Defense Wins Championships: Alternatives “For The Win”

by Igor Tiguy, CFP®, AIF®, MSPFP, Director, Planning Services

An important part of our investment due diligence process involves attending industry conferences and investment manager showcases.  Earlier this summer, I was pleased to hear that an upcoming showcase, which was co-sponsored by a few local investment management firms, was going to take place at Gillette Stadium – the home of my beloved Patriots.  What made this event a must-attend, however, wasn’t the location, but the fact that most of the managers were showcasing their Alternative Investments solutions.

Alternatives play an important part in our clients’ portfolios, as our general approach to investment management is, in many ways, similar to that of Endowments & Institutions (Endowments & Institutions are known for high allocations to Alternative investments – see National Association of College and University Business Officers study, which shows that U.S. College Endowments generally allocate between 30-50% to Alternatives).  While we believe that Alternatives should always play a role in portfolio construction, what makes Alternatives even more important today is the current economic and market environment.

What worries us about the current market environment and has our portfolios underweight U.S. Stocks and Bonds while overweight Alternatives?

• As can be seen in the following chart from the recent J.P. Morgan Guide to the Markets, the S&P 500 is 6+ years into a bull market, having returned 205% (through June 30th, 2015) from its early 2009 low. While it’s tough to predict exactly when the next U.S. stock market drawdown is coming, and how large it will be, the two previous drawdowns seen in the chart, in addition to expensive U.S. stock valuations and lukewarm economic conditions, make us concerned and cause us to take a defensive stance (notice that these two large drawdowns followed bull markets which returned ½ of what the current bull market has returned).
• U.S. bonds are also not attractive – mostly due to the inverse relationship between interest rates and bond prices.  The U.S. Bond market has experienced a 34-year-long bull market, almost entirely driven by the falling interest rates.  The following J.P. Morgan Guide to the Markets chart shows that the 10-year Treasury yield has, gradually, fallen from 15.84% in September of 1981 to 2.35% on June 30, 2015, which has been a tremendous tailwind for bond market returns.   Going forward, bond market returns will not be as attractive.  While it is tough to predict the exact timing of the Federal Reserve raising rates, there is no question that they will start raising rates in the not-so-distant future, albeit slowly, which will be a headwind for bond returns.  Studies have shown that the best predictor of bond returns for any subsequent 10-year period is their current yield.  With that in mind, the average returns for 10-year U.S. Treasuries over the next 10 years are likely to average only 2.35% per year.
• The remaining “Traditional” asset class is Cash, which is also not attractive as a long-term strategic allocation.  With Cash yielding very little, the biggest risk to the Cash investor is losing purchasing power due to inflation, realizing a negative real return.  We often have high Cash allocations in client portfolios, but that Cash is mostly used as “dry powder”– awaiting attractive market opportunities, and not as a long-term strategic allocation.

I’ve been lucky to witness the Patriots win the Super Bowl four times.   I’ve also rooted them on in other seasons when they had great teams, including the 2007 team, which set the all-time regular season points scoring record.   Six years later, that scoring record was broken by the Denver Broncos.  Yet while both of those teams had all-time great offenses, football fans know that neither the 2007 Patriots nor 2013 Broncos won the Super Bowl.  Why?  Because while they had average defenses those years, the teams they faced in the respective Super Bowls had very good, or even great, defenses.

As I was sitting in a suite at Gillette Stadium, listening to the various Alternative investment managers describe how their solutions improve diversification and reduce portfolio risks, I realized that there is something to that cliché “Offense Gets the Glory but Defense Wins Championships.”  After all, the 2007 and 2013 champions had great defenses, and so did the Patriot teams that won those four Super Bowls.

There is a disproportionate relationship between the impact that investment losses and investment gains have on a portfolio.  As can be seen in this Forbes.com image, it takes an exponentially bigger gain to make back a portfolio loss.  A 10% portfolio return only requires an 11% gain to get back to even, but a 50% loss takes a gain of 100% to get back to even.

While spectacular one-day moves in individual stocks make for great headlines, those returns tend to be fleeting historically.  In this uncertain and volatile market environment, our most important goal is to be prudent stewards of client capital – and protect client portfolios from the downside risks, even if that means that we give up some potential for higher returns (i.e., playing sound defense and waiting for the opportunity to present itself to strike on offense).  When none of the Traditional asset classes are attractive, Alternatives allow us to build portfolios that have an expectation for low-but-steady returns, while maintaining an overall defensive stance.

So what exactly are Alternatives, what are their expected benefits, and how do we use them?  Come back next month for Part 2, which will cover all these topics.  And if you have any questions in the meantime, whether it is on Alternatives, or the Patriots, please call us, as we love discussing both!