How Strong Are Your Building Blocks?

Part III in our “How Strong is Your House Blog” Series

In the last blog post of this series, we talked about how current market indicators are pointing to lower expected returns for multiple asset classes. To help solve these lower return expectations, we discussed lowering client expectations, increasing risk and incorporating alternatives into a portfolio, along with some other strategy suggestions. Anyone who has already been incorporating alternative strategies has no doubt been frustrated since the financial crisis—a feeling that was perhaps amplified in 2018 when many alternative strategies struggled. We know it has been hard, but we also want to take a broader view. If you are open to the role that alternatives can play in a portfolio going forward, this post we will discuss the following topics: how much to incorporate in a portfolio, the comparison of returns over the longer term and the more recent time frame, and how much alternatives ‘cost’ investors.

How much to incorporate?

We are asked this question a lot and the answer can be unsatisfying. As you will see in a moment, it sounds self-serving coming from a firm with alternative strategies. It is also frustrating because we are acutely aware that these strategies would have caused diversified portfolios to lag over the last 10 years, given the bull market. However, the how much to add question just comes down to math.

First, if we believe that a 60/40 portfolio is going to return about 4.83% over the next 5-10 years—not including the effects of inflation or advisor fees—but we need a portfolio that returns 6% to meet a client’s goal, how do we proceed? The chart below outlines the proposed allocation to alternatives needed to achieve that return.

Target Portfolio Returns

Source: 361 Capital. For illustration purposes only, assuming a 4.83% return from a 60/40 portfolio.

As you can see, to gain a 6% return, you’d need to add a fair amount of alternatives to have a reasonable chance of achieving that target. But as we’ve seen in looking at many advisors’ portfolios, there is a strong tendency to add a smaller percentage and see if it works before fully committing. The reality, however, is that adding such a small allocation to alternatives would then need to have seemingly impossible returns to make much of an impact, which when it inevitably doesn’t happen will likely lead to disappointment and explanation risk with your clients.

On the other end of the spectrum, you can see that larger allocations to alternatives require a much lower return. It is often why you still hear about foundations and endowments investing in the space heavily. They are seeking to build portfolios that have tight ranges of outcomes so they can match their assets with liabilities; larger allocations to alternatives can help them reach this goal.

Also, it’s important to remember this slice of your portfolio is meant to work in conjunction with your traditional long-only assets. It isn’t meant to beat stocks and bonds. It is meant to be a third leg in your portfolio that when combined with equities and fixed income will get you to your portfolio target with lower volatility over time.

But alts haven’t given me that

It’s great that there is this math around how much to add in alternatives and what return we need, but what alternative category has returned 8%? As you can see below, not one of them has in the last 10 years since the financial crisis.

Post Financial Crisis Returns

Source: EurekaHedge.com. As of 12/31/2018.

They have lagged equities by close to 10% over the same time frame—though alternatives have had much less volatility. (That said, as we’ve discovered in our conversations with advisors over the past couple of years, not many investors are concerned about risk-adjusted returns right now, they simply want the returns.) It is completely understandable why investors and advisors have been frustrated, and congrats to Warren Buffet on winning his big bet, but this is a pretty cherry-picked time frame. What happens if we look at another 10-year time frame? For instance the one leading up to the crisis?

Prior Financial Crisis ReturnsSource: EurekaHedge.com. As of 12/31/2018. *Start date is 01/00 because that is the earliest data set we could get for all strategies.

Suddenly, some of these alternative strategy returns look a lot better, with many delivering double digits; over the same time frame equities were down over 5% with a standard deviation of over 15%. With that, I’m not sure if the hedge fund bet would’ve had the same winner if they had made it in January of 2000.

Over the entire time frame, here are the returns of alternatives, equities and fixed income.

Long Term Returns Source: EurekaHedge.com. As of 12/31/2018.

Now suddenly alternatives weren’t an ‘anchor’ in the portfolio, but rather a source of lower volatility returns that were additive during a time when your long-only assets struggled—proving their value over the entire time frame.

How much have alternatives ‘cost’?

Often in review meetings, investor’s eyes automatically go to the list of funds, view it compared to the S&P 500 Index, and then inquire about why XYZ fund has lagged. While important to conduct continued due diligence on all holdings in a portfolio, we can often miss the forest for the trees. So, what happens if we look at a portfolio of stocks and bonds and compare it to stocks, bonds and alternatives? How much did this allocation cost?

60/40 Cumulative45 Stocks
25 Bonds
30 Alts
Alt Portfolio out/under performance vs 60/40Portfolio Value Without AltsPortfolio Value with AltsDifference with $100,00 Initial Investment
03/09-12/18178.40%152.72%-25.68%$278,399.27$252,723.94$ (-25,675.33)
01/00-02/09-7.60%21.19%27.90%$93,295.41$121,192.08$ 27,896.67
01/00-12/18159.73%206.28%46.55%$259,733.74$306,281.40$ 46,547.66

Source: EurekaHedge.com. As of 12/31/2018.

As you can see, including alternatives over the last 10 years would have “cost” a portfolio about $25,000 (with a $10,000 initial investment). That is a lot of money. However, the initial investment still would’ve grown to over $250,000, so it’s not that the investment actually lost money, but it certainly lagged the 60/40 approach. There is a lot of manager dispersion within alternatives, something we will discuss in a forthcoming blog, that can lead to different individual results.

The decade prior to the crisis is reversed, but in this case, the 60/40 portfolio had a negative return and part of the initial investment was lost. The portfolio with alternatives didn’t just outperform either, it actually grew in value!

If you combine the two time frames, which of course incorporates this most recent (and difficult) 10 years for alternatives, you still enjoy a higher cumulative return and ending portfolio value.

You and your clients are justified to have questioned your alternatives allocation over the recent years, but hopefully this blog provides some food for thought in that they can be a valuable component of your portfolio structure over the long-term.

Read more in How Strong is Your House? Building Resilent Portfolios >