No other slogan defines Bill Belichick’s coaching philosophy better than “Do Your Job.” Every player on the team, from stars to bench players, has a defined and complementary role. When everyone executes their roles at the highest level, and Does Their Job, the team achieves ultimate success.
Each allocation in a diversified portfolio also has a defined role.
- Need growth of capital to reach long-term goals? Stocks typically play that role. On a football team they would be akin to a wide receiver who catches long touchdowns.
- Need income while protecting the portfolio principal from large losses? Bonds are the player you would usually want for this job. On a football team, they would be the bruising 250lb fullback crashing through the wave of defenders to gain 3-yards.
- Worried about protecting capital that you will need for a short-term goal? Cash would typically be your #1 pick for this job. On a football team, cash would be the punter – a perennially underrated position.
A traditional portfolio is built to address a combination of the above-mentioned goals (growth, income, and capital preservation), using a mix of the above-described “players” (stocks, bonds, and cash). In the beginning of the season, when all three are healthy, the team might not need any other players to step up and Do Their Job…but what happens when none of these players are at their best, like when they are dealing with various injuries towards the end of a grueling season? Who takes over their roles in the portfolio during the times when neither stocks, bonds, nor cash are attractive?
- Alternatives are the player for this job – flexible enough to play multiple positions, allowing the portfolio to keep, gradually, progressing towards the goals. On a football team, alternatives would be a versatile slot receiver who catches a lot of short passes and is sometimes called upon for a surprise running play, or a well-executed trick throw.
Alternatives have that name for a reason – they are alternative investment choices to the “traditional” asset classes (stocks, bonds, and cash).
- Alternatives can be broken out into public (liquid – traded just as any traditional mutual fund, ETF, or closed end fund) and private (typically accessed through a partnership, e.g., private equity).
- They can also be broken out into alternative asset classes (e.g., commodities) and alternative strategies (e.g., long/short equity, which uses a traditional asset class, stocks, but allows the portfolio manager to also sell stocks “short” in addition to holding them “long”).
- While some alternatives are added to the portfolio to enhance returns, most are added to reduce risks. This point is critical, as alternatives have an undeserved reputation in the media for being “too risky.” This great infographic from Attain Capital illustrates how “Different Asset Classes React during Crisis Periods.” It looks at five crisis periods, including the Internet Bubble bursting and the 2008 credit crisis, and shows that most alternative asset classes protected capital much better that stocks, with some alternative asset classes (e.g., managed futures) having strong positive returns.
- This handy chart, from Forward, illustrates how liquid alternative strategies can be used for different investor objectives.
- And this page on Daily Alts, a source of liquid alternatives news and information, describes the common liquid alternative asset classes.
Compared to the traditional asset classes, alternatives are a new kid on the block. And for that reason, they are often misunderstood. Historically, they have been only available to institutional investors and ultra-high-net worth individuals, via private partnerships. Their government disclosure filing requirements were also not as demanding as those for publically traded traditional asset classes. For these reasons, they have always been shrouded in a cloud of mystery. To the extent they received coverage in the public media, it was typically with a negative angle – whether it be scandals or implications that alternatives are risky.
A massive shift in the investment landscape took place soon after the 2008 market crash. Many financial planners and investment managers working with individual clients finally realized what the institutional investors, endowments, and foundations have understood all along: alternatives should be an important part of portfolio construction in general, and especially during times of stock market drawdowns. The demand part of this shift took place after these investment advisors observed the (relatively to global stocks) smaller 2008 losses of many, and a positive performance of a few alternative asset classes.
The supply shift came from the mutual fund complexes deciding to, and finally having the capability to, make alternatives available in “liquid,” publically-traded mutual fund form (as compared to the illiquid private partnership / hedge fund form).
As often happens in investments, the public, typically late to the party, rushes into the best performing asset classes during the last innings. Inspired by the (relatively) good 2008 alternatives performance, money started to flow into the newly born liquid alternatives mutual funds in 2009-2010 at the worst possible time, the beginning of a multi-year stock bull market.
Lack of alternatives education and behavioral finance can explain this phenomenon. While alternatives should typically play at least some role in portfolio construction, they should be underweighted after the end of a bear market, and overweighted towards the end of a bull market. Unsurprisingly, investors in alternatives were disappointed with their returns, which trailed the roaring stock market returns.
Six plus years into this new subset of the investment industry, things are different. Both liquid alternative mutual fund providers and investment advisors have created a plethora of alternatives education. Many of the alternative mutual funds now have longer (5+ years) track records. And most importantly, we’re in the later stages of prolonged bull markets in both U.S. stocks and U.S. bonds – the exact time to start overweighting alternatives.
Part 1 of this blog, explaining our view that many traditional asset classes are unattractive, was published on August 12th. Investors know what happened in the global stock markets during the second half of August, but they might be wondering, “How did liquid alternatives do?”
This chart shows that the major liquid alternative categories tracked by Morningstar protected capital better than the S&P 500 and World Stocks during this recent August drawdown. Liquid alternatives did, in fact, Do Their Job.
Studies of historical portfolio returns, such as the one below from J.P.Morgan, have showed that adding an allocation to alternatives should lead to an expectation of improved returns with lower risk.
While the “smart money” institutional investors, such as the folks making asset allocation decisions for college and university endowments, have allocated a very high percentage to alternatives, believing that, in these times, “Alternatives are the right player for the job.”
We agree, and have positioned client portfolios accordingly. Having said that, we don’t recommend to go it alone. The liquid alternatives universe is vast, with a recent Goldman Sachs study showing that Morningstar classifies 621 mutual funds as alternative strategies.
Liquid alternative sub-asset classes should not all be grouped under one umbrella. Different alternative strategies may be appropriate at different times, depending on market conditions. Likewise, there is a lot of dispersion between the best-of-breed alternative managers in each of these sub-asset classes, and the also-rans.
We wholeheartedly recommend finding a wealth advisor versed in the benefits of alternatives and the diversity of liquid alternative solutions available to aid with portfolio design. I encourage you to contact us. Having Done Our Job studying the liquid alternatives universe, we would be happy to have an educated discussion with you.
