Sports fans see it all the time: right before the playoffs or the championship game, coaches rearrange their rosters. Line-ups that might have worked during the regular season are no longer sufficient. Offenses are shuffled, defenses are bolstered, and if the coach makes the right moves, the team walks away a winner.
Investors are at a similar crossroads these days. The six-year bull market that started in 2009 has helped investor portfolios post remarkable growth—but it won’t last forever. It’s important then, for investors to re-examine their investment lineup and start preparing now for what will likely be a tougher game in the near future. For many, that means adopting a diversification strategy that goes beyond the standard 60/40 portfolio.
Over the last six years, the equity side of investors’ portfolios—the offense—has done all of the work. From March 2009 through June 2015, investors benefited from annualized returns of 20% for the S&P 500—well above the average annual return for large cap stocks beginning in 1928. However, let’s not forget that equities bore the brunt of the losses during the financial crisis, experiencing a 51% loss based on monthly returns, so recent gains have only served to offset losses for many investors.
On the other side, fixed income assets—the defense—have historically provided investors with some downside protection but very little growth. While equities annualized at over 20%, bonds, as represented by the Barclay’s Aggregate Bond Index, returned 4.6% annually over the same time frame and interest rates continued to fall. We know that low rates historically, have portend low future returns, and with the 10-year Treasury yielding 2.2% as of August 15, 2015, the “Defense” appears to offer little comfort to investors desiring positive real returns.
Alternatives can provide two main benefits to client portfolios. With little-to-no correlation to traditional markets, certain alternatives can offer investors “true” diversification. True diversifiers can include Managed Futures, Global Macro, Market Neutral and Multicurrency funds. Additionally, other alternatives seek to reduce risk without sacrificing return potential such as: Non-Traditional Bond, Long/Short Equity and Long/Short Credit funds.
Many investment portfolios are too heavily weighted toward long-only assets. This sets investors up for potentially large losses, especially in the event of another major market decline.
For true diversification, it’s essential to invest in funds with results that don’t strongly correlate with those of traditional equities. Of the 46 major Morningstar categories, only 17 exhibit correlations below 0.5 to equities over the last 15 years, ending December 2014. Of those, 12 are bond categories with anemic outlooks and one has a negative expected return over most time frames. That leaves four other categories: Managed Futures, Global Macro, Market Neutral and Multicurrency.
These funds work to diversify portfolios in a variety of ways:
- Managed Futures funds often invest across multiple asset classes and have the ability to go long and short, which can produce low correlations to equities and can reduce overall portfolio risk.
- Global Macro funds are typically able to invest around the world, based on market trends, political changes and varying economic landscapes. This allows investors to capitalize on foreign markets’ growth while limiting reliance on U.S. market performance.
- Market Neutral funds seek to limit general market exposure through a combination of long and short positions. The goal is to neutralize or limit the effect of stock market movement on returns.
- Multicurrency funds invest in U.S. and foreign currencies through the use of short-term money market instruments and derivative securities, in an attempt to take advantage of trends and relative strength, producing returns that are distinctly different from equity and fixed income markets.
In addition to adding true diversifiers to their portfolios, investors should also seek to add funds that have the potential to, or seek to reduce risk without overly sacrificing returns. On this front, we believe many investment portfolios play it too safe resulting in lost opportunities for growth.
Investors should look for funds that hold up during recent downturns, and have the potential to outperform traditional downside risk mitigators over longer periods.
Of the 46 major Morningstar categories, 22 had drawdowns of less than half suffered by the S&P 500 during the financial crisis. Of those, the same bond categories referenced above, offered little on the return side of the equation, and the Bear Market category has had a negative expected return over most time frames. That leaves the true diversifier categories mentioned previously, as well as Non-Traditional Bond, Long/Short Equity and Long/Short Credit.
These funds use several different strategies to minimize a portfolio’s risk without unnecessarily hurting growth:
- Non-Traditional Bond funds typically remove constraints on maturity, sector, credit quality or geography to generate income and returns while keeping volatility low. This gives managers the flexibility needed to adapt to changing rate environments as necessary.
- Long/Short Equity funds have the flexibility to not only buy stocks that they believe will appreciate, but to short stocks that they believe will decline in value, which increases the potential sources of alpha and has the potential to reduce downside risk.
- Long/Short Credit funds offer an alternative way to diversify traditional fixed income investments. Managers use long and short positions with a mix of global credit securities to help mitigate volatility and earn returns that are less dependent on rates.
In the end, there are a number of ways to incorporate alternative funds into a traditional 60/40 portfolio. Investors can:
- Re-optimize the entire portfolio. In building a portfolio, it’s the sum of the parts that matters, not the components in isolation. As such, the preferred approach to incorporating alternatives is to optimize with all traditional asset classes and alternative strategies in order to arrive at the mathematically optimal portfolio. From there, investors need to evaluate the results to consider aggregated risk exposures across all holdings, and if necessary, modify to control for unwanted risks.
- Add some hedging. Investors can swap out a portion of their long-only equity or fixed income exposure for funds like Long/Short Equity or Credit that take a hedged approach to the same asset class.
- Get rid of unwanted risk factors. Investors can reduce exposure to funds that contain undesired risk (e.g., interest rate risk) for alternatives that don’t bear the same risk factors.
As we move into a period of increasing economic uncertainty, it’s important to think like a coach heading into playoff season. Taking proactive steps in an effort to increase diversification and manage drawdown risk, without sacrificing returns, can help investors better manage gains and losses as they strive to emerge as winners over the long run.