As featured in Investment Advisor magazine’s October issue
Even though the long-term goal of investors is often capital preservation, fear of missing out—or FOMO—is leading many to ask why alternatives are part of a portfolio when stocks and bonds are marching ever higher.
While many market observers would say unease has increased this year amid headlines about yield curve inversion, trade wars and a deteriorating outlook for global growth, the VIX index of implied future volatility has declined 54% since December 2018 to near its historical median.
The periods of volatility that have appeared this year have often been short-lived with markets quickly mean-reverting and resuming an upward trajectory after initial fears of contagion dissipated. One example would be on Wednesday, August 14 when the S&P 500 fell 2.93% only to rebound by the following Monday.
The smooth upward ride of the market, coupled with these fleeting bouts of volatility, is understandably causing advisors to have to justify to clients the inclusion of alternatives in their portfolio. Clearly the problem with this dichotomy is that it is putting pressure on advisors to make long-term portfolio decisions based on ultra-short-term performance periods. From a behavioral aspect, as data sets and problems become more complicated, humans tend to rely on biases to heavily influence their decision heuristic. One would never take their retirement savings the day they retire and put it on red in Vegas with the hopes of multiplying their money simply because red just won–that’s irrational. So why would one evaluate the performance of any position, including alternatives, over what are short timeframes by investing standards?
During conversations with clients, advisors should urge them to resist FOMO and recency bias and to remember why a meaningful long-term allocation to alternatives can provide much-needed diversification and downside protection in a carefully constructed portfolio designed to perform over a whole cycle.
Two examples include the DotCom bust in which over an eighteen-month period, from April 2000 through September 2002, the S&P 500 and MSCI World Index shed more than 40% each and slumped by about 50% during the Great Financial Crisis from June 2007 through February 2009. For investors, the impact of these time periods on the realized long-term portfolio returns far exceeded the period specific negative returns as investors fled their investment strategies for cash positions because the fear of loss was too great, which, of course in turn, caused many to miss out on the market rebounds that followed. In those same turbulent periods, the Credit Suisse Managed Futures Index surged 32.6% and 19.5%, respectively. A well-diversified portfolio would have likely kept investors invested during these periods of uncertainty.
Yet while it is well-documented that alternatives provided cover during those storms, the alternative fund universe has suffered $28.1B of redemptions over the last 16 months through July, according to Morningstar, with long/short equity funds seeing $12.8B of outflows over the last 14 months.
While this may be understandable, it is the direct result of recent equity performance versus strategies such as long/short equity, which tend to underperform in steadily rising markets.
As an alternatives investments firm, it is our biggest fear that advisors will succumb to the pressures of their clients–resulting in beta-heavy portfolios at exactly the wrong time. The emotions that are driving the current phenomenon of using extremely short windows to justify portfolio moves (either adding or subtracting alternatives) are the precise emotions that have driven every bubble observed since the tulip cost more than a house. During this time of angst, advisors need to urge clients to resist FOMO and emphasize why they positioned the portfolio as they did—to withstand all market conditions and protect investor assets so they can reach their financial goals.
Otherwise, when the markets turn and clients have nothing in their portfolio to help reduce drawdown risk, advisors might find themselves using a new expression, namely “hindsight is 20/20.”
Read our recent blog post, Why Advisors Should Prepare for Drawdown Now >