In a new whitepaper from ProShares, the company highlights one of the key benefits of allocating to alternatives: a smoother ride. This informative guide, Alternative Investments: Understanding their role in a portfolio, not only identifies how alternatives help mitigate market gyrations, but also takes a closer look at how to distinguish between and utilize both alternative asset classes and alternative strategies.
What is a Normal Market?
Ask most people what they expect their stock portfolios to return long-term, and they may say “around 9% in a normal market.” Over time, the S&P 500’s returns have averaged around that level, but their path to those “normal market” returns over the long term has had lots of short-term setbacks. Markets go up and they go down, and the fall can be significant when they go down – a smoother path with lower drawdowns can significantly enhance returns.
Imagine two portfolios held by Investor A and Investor B:
- Investor A’s portfolio generates successive annual returns of 6%, 6%, and 6%.
- Investor B’s portfolio generates returns of 30%, -20%, and 8%.
In simple terms, both Investor A and Investor B averaged returns of 6% — but in cumulative terms, Investor A’s more consistent approach generated 19.1% returns, while Investor B’s generated 12.3% returns.
ProShares compares the “normal” market’s long-term average of 9% returns to the 76-degree average temperature in Miami, Florida. But once every four years or so, Miami suffers a hurricane, and the same thing can happen in the stock market. If you’re at the age of retirement when one of these hurricanes hits, you can be wiped out without enough time for the market to recover. For this reason, investments with low correlation are essential for true diversification.
Investors have historically used the traditional asset classes of stocks and bonds to diversify their portfolios, but this approach is no longer working. The entire idea behind diversification is to reduce correlation, so that when one investment loses value, not all investments in the entire portfolio are likely to lose value. But over time, correlations have changed, and these correlations have increased further in down markets since 1989.
A Better Path
Not only have correlations between stocks and bonds increased, so have correlations between U.S. and foreign stocks. For this reason, investors may want to consider alternative investments, which include both alternative asset classes and alternative investment strategies – or often a combination of both.
Alternative asset classes include:
- Real estate
- Precious Metals
- Private equity
Alternative investment strategies include:
- Geared investing (i.e., leveraged investing and inverse investing)
- Long/short strategies
- Market neutral
- Absolute return
- Convertible/ merger arbitrage
- Managed futures
- Global macro
What these asset classes and strategies have in common is their limited correlation to the broad-market stock and bond market indices, and this lower correlation allows investors to diversify their returns, which may potentially limit their drawdowns and maximize the compounding effect of less-volatile returns.
Traditional and Alternative Correlations
As the graphic below demonstrates, traditional asset classes have exhibited relatively high degrees of correlation since 1994. Of alternative strategies, only the “2x Geared Large Cap” strategy has had high correlation with the S&P 500, and that’s because it’s simply a leveraged play on the S&P 500, doubling the potential gains or losses. Similarly, the “-1X Geared Large Cap Stocks” strategy is the equivalent of shorting the S&P 500, giving it a -1.00 correlation.
“Investing has become much more challenging,” according to ProShares. The publication of this informative whitepaper has made it at least marginally less so, as it may help investors and advisors build portfolios designed to withstand the occasional broad-market “hurricane,” and not just the fair weather of the “normal market.”