Think diversification and risk reduction only apply to investment portfolios? Think again. They actually apply to many aspects of our everyday life, especially during these coronavirus times. For example, if the Denver Broncos’ quarterbacks had better managed risk, i.e., not exposed themselves to the virus which then forced a quarantine for Sunday’s game, the outcome of the game might have been very different.
The same can be said for an investment portfolio—which we know can take a hit when diversification and risk-reducing elements are not included. While the traditional 60/40 has performed well this year, such traditional allocations may be more challenged going forward. Advisors should thus consider adding new types of investments to the mix if they want to continue to achieve the same level of return that a 60/40 portfolio has historically provided without taking on more equity risk. Alternative investment strategies should be an essential part of this mix.
For example, alternatives can play a valuable role in hedging equity market risk. However, with so many different strategies—many of which are unfamiliar to clients—advisors may benefit from using a framework when explaining the various strategies and their role to clients. We suggest dividing alternatives into two broad categories: alternatives that offer true diversification, and those that reduce risk but don’t sacrifice return potential.
The true diversifier side of the team includes liquid alternatives with little correlation to equities. Their value should not be understated. Most asset classes are highly correlated to stocks, and this has big implications during an equity market downturn. For perspective: an equally weighted portfolio of two assets with like volatilities and a correlation of 0.7 would still exhibit 92% of the volatility of either asset in isolation. True diversifiers offer much lower correlations.
We include three types of more popular liquid alternative strategies within this camp. Here’s a brief description of each type, and their correlation to equities (S&P 500 Index) since the financial crisis:
- Managed Futures: This strategy invests long and short across multiple asset classes, using quantitative signals to identify when an asset class is poised to rise or fall. The strategy’s ability to track different assets and take advantage of both rising and falling markets has led to a substantially different return profile from most other asset classes, and a correlation of 0.13 with equities.
- Market Neutral: These funds include a long portfolio of stocks or other assets expected to outperform and a short portfolio of securities expected to underperform. Near identical long and short exposure makes the returns less related to the overall stock market. As a group, market neutral funds have 0.54 correlation to equities.
- Multicurrency: As the name suggests, this strategy invests in different currencies to capitalize on their relative strength. Traditionally, return streams are different from equity and fixed income markets. Over the last 11 years, the strategy has had a correlation of 0.48 to equities.
Although, finding true diversifiers is only half of the team. Separately, investors need liquid alternatives that reduce portfolio risk, but don’t overly sacrifice returns. We call this camp the “risk reducer” category. In short, these strategies hold up during equity market downturns, but typically outperform more traditional downside risk mitigators over longer time horizons. These alternatives can play an important role in limiting large portfolio drawdowns that may adversely affect investor psychology and behavior. In this camp, we suggest three basic strategies:
- Long/Short Equity: A long/short equity strategy takes long positions in stocks that have superior return characteristics, while shorting stocks with a poor outlook. Historically, the standard deviation of the long/short equity category is much lower than long-only equity and its maximum drawdown has also been less than that of the S&P 500 Index.*
- Long/Short Credit: Such strategies are a diversifier but seek diversification from 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 interest rate dependent.
- Non-Traditional Bond: These funds have few constraints on maturity, sector, credit quality or geography. The flexibility gives the portfolio manager more ability to adapt to changing interest rate environments.
Allocations to both categories, true diversifiers and risk reducers, can help investors prepare their portfolios for the long season ahead.
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