By George Padula, Jr.
Are there asset classes that can adequately protect a portfolio and help an investor sleep well at night? There is no easy or right answer. Many of us are like Ponce de León, who, according to legend, searched in vain for the fountain of youth. Many investors are forever searching for the fountain of diversification that fully protects when volatility strikes and outperforms when markets take off.
I am sorry to say, it does not exist. In fact, those who are looking for the quick fix are searching for something they will never find, while abandoning the principles, discipline and long-term focus that are necessary for successful investment outcomes.
What does work is being disciplined and recognizing that diversifying broadly can help. However, there are many investment asset classes to choose for a portfolio. Traditional asset classes can be thought of from a top level as equities and fixed income. Equities can be further broken down many ways by geography, size, style, or by sector, as examples. Fixed income may also be split into domestic or foreign bonds, treasuries, municipal or corporate bonds, investment grade or non-investment grade, for example. Alternative assets are yet another option available. The goal is to create a portfolio with enough different asset classes that, when combined, will provide the return and risk trade-offs that one needs for a successful long-term investment experience.
Some strategies may work in certain times, say a rising-interest-rate environment, while others may work well in a more turbulent trading environment. No one asset class, whether traditional or alternative, will work equally well in all environments. Easy ways to quickly, simply and cost-effectively diversify include the use of low-cost index-based mutual funds and exchange-traded funds.
Let’s focus on alternatives for a moment. In recent years, the ability to invest in alternatives has come about on the heels of groundbreaking research into investment factors. For example, momentum, quality, value, long/short, and risk arbitrage are different factors that some considered “alternatives.”
There are also strategies that were previously available only as hedge fund or private investment products, like managed futures, risk arbitrage, distressed credit or global macro strategies. The ability to focus on both these factors and strategies has come about because of better technology, reduced computing costs, and new and innovative investment vehicles that were not available five, 10 or 20 years ago. The general idea when considering alternatives is whether or not alternative strategies are highly correlated to traditional equity and fixed-income investments. If so, adding them to a portfolio could, in theory, improve risk-adjusted returns by providing downside protection, improving returns or some combination of both in certain market environments.
Using back-tested data, some researchers of these alternative factors and strategies seem to indicate that they have found the holy grail of investing: lower risks without lower returns.
Keep in mind, however, that many of these alternative strategies have not been readily available to the average investor and may not have had a long enough track record to adequately gauge their benefits.
What if, in addition to alternatives, other asset classes such as international securities or gold were added to a basic portfolio? Do they help?
To help answer these questions, the table below identifies various hypothetical portfolio allocations that are roughly 60% equity-based and 40% fixed income-based and have had increasing amounts of alternatives and gold included. Please note that these allocations do not represent actual client portfolios and are used solely for illustrative purposes. To represent alternative investments, I used the HFRI Hedge Fund of Funds Index because it comprises many of the various alternative strategies into one easy-to-understand index. Gold is included, too, because some investors feel that gold is also an asset class that can offer portfolio protection when times are tough.
Here are the returns that each of the above allocations above would have generated over various time periods.
The analysis above suggests that adding alternatives, using the HFRI HFOF Index as a proxy, do seem to help reduce risk, and improve risk-adjusted returns. Over the long run diversification may provide some excellent benefits. Nobel prize winner Harry Markowitz called diversification "the only free lunch in finance." In this case, the lunch may not be free as the improvements and benefits are all before product fees and expenses are included.
On the surface, the above data seem to show that diversification works. Peeking under the hood, though, we can poke some holes into the above strategy allocations themselves. First, the above data assumes no expenses and that all investments were readily available to all investors for the entire period. For example, the first managed futures mutual fund was opened in 2007; however, it was only available in the private or hedge fund format for many years before. The second issue is that alternatives tend to have much higher expense ratios than traditional investments. Therefore, when adding in fund expenses, alternatives may not provide the benefits that they were expected to provide. Further, there are distinct differences between investing in an alternative strategy within a private hedge fund and using a mutual fund that follows the same strategy. The mutual fund generally cannot use leverage, must maintain daily liquidity and has significantly more regulatory requirements than private funds. These may lead to increased costs, lower returns and more tracking errors as compared to the index.
There are other more general issues to consider as well. Some markets are more liquid and trade more efficiently than others. Second, risks and correlations are not static. They change over time and can change when we least expect them to do so. In times of extreme volatility, correlations have been shown to increase dramatically and there can be few places to hide, as we saw in December 2018. It has been said that diversification doesn’t work well when we need it the most and works great when we need it the least.
To help protect on the downside, the first suggestion is to make sure you have some diversification because even a small amount can help. The chart below shows various blends of the S&P 500 stock index and the U.S. aggregate bond index, just two asset classes. By reducing the equity exposure, one can reduce risk without giving up much in the way of return. In the 1980-2018 period reducing from 100% equities to a 40% equity/60% fixed income blend could have reduced risk by about half, while the annualized returns only declined from 11.3% to 9.4% per year. The worst calendar year return, 2008 in all cases, improves those annualized returns from -37.0% to a -11.7%.
To go back to the original question that opened this article: Are there asset classes that can adequately protect a portfolio and help an investor sleep well at night? Alternatives may be part of the answer although they are certainly not the only answer.
Rebalancing goes hand-in-hand with diversification. A successful investment strategy could benefit from rebalancing back to one’s targeted allocation and could help mitigate some risks by forcing sales of those assets that have increased in value beyond their targets and buying those that have declined.
Ultimately, there are many factors that go into the formulation of a portfolio that allows an investor to sleep well. You should try to understand your goals, be realistic with return expectations, and recognize that there are no easy solutions. There is no one answer for every investor as most everyone will need and want something different from their portfolio. Finally, for those investors who are near retirement or in retirement, having some cash available from which you can draw when investments decline could help mitigate a declining market. No one wants to pull funds from a portfolio when it is down and having cash or access to cash can be helpful. If someone tells you there’s one investment or allocation that is best for everyone, run the other way.
About the author: George T. Padula, Jr. is a principal and wealth manager of Modera Wealth Management, LLC. He specializes in small business owners, college planning, retirement planning, endowments and foundations and charitable giving. In addition, George also serves as Modera’s chief investment officer.