Of all the criticisms against alternative investments, one of the least-accurate is the notion that alternative asset classes and strategies are inherently riskier than traditional investments. Many mainstream financial pundits promote the idea that hedge funds are exotic, freewheeling and risky investments only suitable for the ultra-wealthy, which – in their view – is the reason why only the ultra-wealthy are allowed to invest in them.
The reality, of course, is nearly the exact opposite: The real imperative of most alternative assets and strategies is to dampen volatility and improve the risk-adjusted returns of an entire investment portfolio. Alternatives need to be evaluated within the context of other assets and strategies within a given portfolio, not in isolation. Federated Investors has recently published a white paper underscoring this point. Titled The benefit of putting risk above returns, the paper is part of Federated’s On Point series offering industry and investment insights.
If I told you about an investment that lost 49% of its value in less than six months, rallied to reach a new high five years later, and then plummeted by 57% in the next 17 months, you’d probably think I was talking about a penny stock, an emerging-market stock, or maybe BitCoin – instead, I’m talking about the S&P 500 in the first decade of the 21st century.
Alternatives are designed to dampen this volatility and provide downside protection – typically at the cost of hitting the highest highs during a bull market. “The goal is get higher lows, though the converse – lower highs – also often is the case. That is not necessarily a bad outcome,” according to Federated.
Below is a chart demonstrating the S&P 500’s violent swings through the end of 2013, along with the flows into and out of U.S. equity funds:
Federated says alternative investments tend to be “broadly diversified” and emphasize securities that have exhibited “defensive characteristics” during “market extremes” of the past. Alternatives tend to have low or even inverse correlations to traditional stock-and-bond portfolios, which means the alternative portion of a portfolio may increase in value as the traditional portion of the portfolio declines – and vice-versa. Adding alternatives, therefore, often means trading the “higher highs and lower lows” of long-only stock-and-bond investing for more stable returns.
Stability of returns is particularly important in light of the “Prospect Theory” of Amos Tversky and Nobel prize-winner Daniel Kahneman, which is based on behavioral-finance research findings that “the pain from an economic loss can be felt three to four times as much as a gain of similar magnitude.” Thus, investors unable to take the “pain” of losses “throw in the towel” and sell during bear markets, making it difficult for them to recover from the losses. If an investor would have held on to his stocks throughout the rollercoaster 2000’s, he would have fared decently – but not if he sold near the bottom and got back in near the top.
As Federated points out, much of the Prospect Theory can be attributed to the simple mathematical nature of profits and losses: To “get back” a 20% loss, an investor needs to gain 25%. To “get back” a 50% loss requires a gain of 100%. In Federated’s words, “the bigger the loss, the higher the recovery threshold.”
The above table demonstrates the number of days the S&P 500 swung by 2% or more, from 2000 through 2013. Notice how volatility abated as the Federal Reserve’s “quantitative easing” ramped up in 2012 and 2013, but now that the program has been terminated, we may see a return to the more volatile swings from earlier in the decade, or the ultra-volatile 2008-09 period.
The unifying theme behind alternative investments is that they put risk aversion “on an equal if not elevated footing” with the goal of maximizing returns. Investors and financial advisors are finding the benefit in alternative investments, even as the S&P 500 Index continues to hit new all-time highs with relative frequency. When the next crash happens, many of these investors will likely be thankful for the development and growth of liquid alts, and that they took the time to investigate and intelligently incorporate them into their broad portfolio strategies.
For more information, download a pdf copy of the whitepaper.