In the face of unpredictable natural disasters, building engineering has come a long way. The industry’s progression offers examples that are instructive for our own portfolios: be patient, stay diligent and try to account for every scenario because disasters can, and do, occur.
Construction in earthquake-prone areas serves as an example. Engineers in such areas use steel-reinforced concrete with precise manufacturing requirements so the building will bend and sway when the ground shakes, not topple the way brittle structures would. An earthquake’s lateral movements also put more strain on the corners or joints of a building, so manufacturers take extra steps to reinforce masonry joints so the building acts as a single unit, transferring an earthquake’s forces from one section to the next.
Such innovations take more time, and admittedly, more money. Adding steel to the concrete increases the building cost, for example. It’s a lot of extra effort when an earthquake may not have struck a city for decades and may not strike again for years to come. But building owners are playing the long game; the extra effort means a lot in the worst environments.
The same thinking is applicable to our investment portfolios. Like constructing a building, it’s important to build client portfolios that can withstand all types of environments, because we never know when a disaster may strike. When events haven’t been disastrous for a long while — and in financial markets they haven’t — it’s easy to forget the importance of diligent preparation.
Alternatives are supposed to provide ballast to portfolios during market upheaval, but in the past decade clients simply haven’t needed them. Recent volatility aside, the climate within financial markets has been ideal. From March 2009 (the beginning of the market rebound after the financial crisis) through September 2018, the S&P 500 has outperformed a broad basket of alternatives by more than 1,000 basis points and a 60/40 mix of stocks and bonds has outperformed an alternatives basket by nearly 500 basis points. (An alternatives “basket includes the average of arbitrage, managed futures, long/short equity, macro, multi-strategy, relative value, fixed income hedge,” according to EurekaHedge.com).
Thus, investors wouldn’t have just been “safe” without alternatives, they’d have been better off.
Given the last 10 years’ performance, we empathize with investors’ frustration over alternatives, but environments are rarely this good for traditional investments. Stocks have enjoyed nearly twice their average return over the last decade and with a lot less volatility. At the same time, bonds have benefited as rates fell and remained historically low.
Take a step back from one of the most sanguine market climates in history, however, and one sees the benefits of portfolio construction that prepares for a market crisis. From the beginning of 2000 through February 2009, two major downturns struck financial markets. In that period, the same basket of alternatives returned 9.89%, much better than -5.63% returns from the S&P 500 or 6.11% from the Barclays Capital Aggregate Bond Index.
Putting both periods together, an investor would still have been well served by the protection alternatives offer. From the beginning of 2000 through September 2018, the annualized return of the alternatives basket (8.66%) outperformed the S&P 500 Index (5.75%) and the Barclays Capital Aggregate Bond Index (4.82%).
It also did so with much less volatility than equities. The standard deviation of the alternatives basket was less than half the S&P 500 during the period. Alternatives acted like steel-reinforced concrete in a building, helping the portfolio bend but not break.
As alternatives managers, we understand the last decade has been frustrating for advisors to explain the rationale for holding alternatives. But preparing for uncertainty is smart construction. We don’t know when things will change, but we do know that things will change and yields, growth rates, debt, central banks and politics eventually do matter. The best thing you can do for your clients is to construct a portfolio that’s designed to withstand the unpredictable nature of what the next 10 years might bring.
Andrea Coleman, CAIA, is a Director at 361 Capital.