By Steve Tepper, CFP®, MBA

August 2018

Diversification has been called the only free lunch in investing.

This idea is based on research showing that diversification, through a combination of assets like stocks and bonds, could reduce risk without reducing expected return, or could increase expected return without increasing risk compared to those individual assets alone.

Many investors have taken notice, and today, highly diversified portfolios of global stocks and bonds are readily available to investors at a comparatively low cost. A global stock portfolio can hold thousands of stocks from dozens of countries around the world, and a global bond portfolio can be diversified across bonds issued by many different governments and companies and in many different currencies.

Some investors, in search of additional risk reduction or higher returns, may look beyond stocks and bonds to other assets, many of which are commonly referred to as “alternatives.” Depending on who you’re talking to, alternatives could include:

• hedge funds
• private equity
• commodities
• derivatives
• futures contracts
• pretty much any investment other than stocks, bonds or cash

These investments are often marketed as having greater return potential than traditional stocks or bonds, or low correlation with other asset classes (the definition of diversification).

In recent years, “liquid alternatives” have increased in popularity considerably. This sub-category of alternatives consists of mutual funds that may start from the same building blocks as the global stock and bond market but then select, weight, and even sell securities short (bet on their prices falling) to try to deliver positive returns that differ from the stock and bond markets. Exhibit 1 shows how the growth in several popular classifications of liquid alternative mutual funds in the US has ballooned over the past several years. (Please refer to “Alternative Strategy Definitions” section later in this article for a description of each category.)

The growth in this category of funds is remarkable given their poor historical performance during that same period. Exhibit 2 illustrates that the annualized return for such strategies from 2006 to 2017 has been underwhelming when compared to less complicated approaches such as a simple stock (Russell 3000) or bond (Bloomberg Barclays US Aggregate) index. The return of this category has even failed to keep pace with conservative, low expected return investments such as U.S. Treasury bills. Here’s a pretty good rule of thumb for investing: If your investments cost way more than T-bills, and have much more risk than T-bills, you want a better return than T-bills.

Returns from such strategies (and most other investment strategies) are unknown and unpredictable. However, the costs and turnover associated with them are easily observable. The average expense ratio (cost) of such products tends to be significantly higher than a long-only stock or bond approach. High cost means an investment needs to perform better just to provide the same return as a lower cost investment. High turnover (the percentage of assets within the fund that are bought and sold each year) is also a cost driver for several reasons: more buying and selling means more trading cost, but it also means higher cost structure at the fund company. Someone (or many someones) has to determine what to buy and sell, how much to buy and sell, and actually place the trades. Higher cost and turnover in this category are likely suspects to explain poor performance compared to more traditional stock and bond indices.

CONCLUSION

This data by itself, though, does not warrant a wholesale condemnation of any assets beyond stocks or bonds. The conclusion here is simply that, given the ready availability of low cost and transparent stock and bond portfolios, the intended benefits of some alternative strategies may not be worth the added complexity and costs.

When confronted with choices about whether to add additional types of assets or strategies to a portfolio for diversification beyond stocks, bonds, and cash it may help to ask three simple questions:

1. What is this alternative getting me that is not already in my portfolio?
2.  If it is not in my portfolio, can I reasonably expect that including it will increase returns or reduce risk?
3. Is there an efficient and cost-effective way to get exposure to this alternative asset class or strategy?

If investors are left with doubts about any of these three questions it may be wise to use caution before proceeding. A good advisor can help investors answer these questions and ultimately decide if a given strategy is right for them.

ALTERNATIVE STRATEGY DEFINITIONS

Absolute Return: Funds that aim for positive return in all market conditions. The funds are not benchmarked against a traditional long-only market index but rather have the aim of outperforming a cash or risk-free benchmark.

Equity Market Neutral: Funds that employ portfolio strategies that generate consistent returns in both up and down markets by selecting positions with a total net market exposure of zero.

Long/Short Equity: Funds that employ portfolio strategies that combine long holdings of equities with short sales of equity, equity options, or equity index options. The fund may be either net long or net short depending on the portfolio manager’s view of the market.

Managed Futures: Funds that invest primarily in a basket of futures contracts with the aim of reduced volatility and positive returns in any market environment. Investment strategies are based on proprietary trading strategies that include the ability to go long and/or short.

Category descriptions are based on Lipper Class Codes provided in the CRSP Survivorship bias-free Mutual Fund Database.
 

Adapted from a paper published by Dimensional Fund Advisors LP.