Seeking True Diversification Through Alternatives

 In Market and Investment Insights

Despite generally strong returns and improving economic conditions in the U.S. since the financial crisis, many investors remain mindful of the inherent risks in financial markets. Record low levels of volatility since the 2016 presidential election are enticing investors to step back into equity markets. Many investors are, in turn, preparing for the possibility of a return to more normal market conditions – namely, increased levels of volatility and increased uncertainty around the potential for positive returns of traditional asset classes.

Many investors have already turned to liquid alternatives as a hedge against such rising market risk (i.e. volatility and drawdown). The rationale for having an allocation to alternatives is commonly the dual goal of dampening portfolio volatility and providing uncorrelated returns to traditional asset classes. However, many “alternative” strategies can still exhibit high correlations to the traditional asset classes upon which they’re based. The table below illustrates the challenge of uncovering alternative strategies that can, in fact, deliver low correlation and diversification perhaps when you need it most – during times of market stress. Most concerning, investments that appear to have lower correlation during low risk periods have experienced dramatic increases in correlation during periods of high volatility. Investors ought to evaluate an investment’s ability to deliver their desired return characteristics such as low volatility and low correlation in both high and low risk market regimes.

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Source: Morningstar, Inc. as of 9/30/2017. © 2017 Morningstar, Inc. All Rights Reserved.

Identifying investments that can reliably deliver a certain return characteristic across market cycles can be challenging and requires looking under the hood at the drivers of return. Most strategies tend to be long market factors that have high correlations to the equity markets – equity beta, credit spread and size, to name a few. We performed a simple exercise to prove this: decomposing the returns of the Morningstar Multialternative peer group to understand the exact drivers of return utilizing a set of 11 factors or “alternative risk premia” spanning equity, fixed income, currency and commodities. Understanding such drivers would allow one to draw conclusions on the risk and correlation profile of this universe during crisis periods and to what extent the portfolio is truly diversified across asset classes.

Unsurprisingly, the results of this decomposition showed that nearly all of the behavior of the Multialternative peer group can be explained by two factors: equity beta and credit premium, which have high correlation with equities. Thus, the returns of the Multialternative universe will largely be governed by the whims of the equity and credit markets. Would you consider this “alternative?”

Getting Alternative

We believe the most important characteristic of a truly effective alternative strategy is its lack of correlation to traditional asset class returns. Finding such a strategy– an uncorrelated, liquid strategy that also reduces portfolio volatility – may seem daunting. However, there are well-defined strategies that have accomplished these goals by capitalizing upon behavioral biases that have been documented in financial literature. These are collectively known as “alternative risk premia” (ARP).

One of the valuable tendencies of these ARP categories is their natural lack of correlation with each other. This allows two different strategies to be on opposite sides of the same macroeconomic event, providing adaptability in different market environments.

Key to any ARP strategy is the notion of statistical independence in our view; the portfolio should have many components with low correlations driving returns.

Conclusion

Investors should confirm that the “alternative” portion of their portfolio is actually providing diversification from traditional asset classes. Given the uncertainty and potential volatility inherent in global financial markets, it is important to consider investments with a low correlation to stocks and bonds and a focus on dampening volatility.

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The views presented are as of the date published. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. No forecasts can be guaranteed. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

No investment strategy can ensure a profit or eliminate the risk of loss.

Beta measures the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.

Correlation measures the degree to which two variables move in relation to each other. A value of 1.0 implies movement in parallel, -1.0 implies movement in opposite directions, and 0.0 implies no relationship.

Credit Spread is the difference in yield between securities with similar maturity but different credit quality.

Credit Suisse Hedge Fund Index reflects the performance of hedge funds globally.

S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.

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