Improving Portfolio Diversification With Liquid Alternatives

Liquid Alts Provide Improved Diversification to Traditional InvestmentsA recent report by Cliffwater LLC asserts that liquid alternatives offer investors opportunities to more effectively diversify their portfolios, lowering their investment risks without sacrificing their potential returns. The report examines the expected returns from stocks, bonds and blended portfolios, and compares them with the expected returns from portfolios consisting of or including liquid alternatives. The findings: A “core liquid alternatives” portfolio will likely outperform a “60/40” stock/bond portfolio by nearly 2-to-1 on a risk-adjusted basis.

Alternative Investments Defined

Cliffwater defines an “alternative investment” as any investment or strategy that is not part of a diversified stock or bond portfolio. Traditionally, individual investors have allocated virtually all of their investments to diversified stock and/or bond portfolios, but – not surprisingly – these investments have a high correlation with the overall returns of the stock and bond markets.

Alternative investments have low correlations with the stock and bond markets. Correlation is measured between 1.0 and -1.0, with 0.0 meaning “no correlation.” A correlation of 1.0 would mean “perfect correlation,” while a -1.0 correlation would imply an inverse relationship between the investment and the broad market. Cliffwater defines “alternative investments” as investments and strategies with correlations of 0.75 or less.

According to Cliffwater, differences between traditional and alternatives funds can be found in the type of securities they invest in, their liquidity, their strategies and objectives, or any combination of these elements. Examples of alternatives under this definition include REITs, MLPs, TIPS, covered-call strategies, private equity, real estate, hedge funds, and most real assets. Emerging-market stocks and bonds, small-cap stocks, and high-yield bonds would not qualify under Cliffwater’s definition.

Alpha vs. Beta

Cliffwater divides the world of alternative investments into two broad categories: “Alpha driven” and “beta driven,” based on the reason for the strategy’s low correlation to the stock and/or bond markets.

Alpha-driven investments are typically employed by hedge funds and rely on a manager’s active decisions to produce uncorrelated returns. With the pursuit of alpha comes a level of security specific risk that isn’t present when indexing, and this leads to a performance correlation of less than 0.75. Hopefully, from the investor’s standpoint, the active manager is effective at generating market-beating returns. Examples of alpha-driven alternative strategies include:

  • Market neutral
  • Credit / distressed debt
  • Event-driven
  • Equity long/short
  • Global macro
  • CTA / managed futures
  • Multi-strategy

While alpha-driven strategies often rely on using stocks and bonds in alternative ways, beta-driven funds derive their low correlation with the stock and bond markets by focusing on entirely different kinds of securities. Examples of beta-driven strategies include:

  • REITs / real estate
  • MLPs
  • Private equity
  • Commodities
  • Liquid private assets
  • Infrastructure

Portfolio Construction

The objective of alternative investments is to lower overall portfolio risk without sacrificing long-term returns. In its report, Cliffwater suggests the proper mix of an alternative investments portfolio, and the place of alternatives within a larger, core-holdings portfolio, for maximizing risk-adjusted returns.

First, the core liquid alternatives mix: Cliffwater suggests 50% of alternatives be in “hedge fund” or alpha-seeking strategies; 30% in alternative income strategies; and 20% in inflation-protection strategies:

Hedge Fund Strategies (50%)

  • Long/short equity 15%
  • Event driven 15%
  • Market neutral 10%
  • Macro / CTA 10%

Alternative Income Strategies (30%)

  • Long/short credit 12%
  • Event credit 12%
  • Emerging market debt 6%

Inflation-Protection Strategies (20%)

  • TIPS 5%
  • Listed infrastructure 5%
  • REITS 5%
  • MLPs 5%

Cliffwater’s report states the expected return of such a portfolio would be 6.88%, with an expected risk of 7.1%. This yields a return/risk ratio of 0.97.

By contrast, a 100% stock portfolio is expected to outperform, with an expected return of 7.55% – but stocks have an expected risk of 18%, which is much higher than the core alternatives portfolio at 7.1%. This gives a 100% stock portfolio a return/risk ratio of 0.42 – far worse than the liquid alts portfolio. In fact, on a risk-adjusted basis, a 100% stock portfolio will underperform a 100% bond portfolio, according to Cliffwater (2.4% expected return , 4% expected risk, 0.60 return/risk ratio).

Cliffwater suggests that maximizing exposure to alternatives will improve risk-adjusted returns. Below is a breakdown of the expected return, expected risk, and return/risk ratio of “mixed” strategies:

  • 60% stock, 40% bond: 5.9% return, 10.9% risk, 0.54 return/ risk.
  • 50% stock, 30% bond, 20% alts: 6.2%, 10.3%, 0.60.
  • 40% stock, 20% bond, 40% alts: 6.5%, 9.8%, 0.67.

Conclusion

Cliffwater’s report also examines “non-core satellite liquid alternatives portfolios” for solving special-purpose objectives, such as inflation-protection portfolios, alternative-income portfolios, and absolute-return portfolios.

Until recently, the alternative investments detailed in Cliffwater’s report were available to accredited investors only. “Liquid alternatives” – mutual funds and exchange traded funds that are available to all investors – began gaining in popularity in the aftermath of the 2008 financial crisis. Now individual investors can access the same levels of diversification once reserved to institutional investors and high-net worth individuals.

For more information, download Cliffwater’s report on Diversification through Liquid Alternatives.

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