What is Alternative Investing?
The term "alternative investing" is often used as a catch-all phrase for any assets outside of traditional stocks and bonds. While alternative investments can add significant value to traditional portfolios, the investments must meet specific criteria to be effective. In this post, I will walk through how I define alternatives, which asset classes meet these criteria, and which asset classes do not.
What is Alternative Investing?
When I consider "alternatives," I look for asset classes that will complement and diversify core stock and bond holdings. Ideally, an alternative is an uncorrelated asset that performs well when stocks and bonds struggle.
Stocks and bonds make-up the bulk of most investment portfolios and are excellent complements to one another. Stocks perform well in periods of economic growth, while bonds protect in periods of deflation and negative growth shocks.
With these two major asset classes, an investor covers three of the four major economic environments. However, there is one environment where stocks and bonds both tend to perform poorly: stagflationary environments (the top left quadrant of the below chart).
Stagflationary environments are marked by slowing economic growth and high inflation. Fortunately, these environments have been rare, with the most sustained period of stagflation occurring during the 1970s. However, 2022 was a recent reminder of how inflationary shocks can result in stocks and bonds declining in tandem. Global stocks declined 18% in 2022 and investment-grade bonds declined 13%.
An ideal "alternative investment" for a stock and bond portfolio would:
- Produce positive returns over time
- Exhibit low correlation to stocks and bonds
- Perform well in stagflationary environments
What are the benefits of alternative investments?
Adding diverse, uncorrelated assets to a portfolio can maintain or enhance the return of the portfolio while reducing volatility or risk.
Ray Dalio, founder of the hedge fund Bridgewater Associates, breaks down "The Holy Grail" of investing in the following video. The punchline is investors should seek to combine as many diverse return streams as possible in order to recieve a similar return with less risk.
Importance of Correlation
Correlation, or how two assets move relative to one another, is the critical factor for the diversification value of an investment. If you add an asset class that is highly correlated with the existing portfolio components, you will not realize a significant reduction in risk.
An alternative must have low correlation to stocks and bonds to materially reduce risk.
Benefits of Diversification Visualized
For example, below is a comparison of U.S. stocks, bonds, and gold compared to an equally-weighted portfolio of those three assets from 1972 through July 2024.
An equal mix of stocks, bonds, and gold provides a far better risk-reward profile than any individual asset, as measured by the Sharpe Ratio. Although the equally-weighted mix did not perform quite as strongly as stocks, the equally-weighted portfolio experienced far less risk. In fact, the equally-weighted portfolio had the least severe maximum drawdown compared each portfolio component.
This demonstrates the risk-reducing value of combining diverse, uncorrelated assets in an investment portfolio.
Importantly, these asset classes have demonstrated very low correlation with one another since 1972. Below is a correlation matrix of the assets. A correlation of 1.0 means the assets are perfectly correlated, a correlation near 0.00 means the assets are uncorrelated, and a correlation of -1.0 means the assets are perfectly negatively correlated.
Stocks, bonds, and gold have had correlation readings near 0.00 over this period of over 50 years.
Examples of Alternative Investments
As previously noted, the following are the expectations for an alternative investment in a stock and bond portfolio:
- Produce positive returns over time
- Exhibit low correlation to stocks and bonds
- Perform well in stagflationary environments
Given these expectations, two asset classes are notable candidates as alternative investments: Gold & Managed Futures.
Gold
Gold has historically served as a store of value, a hedge against inflation, and a safe-haven during tumultuous markets or geopolitical events. Historically, gold has met all three criteria for consideration as an alternative to complement stocks and bonds.
From 1972 through July 2024, gold has returned 7.9% annually, has demonstrated a near-zero correlation to both stocks and bonds, and performed remarkably well during the stagflationary environment of the 1970s.
From 1972 through 1979, gold returned an annualized 36% per year, U.S. stocks gained 6% per year, and bonds gained 4% per year before accounting for inflation, which was over 10% per year. That means stock and bond investors lost purchasing power during this timeframe after accounting for the destructive impacts of inflation.
Although gold was an excellent investment during the stagflationary 70's, its performance is not dependent upon inflation shocks. This may surprise some investors, but from 2000 through July 2024, gold has returned 8.7% per year, outperforming both U.S. stocks (7.6% per year) and bonds (4.0% per year).
Ultimately, gold is expected to produce a positive return over time, has demonstrated low correlation to stocks and bonds, and has performed well in stagflationary environments.
Managed Futures
Managed futures is another asset class that has produced positive returns over time, demonstrated low correlation to stocks and bonds, and performed well in stagflationary environments.
Managed futures strategies are also referred to as "trend-following" as they seek to follow trends across a wide range of assets, including commodities, currencies, rates, and equities. Managed futures strategies tend to be systematic and rules-based, reducing the emotional biases that can negatively impact investment decisions.
Managed futures have historically been a challenging asset class to access for individual investors. While these strategies have been employed by hedge funds for decades, they have only recently become available through relatively low-cost ETFs.
Despite the short track record for live ETFs, trend-following managed futures strategies have robust data supporting long-term positive returns and a lack of correlation to stocks and bonds. The chart below shows the performance of a trend-following strategy across 67 markets (29 commodities, 11 equity indices, 15 bond markets, and 12 currency pairs) from 1880-2016. Note the two red outlines which demonstrate decade-by-decade positive returns and low correlation to stocks and bonds.
