A fundamental yet challenging risk management technique of effective portfolio structuring is diversification – dividing a portfolio among a variety of assets and risk exposures to achieve downside protection. Easy to learn and difficult to master, portfolio diversification is best summed up with the adage, “Don’t put all your eggs in one basket.”
The financial crisis of ’08 revealed the limitations of the traditional 60/40 portfolio (60% stocks, 40% bonds), and many investors were unable to remain unscathed in the aftermath of this market turmoil. In response, appetite for alternative assets has risen in recent years due to the potential diversification benefits they can bring to portfolios. Below are some unique characteristics of alternative investments that make them welcome supplements to traditional assets.
Correlation and Risk Diversification
Incorporating alternatives has become an increasingly common diversification technique among both institutional investors and high net worth individuals. Since alternatives are non-traditional investments, they do not tend to move in the direction of the stock market and naturally feature low correlations to traditional asset classes. As a basic principle, assets that feature low correlation with one another produce more opportunities for diversification.
Consider, for example, the traditional 60/40 portfolio. Despite the inclusion of bonds, much of the risk in this hypothetical portfolio can be dominated by equity risk. A seemingly diverse portfolio from an asset allocation point of view is not necessarily ideal from a risk parity perspective. This becomes especially problematic during times of economic crisis when correlation spikes between traditional assets occur. When markets become volatile and sharp drawdowns happen, assets that were already correlated can converge to an even greater degree and ultimately compromise the diversification abilities of a portfolio. What we have learned from the events of 2008 and 2009 is that conventional diversification strategies are not enough to protect against market volatility. Incorporating an asset allocation to alternatives can potentially diversify risk exposures within a portfolio and cast a wider opportunity net.
Potential for Enhanced Returns
Illiquidity is a crucial factor to consider when incorporating alternatives in an investment portfolio. Although alternatives have varying degrees of liquidity, most if not all are not as readily tradable as stocks and bonds. In private equity, for instance, it can sometimes take ten years or more to realize returns from these investments, as it takes time to source the right investment opportunities, improve underlying investments, and successfully liquidate them.
However, illiquid investments can offer higher potential returns, a phenomenon also known as the “illiquidity premium”. By sacrificing tradability and tactical flexibility, the investor should be compensated with higher returns. While this is obviously not always the case, returns are known to generally increase with degree of illiquidity, of more than 3% annually (Illmanen, 2001).
Mitigating Fear-Based Selling
Alternatives represent useful tools to improve the risk-return characteristics of an investment portfolio. However, they may provide the additional benefit of promoting more rational investment behavior by potentially insulating an investment portfolio from financial crisis. As market volatility may be tempered through allocations to alternative investments, so too is the likelihood that an investor may succumb to fear-based selling. All too often during market corrections, investors stray from the course and sell at the wrong time, increasing the potential for losses and damaging returns. Due to their illiquidity, alternatives can temper these knee-jerk reactions to market corrections by mitigating volatility and reducing preemptive reactions to risk.
Alternative investments are speculative and involve substantial risks. Consider the risks outlined in the Investor Document Package before investing. Risks include, but are not limited to illiquidity, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objective.
Expected Returns, Antti Illmanen, 2001.
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