How Strong is Your House? Building Resilient Portfolios

You may or may not recognize this photo; it was taken after Hurricane Michael hit Florida in October of this year. The hurricane caused billions of dollars in damage and sadly destroyed many homes and businesses in the area. After the storm, a picture of this house kept appearing in various news articles because it was one of the only homes still standing in the hardest hit area—Mexico Beach, Florida. Naturally people were curious as to how it remained standing, so reporters went to investigate.

Turns out the house was finished earlier this year by two individuals who specifically set out to build a structure that could withstand an intense hurricane. Building codes in this part of the state (west) were less aggressive than those on the east side. Many of the buildings were built to survive 125 mph winds, but the builders of this house made sure theirs could withstand at least 250 mph. They also built the house on 40-foot pilings to protect from a storm surge, which was responsible for damaging many of the homes that survived the initial hurricane winds. They added steel cables to hold the roof in place, used reinforced concrete walls, and put in siding that could detach from the house without pulling away the entire wall, among other things. These additions were costly and time consuming (an estimated 15-20% increase in construction costs).

You can imagine how much grief these vigilant builders would have gotten had they done this a decade ago. Neighbors may have questioned why they were taking so much extra time to build this house. Or, why were they doing more, and spending more, than was required by law.

It got me thinking about the current market. Like this house, it’s important to build client portfolios that can withstand all kinds of environments, because we never know when the weather will turn.

With alternatives being a focus at 361 Capital, we have felt the performance lag compared with long-only equities, or even a 60/40 portfolio since the financial crisis, just like you.  (Of course, benchmarking uncorrelated assets or hedged equity funds to long-only assets year-by-year isn’t appropriate, but that’s a conversation for another day). We looked at the data to see how large the spread has been.

03/09-09/18 Return Standard Deviation
S&P 500 Index 17.91% 12.25%
Barclays Capital Aggregate Bond Index 3.59% 2.80%
60% S&P 500 Index/40% Barclays Aggregate 12.19% 7.32%
Alternatives* 7.53% 4.30%
45% S&P 500 Index/25% Barclays Aggregate/30% Alts 10.97% 5.59%
  • *Average includes Arbitrage, Managed Futures, Long/Short Equity, Macro, Multi-Strategy, Relative Value, Fixed Income Hedge
  • Source: EurekaHedge.com as of 9/30/2018

It’s perhaps understandable why you and your clients are frustrated. From March 2009 to September 2018, alternatives lagged equities by 1,000 basis points (bps) and a 60/40 portfolio by 500 bps—talk about a portfolio anchor! (Although, you could also say that buying SPY instead of just owning AMZN was an anchor using that logic…) Besides being more expensive than your long-only strategies, Alts have underperformed right? Why deal with the brain damage?

We certainly empathize with that sentiment, but these past 10 years have been amazing for stocks with almost 2x the average return and a lot less volatility. In addition, bonds contributed positively as rates fell, so you could do no wrong. But what happens when things aren’t quite so rosy for equities? We looked at the same data source but from the earliest point that we could get standardized data, up to the financial crisis.

01/00-02/09 Return Standard Deviation
S&P 500 Index -5.63% 15.70%
Barclays Capital Aggregate Bond Index 6.11% 3.90%
60% S&P 500 Index/40% Barclays Aggregate -0.75% 9.47%
Alternatives* 9.89% 5.65%
45% S&P 500 Index/25% Barclays Aggregate/30% Alts 2.16% 7.35%
  • *Average includes Arbitrage, Managed Futures, Long/Short Equity, Macro, Multi-Strategy, Relative Value, Fixed Income Hedge
  • Source: EurekaHedge.com as of 9/30/2018

Quite a different picture, isn’t it? People were certainly scared after this time frame, but I don’t remember investors saying, “We should only buy fixed income or pile everything into alternatives.” (Fixed income still had the tailwind of falling rates during this period.) We can’t predict what the next 10 years will look like. However, when you invest you take risks to get returns, and one of the best ways to spread your risk is to diversify across different asset classes and strategies, so when combined, it can potentially generate returns in both good and bad environments. This strategy gives portfolios a chance to hold up in unpredictable markets that vary in length and severity compared with averages.

These examples are both extreme on either end, so what happens when you combine them?

01/00-09/18 Return Standard Deviation
S&P 500 Index 5.75% 14.36%
Barclays Capital Aggregate Bond Index 4.82% 3.39%
60% S&P 500 Index/40% Barclays Aggregate 5.66% 8.60%
Alternatives* 8.66% 5.04%
45% S&P 500 Index/25% Barclays Aggregate/30% Alts 6.58% 6.60%
  • *Average includes Arbitrage, Managed Futures, Long/Short Equity, Macro, Multi-Strategy, Relative Value, Fixed Income Hedge
  • Source: EurekaHedge.com as of 9/30/2018

Take in the entire picture and suddenly alternatives have a better risk-adjusted return than everything else. I’ve heard time and again that investors don’t care about risk-adjusted returns—of course they don’t with what we’ve seen in equities.

If you had invested in the S&P 500 Index, a 60% S&P 500 Index/40% Barclays Aggregate portfolio, or in a portfolio that included 30% alternatives, over the last ~20 years, here’s a look at what risk-adjusted returns did for you in actual dollars:

01/00-09/18 Growth of Hypothetical $1,000,000 Standard Deviation
S&P 500 Index $2,848,474 14.36%
60% S&P 500 Index/40% Barclays Aggregate $2,809,701 8.60%
45% S&P 500 Index/25% Barclays Aggregate/30% Alts* $3,300,217 6.60%
  • *Includes Arbitrage, Managed Futures, Long/Short Equity, Macro, Multi-Strategy, Relative Value, Fixed Income Hedge
  • Source: EurekaHedge.com as of 9/30/2018

If better risk-adjusted numbers equates to almost a half a million dollars extra, I’d say that I care quite a bit. The alternatives portfolio made more money, even though it has lagged every year except one (2015) since the crisis.

I know you have heard these things many times over the last decade, and if you have diversified in any way (e.g., international, emerging markets, alternatives), I’m sure it has been frustrating to explain your rationale to clients.  We don’t know when things will change, but we do know that things will change and yields, growth rates, debt, central banks and politics eventually do matter. The best thing you can do for your clients is to construct a portfolio that’s designed to withstand the unpredictable nature of what the next 10 years might bring.

Read more in A Simple Framework to Prepare for the Next Bear Market >