Alternatives Make Your Investment Portfolio Ride More Comfortable
How alts can help smooth out the bumps caused by market volatility.
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.
The S&P 500 index has been increasing at an average 9.7% a year since 1970, but with some very big bumps along the way. Alternatives may add diversification and performance to a portfolio over the long haul. These investments don’t necessarily turn in the same direction as stocks, bonds and cash, the traditional holdings for most portfolios.
The alternative investments that are commonly used include:
- Private equity, which are investments in private companies of various sizes where the sponsor’s focus is on achieving absolute returns through active operational improvements and financial restructuring.
- Private credit, which are loans to private companies and distressed situations resulting from capital dislocations, with a goal of improving overall diversification while offering income opportunities.
- Real estate, typically investments that include commercial and residential property types that seek to generate income and capital appreciation while providing inflation protection.
- Hedge funds, which invest long and short in a wide range of markets and securities in an effort to capture market inefficiencies while minimizing exposure and correlation to traditional markets.
An allocation to alternatives should consider the investor’s financial plan and near-term and long-term goals, as well as their risk tolerance, liquidity needs and values; they are only appropriate for qualified investors.
But it’s more than just a simple asset allocation. Judgment, common sense and investment selection are crucial to success in alternative investing. Choosing the appropriate alternative managers is vital, too. There are thousands of alternative investments available, all with different investment objectives, risk profiles, fee structures, liquidity terms and management teams.
Returns from alternatives can vary widely by manager and by market environment. It is important to know how to evaluate an investment manager’s people, process, philosophy and performance.
Investing isn’t a short drive; it’s a long-distance ride. Alternatives can potentially help investors reach their destination faster while making their ride more comfortable.