Source: A Century of Evidence on Trend-Following Investing, AQR
The above chart does a nice job of highlighting how managed futures trend-following meets the three criteria of an alternative investment. The strategy has exhibited long-term positive returns (+7.3% per year), consistently exhibited low correlation to stocks and bonds, and performed well in the stagflationary 1970s (+15.1% per year).
As importantly, trend-following has demonstrated consistent positive performance in the worst periods for stocks and bonds. The chart below depicts the performance of trend-following compared to a 60% stock and 40% bond portfolio during the worst drawdowns for a 60/40 portfolio since the 1890's.
Source: A Century of Evidence on Trend-Following Investing, AQR
Stocks, Bonds, Gold, & Managed Futures
As an added bonus, gold and managed futures have historically been uncorrelated with one another. This means the diversification benefit of gold or managed futures is not hampered by the other asset class' inclusion. Below are correlations of U.S. stocks, bonds, gold, and managed futures from January 1988 through June 2024. The Mount Lucas Management Systematic Trend Following Index is used as a proxy for managed futures.
Below are returns and risk statistics for each of these asset classes compared to a naive, equally-weighted mix (25% each, rebalanced annually). The equally-weighted mix of the four asset classes provided the best return per unit of risk (Sharpe Ratio) and suffered less than half the decline of any individual asset class.
Combining uncorrelated, positively-returning assets demonstrates the power of diversification.
What is not an alternative investment?
One last time, the expectations of an alternative investment are:
- Produce positive returns over time
- Low correlation to stocks and bonds
- Perform well in stagflationary environments
The principal issue I have with many asset classes labeled "alternatives" is that many of these so-called "alternatives" are highly correlated to stocks or bonds. A few examples include:
Real Estate Investment Trusts (REITs)
Although data on privately held real estate is challenging to measure, the data on publically traded real estate (REITs) is clear: REITs behave like stocks.
The correlation between major REIT ETFs and the S&P 500 has averaged around 0.70. Real Estate is also a sector within the stock market. So if you own the broad market, you already own REITs.
Private Equity
Private Equity is first and foremost equity (stocks). Although the volatility of private equity is masked by its illiquidity and opaque valuations, the asset class is expected to highly correlated with stocks. JP Morgan expects private equity and the S&P 500 to exhibit a 0.79 correlation.
High Yield Bonds
High yield bonds actually act a lot like stocks. The oldest high yield bond ETF has exhibited a correlation of 0.75 to the S&P 500 since its inception.
Dividend Stocks
Similar to the argument against private equity, dividend stocks are stocks. Historically, dividend-focused ETFs have exhibited the same volatility as the broad stock market and have not offered notable protection during major market drawdowns.
Challenges to Alternative Investing
Alternative investments also come with unique challenges and risks. Compared to traditional stock and bonds investments, alternative investments are often more complex, have higher fees, and will have periods of underperformance.
Complexity & Transparency
Traditional stocks and bonds are very familiar to most investors and are typically very straightforward. In contrast, alternative investments encompass a wide range of asset classes with unique characteristics, risks, and return profiles.
Alternative strategies may invest in diverse and unfamiliar asset classes (like commodities or currencies), employ the use of leverage, and even go "long" and "short" certain markets. These strategies can feel like more of a "black box" compared to an indexed approach, complicating an investor's due diligence.
Fees
Given the more sophisticated nature of alternative strategies and the absence of an investable index, the fees and expenses for these funds are far greater than indexed stock and bond portfolios.
While the return and diversification benefits of an alternative investment should exceed its cost, the expense ratios of alternative ETFs and mutual funds are often closer to 1% or more, compared to near-zero percent expense ratios for indexed stock and bond funds.
Periods of Underperformance
Alternative investments will not consistently outperform stocks and bonds. There have been and will be prolonged periods where an investor would have been better off eschewing diversification and investing wholly in stocks or bonds. Take for example the late 90's Dotcom bubble or the tech sector's run during the 2010's.
During these periods of underperformance and especially when stocks are performing lights-out, alternative investors will be tested to maintain their diversified approach. In these periods, the greater complexity and higher fees of alternative investments will be challenging to stomach compared to low-cost index funds.
Acknowledging that these moments will arise and will likely last longer than you would like is critical for investors to realize the long-term benefits of alternative investments.
Final Considerations for Alternative Investing
Alternative investments offer an opportunity to enhance portfolio diversification and improve risk-adjusted returns. Incorporating uncorrelated assets that have historically performed well in challenging economic environments, such as stagflation, can provide an invaluable hedge when traditional investments falter.
However, navigating the alternative investment landscape is not without its challenges. Investors must be aware of potential pitfalls, including periods of underperformance relative to conventional assets. The lack of familiarity and transparency associated with some alternative investments can also pose significant hurdles. As such, it is crucial for investors to conduct thorough due diligence and consider their risk tolerance before integrating alternative assets into their portfolios.
Ultimately, while alternative investments can significantly enhance diversification and resilience, they require careful consideration and strategic implementation to realize their full potential.
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