely aware of this problem. To meet their long-term return assumptions of about 7.6% on average (an almost impossible goal), state and local pensions have dramatically shifted their asset allocations.
Over the last decade, according to the Center for Retirement Research at Boston College, public pension plans have increased their alternative investment allocations from 6.9% in 2007 to 17.6% in 2016. Foundations and endowments have gone much further, with allocations to alternatives reaching 55%, according to a 2016 NACUBO-Commonfund Study of Endowments. (NACUBO stands for the National Association of College and University Business Officers; Commonfund is an independent non-profit asset management firm.)
But as we speak with advisors about these issues, suggesting that they too should be making major allocation changes to combat the problem, we know that effecting change will be difficult. The performance of cheap beta products has been fantastic post-financial crisis, and there is a pervading sense of “if it ain't broke, don't fix it.”
On top of that, there are widespread misconceptions about the definition of alternatives, the expectations for alts, how to educate clients about these strategies and how to incorporate them into a portfolio of diversified assets.
Where does the confusion around “alternatives” come from? If you Google “alternative investments” the first unpaid listing defines them as, “An alternative investment is an asset that is not one of the conventional investment types, such as stocks, bonds and cash.”
This belief is pervasive, and completely wrong. The explanation further goes on to say that, “Alternative investments include private equity, hedge funds, managed futures, real estate, commodities and derivatives contracts.”
The problem is that asset classes, vehicles, and strategies are all being confused. Asset classes are what you invest in, and at the most basic level, there are only four: equity, debt, commodities and currencies.
Vehicles, for example, mutual funds, ETFs or hedge funds/LPs, are the legal structures. Strategies consist of the ways in which you invest in asset classes within a legal structure.
If we break down what the definition labels as “alternative” using this framework, we can see that:
Private equity = equity = asset class (yes, there is a liquidity premium, but that apparent correlation benefit is illusory)
Hedge funds = vehicles
Managed futures = strategy
Real Estate = equity = asset class (publicly traded REITs are already included in the S&P 500, the Russell 2000, etc., and private real estate is to REITs what private equity is to public equity)
Commodities = asset classes
Derivative contracts = instruments tied to asset classes, strategies or securities
We believe that alternatives are neither defined at the asset class level, nor at the vehicle level, but rather, at the strategy level. Alternatives such as long/short equity, managed futures or global macro, are simply different ways to invest in equities, debt, commodities and currencies.
They have the flexibility to go long or short, they may employ leverage, and they may gain exposure to these asset classes using derivatives, but at the end of the day, investors in alternative strategies have exposure to equities, debt, commodities and currencies. Those asset classes are just mixed in different proportions, with varying directional exposures, to expand the opportunity set and to fine tune risk.
Does it really matter what we call these things? If investors focus on the risk exposure that each investment contributes to the portfolio, then no, it doesn't matter. But too often, we find that investors do make decisions based on labels, and they frequently compartmentalize their decisions, with asset allocation and manager selection occurring in isolation.
For example, if the asset allocation process dictates a portfolio that is 55% equity, 20% fixed income and 25% alternatives, and then the alternatives sleeve is filled with REITs, MLPs, BDCs, private equity and long/short equity, the risk exposure will be substantially similar to an 80% equity/20% fixed portfolio. Remember even true alternatives, like long/short equity, must be thought of in terms of the risk exposures that they introduce, and not the category under which they are assigned.
Our industry doesn't do itself any favors when even publications dedicated to alternatives routinely put out headlines like, “Hedge Funds Underperformed the S&P in the Second Quarter.”
Of what relevance is the performance of the S&P 500 to a market-neutral strategy or a fixed income arbitrage strategy? And doesn't it reinforce the mistaken idea that these disparate strategies are trying to beat the S&P 500?
All returns come from bearing risk in some form, so how well a strategy performs must be measured against the risks prevalent within the portfolio. Broad comparisons to U.S. equities set incorrect expectations for investors.
