Neuberger Berman Looks at Investing with Alternatives

Neuberger Berman Looks at Investing with AlternativesThe world of investing has expanded and evolved since the financial crisis, according to Neuberger Berman, and investors must be careful not to revert back to old behaviors. In a recently published whitepaper, the $257 billion asset manager makes the case for alternative investments in general and liquid alts in particular as vehicles likely to enhance a portfolio’s risk-adjusted returns.

Buy High, Sell Low, Big Drawdowns

Behavioral finance research shows that human beings typically feel the pain of financial losses more deeply than the pleasure of financial gains. This should lead investors to seek low-volatility investments, but despite all of the data at hand, many investors habitually “buy high” late in a bull market and “sell low” when the market is in decline.

According to Neuberger Berman, the largest drawdown on the S&P 500 between March 30, 2007 and June 30, 2014 was 50.95%, while the largest drawdown on the MSCI World Index of global stocks was 53.65%. Hedge funds, by contrast – a good, rough approximation of the alts sphere – suffered a maximum drawdown of just 21.42% during that same time.

On this basis, it would seem hedge funds and the alternative strategies they employ should have more appeal, and they’ve always had support from the ultra-wealthy. In fact, as Neuberger Berman points out, alternative strategies have largely been the privilege of the super-rich, but that has changed with the advent of “liquid alts,” which are essentially alternative investments packaged under the ’40 Act rules governing mutual funds and ETFs. Now these strategies can be accessed by all investors, which should reduce the bear-market drawdowns for investors who allocate a portion of their portfolios to alternatives.

Reducing Correlation

The “traditional” portfolio allocation of 60% stocks, 40% bonds is no longer advisable, according to Neuberger Berman. This is because diversification is the idea behind the “60/40” split, and the idea behind diversification is to own assets that exhibit low correlation. To the extent that investments are correlated, meaning their prices tend to move in the same direction, there are no diversification benefits from holding those investments. The polices of the Federal Reserve and other global central banks have led to higher-than-usual correlation between traditional assets.

Alternative assets, by contrast, exhibit comparatively lower correlation between the broad stock and bond markets, as well as with one another. Alternatives essentially include anything that isn’t a stock or a bond that’s not highly correlated with stocks and bonds. Examples include real estate, private equity, infrastructure, master limited partnerships, and even stock and bond strategies that exhibit different characteristics than the broad markets, with limited correlation. These strategies include long/short equity, event-driven, global macro, and multi-alternative strategies that encompass several alternative strategies and may span multiple alternative asset classes.

Allocating to Alternatives

While private-placement alternative investments may be suitable for some accredited investors due to their illiquidity premia and low correlation to publicly traded investments, Neuberger Berman’s new whitepaper puts more of the focus on liquid alts. The paper’s authors tout the benefits of liquid alts by demonstrating how the asset class has the liquidity, transparency, and lower fees of mutual funds, while pursuing the strategies and return characteristics of much more expensive, much more exclusive alternative investments for the ultra-wealthy only.

How should one allocate to alternatives? Of course, this is a subjective question dependent upon each individual’s financial objectives and current standing – but Neuberger Berman recommends allocating according to risk, rather than capital. A traditional “60/40” portfolio may derive more than 80% of its risk from its 60% equity exposure, for example. Neuberger Berman offers a sample portfolio consisting of 42% broad-market equity, 30% broad-market fixed-income, and 28% to alternatives – the risk of such a portfolio would be derived as follows: 55% from equities, 11% from fixed-income, and 34% from alternatives, which Neuberger Berman considers more appropriate for the archetypal “average” investor.

For more information, download a pdf copy of the whitepaper.

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