If you’ve ever watched the races at Le Mans — or Indianapolis, for that matter — one thing you don’t see is the safety features built into the cars. Race car drivers go fast, but they are among the most safety-conscious drivers in the world. Many of the lifesaving features in the car you drive home come from the world of racing.
The past decade has been particularly good for stocks. The S&P 500 index has sped along at a 14.3% annual pace from January 2009 to September 2019 — approximately 45% faster than the long-term average since 1970. At the same time, the S&P 500’s volatility of 13.7% has been nearly 10% lower than the long-term average of 15.4%, thanks in part to the Federal Reserve’s ongoing monetary accommodations.
Stock returns generally revert to their long-term averages, and we don’t expect the stock market to continue at this accelerated pace with decelerated volatility. With more than $15 trillion of negative yielding corporate and government debt outstanding, it’s not going to be easy to make money with a traditional asset allocation.
Typically, we see that many investors are improperly allocated to alternatives. Adding an appropriate allocation of alternatives, consisting of equal parts private equity, private credit, real estate and hedge funds, to a traditional 60/40 portfolio mix of stocks and bonds can potentially improve returns while reducing volatility. One reason is that some alternatives, such as real estate, don’t necessarily respond to the economy the same way the stock market does. They can zig when the S&P 500 zags.
This potential improvement may also be partially explained by the illiquidity premium. Liquidity is the ability to sell an investment quickly. Investors normally get a lower rate of return by cashing in investments in an instant. Long-term investors get a premium for investments with less liquidity, and alternatives can help capture that premium for them.