Most alternative strategies attempt to generate unique sources of alpha; they try to manufacture returns with low correlations to traditional asset classes and with less volatility; they aim to provide downside protection when markets take a turn for the worse. Few alternative strategies explicitly attempt to outperform the S&P 500.
We’ve observed that investors think in relative terms when equities are rising and in absolute terms when equities are falling, which is a bar that is all but impossible to reach, let alone exceed.
What are proper expectations for alternatives? We aren't trying to punt on this, but the reality is, that it's impossible to say without identifying the specific strategy being employed and the accompanying risk exposures, and there are far too many combinations to consider here.
But on a related note, since we began by laying out the problem of a low return environment, we need to be clear that merely incorporating all things alternatives likely won't solve the problem. However, if selected properly, adding alternatives could meaningfully reduce the prospects of a big loss, which is of great importance in the math of compounding, and could add differentiated sources of return that could improve upon the results.
Admittedly, it is unlikely that alts will transform that 1% real return expectation for a 60/40 portfolio into anything close to the historic average. We are talking improvement at the margin, not miracles, but every basis point will count going forward.
We certainly believe that part of our job is to educate clients about the strategies that we run, and the more transparency and insight we provide, the greater the confidence they will have in us. The same is true, of course, for advisors in their client interactions.
But while keeping clients informed is important, the difficulty of that task can't be allowed to alter the appropriate solution.
Think about it in terms of other professions. Doctors, lawyers and accountants all proceed with the end in mind. Cure cancer. Win the lawsuit. Reduce the tax liability.
Outcome is what matters to all of them. And while they may attempt to provide some education about the treatment or approach, they certainly don't let the complexity therein dictate their course of action. They do what they need to do to achieve the best outcome for the client.
The sum of the parts, not the individual pieces, is what ultimately matters. Clients may be intellectually curious about the components, but they task advisors with meeting some sort of goal, and if their need for information is incongruent with meeting those goals, then education becomes not a help, but a hindrance.
The focus must be on the total portfolio and on outcome. Change the conversation to focus on outcome, and you just might find that the need to explain the intricacies of a market neutral strategy, for example, cease to exist.
Portfolios & Outcomes
To determine how to select and use alternatives in a portfolio, investors must start with the end in mind.
What are you trying to accomplish at the total portfolio level? Only by defining the goal can you determine which tools are most appropriate for the job. What risks are you willing to bear, or not, and what are the associated costs with enhancing, reducing or eliminating those risks?
Are you looking for something that can provide crisis alpha in a market crash or prolonged down trend? Or maybe something that counters duration or credit risk elsewhere in the portfolio?
Perhaps something that improves upon the paltry returns offered today by investment grade debt without taking on additional equity risk? Maybe you simply want to add an asset that has an attractive risk-adjusted return profile that is uncorrelated to stocks and bonds?
This is such a voluminous topic that we can't begin to do it justice here, but the goal defines the tool, and the tool must be viewed from the vantage point of how it interacts with the other portfolio components.
Don't Be Left Behind
Balancing risk against the opportunity cost of being left behind is always a tough call. Fundamentals and valuation levels are rarely, if ever, good short-term market indicators.
But they do provide great insight in terms of what a reasonable longer-term payoff to any particular asset should be. Today, valuation metrics portend less than rosy returns from here.
In a period when many advisors have expressed deep frustration with the inability of a diversified portfolio to keep up with U.S. equities, it's worth remembering that over the short to medium term, we are all at the mercy of what the market delivers in terms of return; that can't be controlled.
But risk can and must be managed to a level consistent with the goals of the client, as anticipating rogue waves of volatility in an otherwise artificially calm sea is all but impossible; protection from adverse market events needs to be in place prior to volatility spikes to be effective.
Admittedly, there aren't many places to look to fulfill the competing goals of improving upon return, while properly managing duration, credit, inflation and equity risk, to name a few. But alternative strategies must receive serious consideration.