The Little Book of Alternative Investments

1. Traditional portfolios need updating: The 60/40 stock/bond mix is outdated

The 60/40 stock and bond portfolio looks like it is standing on two legs, when it's mostly standing on one: stocks.

Rethink risk allocation. The traditional 60/40 portfolio allocates 60% to stocks and 40% to bonds in terms of dollar value. However, this allocation doesn't accurately reflect the risk distribution. Stocks are typically 3-4 times riskier than bonds, meaning that about 85% of the portfolio's risk comes from the stock portion.

Diversification is crucial. This imbalance in risk exposure can lead to significant losses during stock market downturns, as experienced in 2008. To mitigate this risk, investors should consider alternative investments that have low correlations to both stocks and bonds. These can include:

• Commodities
• Real Estate Investment Trusts (REITs)
• Hedge fund strategies
• Managed futures

By incorporating these alternatives, investors can create a more balanced risk profile and potentially improve their risk-adjusted returns over time.

2. Diversification is key: Low correlation assets improve risk-adjusted returns

Low correlation puts the disco in diversification.

Understand correlation. Correlation measures how two investments move in relation to each other. A correlation of +1 means they move in perfect lockstep, while -1 indicates they move in opposite directions. Assets with low or negative correlations to each other can significantly improve portfolio diversification.

Benefits of diversification:

• Reduces overall portfolio risk
• Smooths out returns over time
• Potentially improves risk-adjusted returns

Examples of low correlation assets:

• Commodities relative to stocks and bonds
• REITs relative to stocks
• Managed futures relative to traditional investments

By combining assets with low correlations, investors can potentially achieve similar returns with less risk or higher returns for the same level of risk.

3. Hedge fund strategies can be accessed through mutual funds

Greenwich is moving to Main Street.

Democratization of alternatives. Traditionally, hedge fund strategies were only available to wealthy investors and institutions. However, many of these strategies are now being packaged into mutual funds and exchange-traded funds (ETFs), making them accessible to a broader range of investors.

Benefits of hedge fund strategies in mutual funds:

• Lower investment minimums
• Daily liquidity
• Increased transparency
• SEC regulation
• Simplified tax reporting

Popular hedge fund strategies in mutual funds:

• Long/short equity
• Market neutral
• Global macro
• Managed futures
• Event-driven

While these funds may not replicate hedge fund returns exactly, they can provide similar diversification benefits and return patterns at a lower cost and with greater accessibility.

4. Commodities offer inflation protection and portfolio diversification

If you believe that commodities have almost any real positive expected return, they are going to have a place in your portfolio.

Inflation hedge. Commodities tend to perform well during periods of high inflation, as their prices typically rise along with overall price levels. This makes them an effective hedge against the erosion of purchasing power.

Diversification benefits:

• Low to negative correlation with stocks and bonds
• Can perform well during economic downturns
• Provides exposure to global economic growth

Ways to invest in commodities:

• Commodity index funds (e.g., DBC, DJP)
• Commodity-focused mutual funds
• Exchange-traded notes (ETNs) linked to commodity indexes

A small allocation to commodities (5-10% of portfolio) can potentially improve risk-adjusted returns and provide valuable diversification benefits.

5. Real Estate Investment Trusts (REITs) provide steady income and growth potential

The premise of landlords collecting rent is about as durable a business proposition as can be imagined.

Income and growth. REITs offer investors exposure to commercial real estate without the need to directly own and manage properties. They provide a steady stream of income through rent collection and the potential for capital appreciation as property values increase.

REIT advantages:

• High dividend yields
• Potential for long-term capital appreciation
• Inflation protection through rising rents
• Low correlation with stocks and bonds

Types of REITs:

• Equity REITs (own and operate income-producing properties)
• Mortgage REITs (invest in real estate loans)

Investors can access REITs through individual stocks, mutual funds, or ETFs. A typical allocation might be 5-15% of a diversified portfolio.

6. Long/short equity strategies can enhance returns in various market conditions

Long/short funds are perhaps the most similar to conventional equity funds, in that they rely on individual managers' stock picking and market timing skill.

Flexible approach. Long/short equity funds aim to profit from both rising and falling stock prices. They buy (go long) stocks they believe will appreciate and sell short stocks they expect to decline.

Potential benefits:

• Can generate positive returns in both up and down markets
• Reduced market exposure compared to long-only funds
• Ability to profit from overvalued stocks

Considerations:

• Higher fees compared to traditional mutual funds
• Relies heavily on manager skill
• May underperform in strong bull markets

Long/short equity funds can be a valuable addition to a portfolio, potentially providing smoother returns and downside protection. However, careful manager selection is crucial.

7. Market neutral funds aim for consistent returns regardless of market direction

Market neutral equity funds evenly balance their long and short holdings, leaving you with a portfolio whose entire return has nothing to do with the performance of the stock market and everything to do with the skill of the manager picking stocks.

Seeking absolute returns. Market neutral funds aim to generate positive returns regardless of overall market direction by maintaining equal long and short positions.

Key characteristics:

• Low correlation to stock market
• Potentially lower volatility than long-only funds
• Aims for consistent, modest returns

Strategies employed:

• Pairs trading (long one stock, short a similar stock)
• Statistical arbitrage
• Fundamental analysis to identify mispriced securities

Market neutral funds can be an effective diversifier in a portfolio, potentially reducing overall volatility and providing returns uncorrelated with traditional assets.

8. Global macro strategies offer flexibility across asset classes and geographies

Global macro managers take a 35,000-foot view of the world economy at a macro level and place their bets where they perceive imbalances, relative misvaluations, or other opportunities.

Broad investment universe. Global macro funds have the flexibility to invest across various asset classes and geographies based on macroeconomic trends and market inefficiencies.

Potential advantages:

• Ability to profit from global economic trends
• Flexibility to go long or short in multiple markets
• Can provide diversification benefits

Common strategies:

• Currency trades
• Interest rate bets
• Commodity positions
• Equity index futures

Global macro strategies can offer valuable diversification and return potential, but they often rely heavily on manager skill and may have higher fees than traditional investments.

9. Managed futures can provide strong returns during market turmoil

Managed futures have been up more than 10 percent during each of the five worst quarters for the stock market since 1985.

Crisis alpha. Managed futures funds, also known as trend-following strategies, have historically performed well during periods of market stress, providing valuable portfolio protection.

Key characteristics:

• Ability to go long or short in various futures markets
• Low correlation to traditional assets
• Potential for strong returns in both up and down markets

Markets traded:

• Commodities
• Currencies
• Interest rates
• Stock indexes

Managed futures can be an effective diversifier and potential hedge against market downturns, but they may experience periods of underperformance during trendless markets.

10. Alternative strategies require careful consideration and understanding

Don't invest beyond your headlights.

Due diligence is crucial. Alternative investments can be complex and may involve risks that are not present in traditional investments. It's essential to thoroughly understand any alternative strategy before investing.

Key considerations:

• Strategy complexity and transparency
• Historical performance and risk characteristics
• Manager track record and experience
• Fees and expenses
• Liquidity terms

Implementation options:

• Mutual funds and ETFs offering alternative strategies
• Fund-of-funds products
• Direct investment in hedge funds (for qualified investors)

Start with a small allocation to alternatives and gradually increase exposure as you become more comfortable with their characteristics and performance patterns. Remember that alternatives are meant to complement, not replace, a core portfolio of stocks and bonds.

Last updated: November 19, 2024